Governments used to play a lot bigger role worldwide in managing the value of their currency relative to other currencies, the exchange rate in other words. There was a time, not so long ago actually, where free markets in currency exchange, the forex market, did not even exist.
Governments would manage their currencies a number of other ways, instead of what is called a free-floating currency, letting the market decide upon its value. This is called a fixed exchange rate policy. They might just set it at a fixed rate relative to other currencies, peg it to a certain currency such as the U.S. dollar or a basket of other currencies, and take various other measures to directly influence the rate that it is traded at.
To various degrees, many countries do still engage in these practices today, even though most major currencies are now free floating and are traded on the foreign exchange market, otherwise known as the forex market or simply the FX market.
Governments can also pursue a hybrid strategy here, where currencies are allowed to float within a certain range which they deem acceptable for their purposes, and if and when the currency trades outside that range, they will step in.
Having a free-floating currency simply means that people will pay whatever prices they wish to exchange it with whatever else they wish, allowing the market to decide completely what the exchange rate is. It then becomes merely a matter of supply and demand.
Some governments may have a big interest in exercising more control over their exchange rate, for instance with China keeping the exchange of the Yuan down so that their exports will be relatively cheaper, especially cheaper compared to the U.S. dollar. U.S. authorities have objected to this, although the Chinese government does exercise exclusive control over this policy.
Even with the free market of floating exchange rates though, central banks of governments intervene to influence the price of their currency, through both direct and indirect means. The goals here are the same as with monetary policy in general, and include such things as increasing employment by seeking to devalue the currency, to look to manipulate inflation rates by increasing or decreasing the value of their currency, and to promote stability by looking to reduce volatility with their currency and make it more stable and therefore making it more appealing to do business in their country.
How Governments Influence the Forex Market Directly
Central banks, especially central banks of developed countries, maintain large currency reserves in both domestic and foreign currency, and this may be mobilized in times of need, when they want to influence the currency market and effect the relative value of their currency.
If the central bank wants to devalue their currency, they can simply sell their own currency on the market, whereby the increase in supply that causes will exert downward pressure upon it and lower its price, at least for a time.
If the goal is instead to raise the value of their currency, they can exchange foreign currency for domestic currency, which serves to increase the demand for their own currency and therefore raise its price, for now anyway.
Depending on the other currency traded in both these instances, this can also influence the other currency in the same way that it affects their own, only in reverse of course. The goal is always to affect the trading value of their own currency, but there may also be the goal of influencing a specific other currency as well, and this effect will always occur. So they can target a certain currency or spread it around by buying or selling several other currencies, as desired.
Governments have a choice of whether or not this foreign currency buying or selling will affect their own money supply, and they may choose what is termed a sterilized or non-sterilized approach to this. If they want to change the money supply, they will just perform the foreign currency transactions.
If they want to buffer or eliminate the effects of these operations on the money supply, they can do the opposite with their own bonds, which serves to offset, or “sterilize” the operation to various degrees, including completely. This all depends on what the overall objectives of the central bank are.
The biggest problem with these operations, whether sterilized or not, is that the market will end up correcting to a certain degree over time to this artificially created supply or demand, and therefore the objectives of the policy may not be fully realized. This still is a useful tool at times though, in the right proportion at the right time.
Forex traders therefore need to be aware of the planning and execution of these policies as they do have an effect on the market, especially short term.
Indirect Means of Governments Influencing Forex Markets
By way of their monetary policy, governments do affect the money supply of a currency, and money supply certainly is very relevant to the supply and demand of currency.
Governments have several means to affect their money supply, with a big one being their manipulation of interest rates. Governments do this by lowering or raising the rates that central banks charge banks to lend money, which has a number of consequences in the economy, including influencing the amount of money flowing in and out of a country.
If interest rates rise, this will encourage people to increase the deposits they hold in the country, due to having deposits there becoming relatively more attractive. This is because, by increasing their rates, the rates of the banks tend to increase as well, the rates that they lend at and the rates that they pay out for deposits.
The opposite happens when central banks lower their rates, as now having deposits in the country become less attractive, and having them elsewhere becomes relatively more attractive. So both of these measures influence the inflow and outflow of foreign currency.
Raising interest rates also reduces the money supply of a country, whereby lowering them increases it, and this is due to the money supply primarily consisting of credit. The more lending that goes on, the more money that is in circulation, and vice versa, which affects the inflation rate up or down.
A higher inflation rate devalues a currency, whereby lowering inflation increases it, because its actual value over time will be devalued more or less depending on how much inflation there is. This is all relative, and if one currency’s inflation rates go up and the other goes down, this will serve to make the more inflated currency less valuable.
Interest rate changes have more widespread effects upon the economy than just affecting foreign exchange rates though, and governments must also pay attention to how this is going to influence the business cycle, where the goal is to add stability and reduce the peaks and valleys.
So if interest rates are going to be used to influence the value of a currency, these other factors need to be taken into account and the overall strategy with interest rates are going to have to account for all factors in coming up with the best objective overall in shaping a country’s monetary policy.
What to Look for Here
All activities of central banks need to be on the radar of forex traders because these decisions, or even just mere speculation of them, can really move markets.
Sometimes central banks will just resort to creating a certain type of speculation to look to influence things, saying things like it looks like we might have to do this or that, and they may not even have any intention of doing it at the present time but they may want to create a perception of something to help achieve their purposes.
Rumors of the possibility of an interest rate change can influence the forex market in a meaningful way, in addition to other markets, and if they are looking to have it move in this direction, well placed speculation can achieve a certain purpose without actually having to do something to alter the money supply at all.
Leading indicators which may influence these decisions also needs to be paid attention to and looked upon carefully by forex traders, to look to assess the possibility of future policy changes and look to anticipate them.
This is going to matter more to those who hold longer term positions, as if you’re only in a position for a few days, what happens in 3 months may not matter that much, but even so, there may be some news that will affect your trade over the few days you are in it as well.
This means that a lot of reports and other news is going to play a role in the decisions of forex traders, both when looking to decide upon prospective trades and while engaged in them, if one or both of the currencies that they are trading are involved.
Some of this may pertain to central bank operations and some may be more of a general nature, and both drive forex prices. There is no financial market where fundamentals and news play such a big role as in the forex market, and this is something that all forex traders are wise to give the proper heed to.
Ideally, we will look to trade on both fundamental and technical indicators, what the market may be reacting to and the actual reacting, and together this is what drives the forex market.