February 25, 2024

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Business & Finance

Reasons Why Monetary Policy Drives Forex Rates

2 min read

Forex traders that use fundamental analysis for making trade decisions, especially in determining swing trade ideas, monetary policy decisions and central bank statements provide good clues in forecasting price behavior of currencies. After all, it is the central bank officials that decide on the level of interest rates and money supply. In turn, these determine the rate of return on the country’s currency and the supply of cash circulating in the economy. This is also why forex traders often keep close tabs on economic releases, as these help them predict if a currency is about to rally or drop.

Upbeat economic data or figures that show consistent improvement across time periods reflect improving economic performance, which eventually translates to an interest rate hike or a tightening of monetary supply. This is because good economic data means that the economy can survive even without additional stimulus from the central bank. By the Law of Supply and Demand, the lower amount of currency in circulation in the economy increases its value. At the same time, the hike in interest rates means that there’s a higher return in holding the country’s assets and currency, leading it to appreciate.

On the other side of the coin, poor economic figures mean that the economy isn’t doing so well. This can lead the central bank to slash interest rates by a few basis points or flood the economy with extra cash. The increased money supply in the economy translates to a reduction in value of the currency, as dictated by the Law of Supply and Demand. The drop in interest rates reflects lower return on holding the currency, so there’s weaker demand for the currency, leading it to depreciate.

This explains why traders usually monitor monetary policy statements and central bank interest rate announcements. Other than showing if the central bank decided to change interest rates or asset purchases, central bank officials’ assessment and predictions for the economy are also typically included. In fact, some central bank governors hold press conferences right after the actual announcement in order to shed more light on their monetary policy plans. They can even talk about the factors, such as employment or inflation, that can influence their decision to change interest rates or money supply.

Speeches and interviews by policymakers also tend to contain helpful clues on future monetary policy. When a policymaker or voting committee member is quoted saying that further quantitative easing is likely, the corresponding currency tends to sell off sharply as traders anticipate and price in an actual monetary policy move. This is why testimonies by important central bank officials are usually marked on the forex calendar, as traders tend to pay close attention to their remarks.

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