Central Banks in the Forex Market

Central banks are not banks in the usual sense.

Central banks are the Government entities in charge of defining and implementing each country’s monetary policy. This involves controlling the supply of money, the availability of money and the interest rates. Central banks play a large role in forex trading because the forex markets are direct recipients and actors of these monetary policies.

Because Central Banks have tremendous financial powers – they are by far the biggest actors in the forex markets and dwarf any Commercial Bank – they can move the forex markets in a large way if they decide to. Even more so if they act in concert.

Despite the potential for moving the currency markets significantly, Central Banks cannot control the markets for an extended period of time, as the law of supply demand always wins ultimately.

Each country has its Central Bank (see below for exceptions) as one of each Central Bank’s duties is to print money in the local currency. Hence there are hundreds of them, from the United States of America to the smallest emerging economy.

The biggest and most recognizable Central Bank is the so-called Federal Reserve (Fed), i.e. the Central Bank of the USA. As the greenback is the most important currency, used in business, trade, commodity trading, traveling, etc and as the USA is the largest economy by far, every move or comment by the Fed is watched and analyzed in great depth by many traders hoping to get a clue for the direction of the dollar and the foreign exchange market.

The Fed’s current Chairman is Ben Bernanke. Technically he is one of the most powerful men in the World, even more so as in principle he does not report to the President of the United States. In the USA and elsewhere, Central Banks are separate from the Government because of conflict of interest, as the Government is always tempted to use the Central Bank to inject liquidity in the economy in times of crisis.

This political separation between Central Banks and Government is more or less a reality depending on the country and economic context, but it is the duty of the Governor or Chairman of the Central Bank to act independently and solely with the goal of establishing a sound monetary policy.

The second most important Central Bank is the European Central Bank (ECB). It is a recent exception to the rule that each country has it Central Bank, as the 16 countries of the Eurozone have renounced the control of their monetary policy in 1998, leaving that task to the ECB.

The ECB’s current Chairman is Jean-Claude Trichet. As it gathers nearly all the economic power of Europe (except England), the ECB is nearly as powerful as the Fed. Nearly as the relatively new euro is still only the distant second reserve currency behind the green back. As the largest European economy, Germany has a lot of influence on the policy of the ECB, including a dominant theme of fighting inflation coming from the 1930’s.

Other important Central Banks are the Bank of Japan (as Japan is the third largest economy and a large trading partner of other large economies), and the Bank of England which chose to stay monetarily separated from Continental Europe and to keep its beloved Pound.

Watch for the Central Banks of emerging countries such as China to gain more and more influence in the forex market. Especially as some of these exporting countries are building massive currency reserves in the hundreds of billions of dollars, which result from the trading surpluses.