Central banks are an impactful force across global markets, but how do they decide to mold policy?
Central bank policies have a direct and oftentimes immediate impact on the FX markets. As central banks loosen or tighten policy, their respective currencies become more or less attractive to hold. Understanding the process by which central banks make such decisions is a valuable skill to any trader, as being able to predict what a central bank might do will give a greater depth of understanding to each key economic data release.
The ever-evolving world economy has led to continual evolution of central bank policy frameworks. Monetary policy setting was once based on simple rules and equations that dictated a proper level of interest rates given the relationship between inflation and employment. The world has since become much more complex, and central banks have moved away this simplistic, rules-based approach to policy.
Once the central bank reconciles new economic data and projections with its framework, it makes a decision. While such a decision was once as simple as raising or lowering rates, central bank toolkits have expanded dramatically since the financial crisis as central banks have played a larger role in supporting the financial system and the overall economy.
Following the financial crisis, central banks set out on a journey to manipulate longer-term rates and flood the financial system with liquidity in order to better support economic spending, growth, and inflation. Through large-scale asset purchase programs, better known as, central banks have bought large quantities of government debt from the open market.
QE programs are implemented in the same way that open market operations are. Traders in the central bank’s policy implementation division publish announcements and schedules detailing their purchase plans. Their counterparties submit a list of bonds they are willing to sell to the central bank and the central bank’s traders select and transact with the most competitive bids.
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