The one factor that is sure to move the currency markets is interest rates. Interest rates give international investors a reason to shift money from one country to another in search of the highest and safest yields. For years now, growing interest rate spreads between countries have been the main focus of professional investors, but what most individual traders do not know is that the absolute value of interest rates is not what's important - what really matters are the expectations of where interest rates are headed in the future.

Tutorial: Popular Forex Currencies

Familiarizing yourself with what makes the central banks tick will give you a leg up when it comes to predicting their next moves, as well as the future direction of a given currency pair. In this article, we look at the structure and primary focus of each of the major central banks, and give you the scoop on the major players within these banks. We also explain how to combine the relative monetary policies of each central bank to predict where the interest rate spread between a currency pair is headed. (To learn more, check out What Are Central Banks?)

Take the performance of the NZD/JPY currency pair between 2002 and 2005, for example. During that time, the central bank of New Zealand increased interest rates from 4.75% to 7.25%. Japan, on the other hand, kept its interest rates at 0%, which meant that the interest rate spread between the New Zealand dollar and the Japanese yen widened a full 250 basis points. This contributed to the NZD/JPY's 58% rally during the same period.

Figure 1

On the flip side, we see that throughout 2005, the British pound fell more than 8% against the U.S. dollar. Even though the United Kingdom had higher interest rates than the United States throughout those 12 months, the pound suffered as the interest rate spread narrowed from 250 basis points in the pound's favor to a premium of a mere 25 basis points. This confirms that it is the future direction of interest rates that matters most, not which country has a higher interest rate.

Figure 2

The Eight Major Central Banks

U.S. Federal Reserve System (The Fed)
Structure - The Federal Reserve is probably the most influential central bank in the world. With the U.S. dollar being on the other side of approximately 90% of all currency transactions, the Fed's sway has a sweeping effect on the valuation of many currencies. The group within the Fed that decides on interest rates is the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board plus five presidents of the 12 district reserve banks.

Mandate - Long-term price stability and sustainable growth

Frequency of Meeting - Eight times a year

European Central Bank (ECB)
Structure - The European Central Bank was established in 1999. The governing council of the ECB is the group that decides on changes to monetary policy. The council consists of the six members of the executive board of the ECB, plus the governors of all the national central banks from the 12 euro area countries. As a central bank, the ECB does not like surprises. Therefore, whenever it plans on making a change to interest rates, it will generally give the market ample notice by warning of an impending move through comments to the press. (Learn more in Why Interest Rates Matter For Forex Traders.)

Mandate - Price stability and sustainable growth. However, unlike the Fed, the ECB strives to maintain the annual growth in consumer prices below 2%. As an export dependent economy, the ECB also has a vested interest in preventing against excess strength in its currency because this poses a risk to its export market.

Frequency of Meeting - Bi-weekly, but policy decisions are generally only made at meetings where there is an accompanying press conference, and those happen 11 times a year.

Bank of England (BoE)
Structure - The monetary policy committee of the Bank of England is a nine-member committee consisting of a governor, two deputy governors, two executive directors and four outside experts. The BoE, under the leadership of Mervyn King, is frequently touted as one of the most effective central banks.

Mandate - To maintain monetary and financial stability. The BoE's monetary policy mandate is to keep prices stable and to maintain confidence in the currency. To accomplish this, the central bank has an inflation target of 2%. If prices breach that level, the central bank will look to curb inflation, while a level far below 2% will prompt the central bank to take measures to boost inflation.

Frequency of Meeting - Monthly

Bank of Japan (BoJ)
Structure - The Bank of Japan's monetary policy committee consists of the BoJ governor, two deputy governors and six other members. Because Japan is very dependent on exports, the BoJ has an even more active interest than the ECB does in preventing an excessively strong currency. The central bank has been known to come into the open market to artificially weaken its currency by selling it against U.S. dollars and euros. The BoJ is also extremely vocal when it feels concerned about excess currency volatility and strength.

Mandate - To maintain price stability and to ensure stability of the financial system, which makes inflation the central bank's top focus.

Frequency of Meeting - Once or twice a month

Swiss National Bank (SNB)
Structure - The Swiss National Bank has a three-person committee that makes decisions on interest rates. Unlike most other central banks, the SNB determines the interest rate band rather than a specific target rate. Like Japan and the euro zone, Switzerland is also very export dependent, which means that the SNB also does not have an interest in seeing its currency become too strong. Therefore, its general bias is to be more conservative with rate hikes.

Mandate - To ensure price stability while taking the economic situation into account

Frequency of Meeting - Quarterly

Bank of Canada (BoC)
Structure - Monetary policy decisions within the Bank of Canada are made by a consensus vote by Governing Council, which consists of the Bank of Canada governor, the senior deputy governor and four deputy governors. (For more on the Canadian dollar, check out The Canadian Dollar: What Every Forex Trader Needs To Know.)

Mandate - Maintaining the integrity and value of the currency. The central bank has an inflation target of 1-3%, and it has done a good job of keeping inflation within that band since 1998.

Frequency of Meeting - Eight times a year

Reserve Bank of Australia (RBA)
Structure - The Reserve Bank of Australia's monetary policy committee consists of the central bank governor, the deputy governor, the secretary to the treasurer and six independent members appointed by the government.

Mandate - To ensure stability of currency, maintenance of full employment and economic prosperity and welfare of the people of Australia. The central bank has an inflation target of 2-3% per year.

Frequency of Meeting - Eleven times a year, usually on the first Tuesday of each month (with the exception of January)

Reserve Bank of
New Zealand (RBNZ)

Structure - Unlike other central banks, decision-making power on monetary policy ultimately rests with the central bank governor.

Mandate - To maintain price stability and to avoid instability in output, interest rates and exchange rates. The RBNZ has an inflation target of 1.5%. It focuses hard on this target, because failure to meet it could result in the dismissal of the governor of the RBNZ.

Frequency of Meeting - Eight times a year

Putting It All Together
Now that you know a little more about the structure, mandate and power players behind each of the major central banks, you are on your way to being able to better predict the moves these central banks may make. For many central banks, the inflation target is key. If inflation, which is generally measured by the Consumer Price Index, is above the central bank's target, then you know that it will have a bias toward tighter monetary policy. By the same token, if inflation is far below the target, the central bank will be looking to loosen monetary policy. Combining the relative monetary policies of two central banks is a solid way to predict where a currency pair may be headed. If one central bank is raising interest rates while another is sticking to the status quo, the currency pair is expected to move in the direction of the interest rate spread (barring any unforeseen circumstances).

A perfect example is EUR/GBP in 2006. The euro broke out of its traditional range-trading mode to accelerate against the British pound. With consumer prices above the European Central Bank's 2% target, the ECB was clearly looking to raise rates a few more times. The Bank of England, on the other hand, had inflation slightly below its own target and its economy was just beginning to show signs of recovery, preventing it from making any changes to interest rates. In fact, throughout the first three months of 2006, the BoE was leaning more toward lowering interest rates than raising them. This led to a 200-pip rally in EUR/GBP, which is pretty big for a currency pair that rarely moves.

Figure 3

Curious to learn more about central banks and monetary policy? Check out Formulating Monetary Policy and the Federal Reserve Tutorial.

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Investing Basics

    Why Interest Rates Affect Everyone

    Learn why interest rates are one of the most important economic variables and how every individual and business is affected by rate changes.
  3. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  4. Economics

    Long-Term Investing Impact of the Paris Attacks

    We share some insights on how the recent terrorist attacks in Paris could impact the economy and markets going forward.
  5. Investing

    The Hunger Games Economy: 5 Unanswered Questions About Panem

    The Hunger Games's fictitious nation of Panem has technology, black markets, and government. But, we know precious little about Panem's economy and the reasons for its rampant inequality.
  6. Stock Analysis

    What Chevron Hopes to Find in its Exploration of the Great Australian Bight

    Learn about Chevron's agreements that allow the oil company to explore the Great Australian Bight and the state of current Australian oil projects.
  7. Economics

    Understanding Donald Trump's Stance on China

    Find out why China bothers Donald Trump so much, and why the 2016 Republican presidential candidate argues for a return to protectionist trade policies.
  8. Forex Education

    Top 6 Most Tradable Currency Pairs

    The most frequently traded currency pair is the euro/U.S. dollar. The euro is the base currency in the pairing, while the dollar is the quote currency.
  9. Forex Fundamentals

    How to Buy Chinese Yuan

    Discover the different options that are available to investors who want to obtain exposure to the Chinese yuan, including ETFs and ETNs.
  10. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  1. Is the financial services sector appropriate for a growth investor?

    Financial services are a great option for growth investors, historically speaking. From the end of World War II to 2013, ... Read Full Answer >>
  2. How do central bank decisions affect volatility?

    Volatility is defined and measured in several different ways, making it somewhat difficult to generalize the impact of central ... Read Full Answer >>
  3. Is Australia a developed country?

    Australia is one of the most developed countries in the world. The nation's per capita gross domestic product (GDP), one ... Read Full Answer >>
  4. Is Canada a developed country?

    Canada is a developed country. Countries that are considered to have developed economies exhibit strength in typical economic ... Read Full Answer >>
  5. How do you make working capital adjustments in transfer pricing?

    Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax ... Read Full Answer >>
  6. Are Canadian Pension Plans inflation-protected?

    The Canada Pension Plan protects pension holdings against inflation and adjusts its annual rates for inflation. The Canada ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center