How Do Central Banks Influence Currency Rates?

How Do Central Banks Influence Currency Rates

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Every country in the world has a central bank to oversee the economy and protect the national currency. Most countries have just one central bank, often call "national" bank but other examples also exist. The Federal Reserve is the central bank of the United States although every state also has a separate central bank operating on a state level. This is an exception, though.

The central banks usually operate with vast amounts of money because they handle all government accounts and every commercial bank is obliged to deposit a certain amount of money with the central bank. The central banks also profit from short term loans to commercial banks under their jurisdiction and traditionally are the largest banks in the state.

The most powerful weapon of the central banks regarding the currency rates is their right to change the base rates within the country. Every adjustment of the base rates affects the currency exchange market immediately; hence, has impact on the currency rate levels. That is why all market players watch closely every move and statement of the central banks and an interview of the Federal Reserve or European Central Bank governor can provoke bullish or bearish market trend in a few seconds.

Some central banks tend to intervene in the Forex market directly while others prefer to avoid implementing such measures. There are contrasting views on the benefits and harms caused by such interventions by the central banks but these interventions happen all the time and have a major impact on the market.

In the past few years, the central bank governors cannot utilise efficiently their main tool because the interest rates are at record low. Some countries maintain near-zero interest rates in the past couple of years trying to overcome the after-effects of the global financial crisis. During the peak of the global financial crisis, Bank of England decreased the base interest rates to their lowest level in history, for instance.

This unparalleled situation forced some central bankers to voice concerns that the world is on the verge of a currency rate war but such statements are some what exaggerated. Despite that, the central banks remain a major government body possessing the power to turn the market direction or to pour vast amounts of money to defend their currency. Backed by all the power of the state they are a key market maker and all currency rates depend heavily on their actions. The institution of the central bank must be considered as a place where the state manages the market.

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