How do central banks influence the foreign exchange market?

Through the various tools at their disposal, their announcements and monetary policies, they influence exchange rate movements and overall economic activity. Consequently, their actions are closely monitored by economic actors operating internationally who are exposed to exchange rate fluctuations. 

Find out what measures central banks can take to influence the foreign exchange market and thereby fulfil their role in monetary regulation.

What is a central bank?

To understand exactly where central banks’ influence on the foreign exchange market comes from, it’s best to start with a brief overview of what they are! 

Central banks are public, independent banking institutions that act as ‘banks for banks’. There are national central banks, such as the Swiss National Bank (SNB) or the Banque de France (BDF), but also supranational central banks, whose activities extend across an entire currency area, such as the US Federal Reserve (Fed) or the European Central Bank (ECB).

National central banks are owned by the states to which they are affiliated (which are their shareholders), whereas supranational institutions are owned by the various central banks of the currency areas they manage. Thus, for example, the ECB is owned by the central banks of the 19 countries in the euro area.

Good to know: Unlike most central banks around the world, the SNB issues shares to private investors, who hold almost a quarter of its total value.

In any case, central banks are key institutions in our economic system, as they control a number of levers that enable them to maintain banking and monetary stability within their respective countries or currency areas. Interest rates, inflation, exchange rates… Many of the factors closely monitored by economic actors fluctuate in line with central bank decisions.

What is the aim of central banks?

Central banks have a number of specific roles. 

Their primary objective is to maintain price stability within their economic area. Their aim is generally to maintain a reasonably positive inflation rate (around 2%) and to avoid deflation, in order to promote economic growth and the stability of their currency.

Another key role of central banks is to create the money in circulation. It is these institutions that issue the fiat currency (coins and banknotes) we use every day. 

Here too, they play a key regulatory role, as the amount of money in circulation depends on their monetary policy. They can therefore decide at any time to issue more money, or conversely to withdraw it, in order to influence its value. In the case of the world’s largest central banks, these decisions influence the international market.

It is also the central banks that manage the foreign exchange reserves of the relevant currency area or country. Whether it be gold or foreign currencies, central banks buy, sell or exchange them as required, always with a view to maintaining a stable exchange rate for their own currencies.

Finally, central banks also have the role of lending money to commercial banks, in particular by setting the key interest rates at which the latter must borrow from them.

Which central banks are the most influential?

Whilst there are, of course, many central banks around the world, not all of them wield the same influence over the foreign exchange market. Thus, the larger the currency area a central bank covers, and the more central the currency it manages is to global trade, the greater its influence will be.

In fact, the world’s largest central banks are:

• the US Federal Reserve (Fed), which issues the US dollar (USD), the world’s leading currency in international trade, and manages the monetary policy of the United States, the world’s leading economic power;
  
• the European Central Bank (ECB), which issues the euro (EUR), the single currency used by 19 European countries and central to trade across the continent, whilst managing the European Union’s (EU) overall monetary policy;
  
• the Bank of Japan (BoJ), which issues the yen (JPY) and manages monetary policy in Japan, the world’s third-largest economy;
  
• the Bank of England (BoE), which issues the pound sterling (GBP) and manages monetary policy in the United Kingdom, the world’s fifth-largest economy;
  

the Swiss National Bank (SNB), which creates and issues the Swiss franc (CHF) – a currency regarded by many investors as a store of value in times of crisis – and is responsible for the monetary policy of the Swiss Confederation.

How do central banks directly influence the foreign exchange market?

To carry out their various tasks, central banks have a range of tools at their disposal that have a significant impact on the foreign exchange market.

Firstly, they can adjust their key interest rates, which are the rates at which commercial banks borrow funds from them. Consequently, commercial banks will naturally pass these rates on to their customers by adjusting the cost of credit in turn. Thus, a high key interest rate can, for example, stimulate economic growth and limit deflation, i.e. the rise in the value of money.

Central banks also have a significant impact on the foreign exchange market when they issue, withdraw or exchange currencies rapidly and on a large scale. If a central bank withdraws a large amount of money from the market, the currency in question will become scarcer and its value will therefore rise. Conversely, if it prints money and floods the market with liquidity, the value of its currency will, in effect, fall.

It all depends, then, on the specific monetary policy of the government in conjunction with the central bank: some heavily export-oriented nations keep their currency’s exchange rate relatively low (through the actions of their central bank) in order to stimulate orders from abroad.

Finally, announcements by central banks also have a significant impact on the foreign exchange market. Economic actors and investors involved in the currency market closely scrutinise these statements in order to anticipate movements in exchange rates. Indeed, a single announcement can prompt many investors to change their market positions. 

You now know the ways in which central banks influence the foreign exchange market, with a view to maintaining price stability within the economy or the currency area they regulate. 

If you are directly affected by foreign exchange issues (regular exposure to exchange rate risk), it is in your best interests to keep a close eye on announcements and actions by central banks, but also to hedge against any adverse exchange rate movements. To do so, please do not hesitate to contact b-sharpe for their specialist services!