Tools of a central bank
Generally used to control inflation
If inflation is going up, central bank will raise rates to discourage spending and encourage saving, thereby p[preventing prices from rising further
Cut rates when inflation is down to encourage borrowing. Investors borrow money and invest in the economy thereby driving the economy and creating more growth again
Banks tells the market that it desires a certain level of price for the currency
Bank may threaten the market that it may take action to correct price if it hits a certain level
If you have a central bank backing a trade like this, it can provide a good opportunity with very little risk because a central bank can print money whereas the rest of the market cannot. So the bank should typically win
Central bank language
The things the bank says rather than what it does.
By indicating where it wants the price to be, the bank hopes that the market will take the message and trade along with it
This is why credibility is so important to a central bank. If the market does nto believe that the bank will follow through with its threats if it needs to. The central bank will lose its effectiveness in being able to dictate the direction of the currency
Most of the time this works but sometimes it doesn’t. When it doesn’t the bank will have to step in and take action
Unconventional policy that many banks only use as a last resort
It is essentially printing money then injecting the money into the financial system
This devalues the currency and ensures a lot of cheap money floating around the economy
This currency devaluation further supports growth as a countries exports become much more competitive which is good for an economy
It is usually very effective, hence when a central bank decides to do QE many people will be playing close watch
When central banks implement these tools it gives us as traders opportunity to trade
Hence we should be looking at this indicators and then listen to what the central bank is saying.
But how can you figure out what the bank is thinking of doing. This is fairly simple. The central banks will very rarely focus on more than 1 or 2 things at any given time, so this makes it much easier to track and understand.
For example if a bank was worried about interest rates being too low, it will express its concern and as traders we know there is a good chance that they will cut interest rates in order to combat the falling inflation. In this case we can ignore the other indicators such as GDP and employment, so we can focus on the data of interest rate cuts and inflation. We can then evaluate the impact on the price of the currency and trade the correct way. If we follow what the banks are focusing on, our trading becomes a lot simpler
Focus on the indicators, focus on the central banks and once we know what they are focusing on we can then figure out what tools they can possibly use and how that will influence the market.