How Does Monetary Policy Influence the Forex Market?

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How Does Monetary Policy Influence the Forex Market

We closed the previous article (What is the Central Bank Monetary Policy) emphasizing that the main purpose of the central bank monetary policy is to ensure price stability and low inflation.

In this article, we propose to discuss the influence of monetary policy on the Forex market.

Monetary Policy – What is it?

When you start Forex trading, one of the aspects of primary importance to consider during your analysis is precisely that of monetary policy.

Monetary policy refers to the strategies employed by a country’s central bank regarding the amount of money circulating in the economy and its value. The primary goal of monetary policy is long-term economic growth, but central banks can set different goals for that purpose. 

In the United States, the goal of the Federal Reserve’s monetary policy is to promote employment, stable prices, and moderate long-term interest rates.

Interest rates and exchange rates are strongly correlated. 

Hence, Forex traders need to be aware of central bank monetary policies, as they can have a significant impact on currency pairs.

How does monetary policy influence the Forex market? 

How Monetary Policy Affects the Forex Market

One of the main functions of central banks is to regulate economic activity by raising or lowering interest rates. 

Interest rates strongly influence the Forex market. They encourage traders globally to invest their money in Forex trading in order to get a high return.

For many central banks, inflation is a priority. If inflation (usually measured by the (Consumer Price Index) is above the central bank’s target, the trader can expect to see tighter monetary policy. 

A rise in interest rates is a way of combating excessive inflation. Inflation reduces the value of a currency on the Forex market. Higher interest rates thus have a positive impact on the value of a currency. 

 For example, if rates are raised in the U.S., the dollar should rise relative to other currencies. As a result, the EUR/USD exchange rate should decrease.

Similarly, if keeping inflation under control is not the goal, the central bank will try to ease its monetary policy by reducing interest rates.

Reducing interest rates lowers the remuneration of assets denominated in the reference currency and favors inflation. Therefore, the affected currency will depreciate against the others. 

For example, if rates are cut in the United States, the EUR/USD exchange rate should increase.

The Most Important Central Banks in the Forex Market 

Here are the most influential central banks in the world, which with their monetary policy stance and interest rates affect the most important currencies in Forex, such as the US dollar, Euro, Pound, and Yen.

Interest rate decisions are typically announced on a monthly basis or at six-week intervals. Sometimes, a press conference follows explaining the interest rate decision and other monetary policy decisions made.

By combining the relative monetary policies of the two central banks, a trader can then predict the performance of a currency pair.