Central banks 101
Learning objectives
Describe what a central bank does and the mandate that drives its decisions
Explain why markets price an expected path of decisions rather than the next one alone
Distinguish the decision, the statement and the press conference, and say which usually moves price most
What a central bank is for
A central bank sets monetary policy for a currency area. Mandates vary, but most centre on price stability, usually expressed as an inflation target. Some carry more: the US Federal Reserve has a dual mandate covering both maximum employment and stable prices.
One thing to be clear about from the start. Central banks are not trying to move your currency pair. They are managing domestic conditions such as inflation, employment and financial stability. The effect on the exchange rate is a consequence, not an objective, and treating policy as though it were aimed at foreign exchange traders will mislead you.
The main tool
The policy rate is the headline instrument: the rate at which the central bank lends to commercial banks, which then propagates through the wider economy into mortgage rates, business borrowing and savings returns.
The textbook chain runs like this:
- Raise rates. Borrowing becomes more expensive, demand cools, inflation pressure eases, and the currency tends to attract capital seeking better returns.
- Cut rates. The reverse.
Note "tends to". The relationship is real and it breaks regularly. When growth fears dominate, a rate rise can weaken a currency instead, because the market reads it as damaging to the economy rather than attractive to capital. What is fundamental analysis? warned about this and it's worth repeating here.
Other tools
Quantitative easing and tightening. Buying or selling assets to influence longer-term interest rates and the amount of liquidity in the system, used when the policy rate alone isn't enough.
Reserve requirements. How much capital banks must hold, which affects how much they can lend.
Forward guidance. Simply telling markets what they intend to do. This sounds like the weakest tool on the list and is often the most powerful, for the reason the next section explains.
The concept that matters most
Here it is, and it's the counterpart to The big four: NFP, CPI, interest rates and GDP's point about surprises.
The market does not price the next decision. It prices an expected path of decisions stretching out over the coming year or two. Currency valuations rest on that whole path, not on today's rate.
Follow the consequence through, because it explains reactions that otherwise look irrational:
A central bank cuts rates, and the currency rises. How? Because the market had priced four cuts this year and the accompanying guidance suggested there would be two. The cut happened, and the expected path got shallower, and the path is what was being traded.
A central bank holds rates, and the currency falls sharply. Because the statement dropped a phrase about future tightening that had been there for six months.
Nothing about the current rate explains either move. Everything about the expected path does.
This is why forward guidance is so powerful. A central bank can shift a currency substantially without changing anything at all, purely by changing what people expect it to do next.
Three events, one afternoon
A central bank meeting typically produces three separate things, and they frequently produce three different market reactions.
1. The decision. Usually priced in advance, often the smallest mover of the three.
2. The statement. Analysts compare it word by word against the previous version. A removed sentence, a changed adjective, a shift from "will" to "may" can move markets more than the rate itself, because those words are the path.
3. The press conference and question session. Frequently the largest mover of the three. Prepared statements are drafted carefully by committee. Unscripted answers to unexpected questions reveal considerably more, and occasionally reveal something the committee would rather have kept vague.
The practical implication is worth noting: the biggest move often isn't at the announcement time. It can arrive thirty to sixty minutes later, during the questions. Traders who close a position at the announcement and consider the event handled sometimes discover this the hard way.
The banks behind the major currencies
Since currencies trade in pairs, as How traders make money: bid, ask, spread, long and short (Markets 101) established, you are always trading two central banks against each other. EUR/USD is the European Central Bank against the Federal Reserve. Either side can move the pair, which means a European trader watching only the ECB is watching half the trade.
Divergence
One concept explains a large share of the biggest currency trends.
Divergence is when two central banks move in opposite directions, or in the same direction at very different speeds. One tightening while the other eases produces a widening rate differential, and that differential is precisely what What is fundamental analysis? (Fundamental Analysis)'s chain describes. Sustained divergence has driven some of the largest and longest currency moves on record.
Convergence is the opposite: both banks doing broadly the same thing. The differential stops changing, and pairs tend to range rather than trend.
Knowing which of the two you're in is the single most useful piece of macro context available, and it changes which technical approaches are likely to work. Introduction to indicators: moving averages and RSI (Technical Analysis Basics) made the same point from the other direction: moving averages struggle in ranges, oscillators struggle in trends.
| Currency | Central bank |
|---|---|
USD | Federal Reserve |
EUR | European Central Bank |
GBP | Bank of England |
JPY | Bank of Japan |
CHF | Swiss National Bank |
AUD | Reserve Bank of Australia |
CAD | Bank of Canada |
NZD | Reserve Bank of New Zealand |
What to actually do with this
Three uses, in line with What is fundamental analysis? (Fundamental Analysis)'s honest framing:
- Know which way each relevant central bank is currently leaning. Not what they'll decide. Which direction they're facing.
- Know when the meetings are, and that the reaction may arrive at the press conference rather than the announcement.
- Understand that a surprise means a changed path, not a changed current rate. That single reframe explains most reactions that look wrong.
Key takeaways
Central banks manage domestic conditions under a mandate usually centred on price stability. Currency effects are a consequence, not an aim
Markets price an expected path of future decisions, not just the next one. A bank can cut rates and see its currency rise if the path became shallower than expected
The decision, the statement and the press conference are three separate events, and the largest move often arrives during the unscripted questions
Every currency pair is two central banks against each other, and divergence between them drives many of the largest sustained trends