Tools Of A Central Bank

with No Comments

19

Tools of a central bank

Interest rates

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

Vice versa

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

Price controls

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

Quantitative Easing

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.