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, the growing interest rate spread 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.
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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.
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.
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.
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.
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 the 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 eurozone, 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.
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.