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Your Money > Investing Ideas Articles > Why Central Banks...
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By Kathy Lien
In this article, we look at the structure and primary focus of each of the major central banks and give you the scoop on the major players within these banks. We also explain how to combine the relative monetary policies of each central bank to predict where the interest rate spread between a currency pair is headed. The Eight Major Central Banks The one factor that is sure to move the currency markets is interest rates. Interest rates give international investors a reason to shift money from one country to another in search of the highest and safest yields. For years now, growing interest rate spreads between countries have been the main focus of professional investors, but what most individual traders do not know is that the absolute value of interest rates is not what's important - what really matters are the expectations of where interest rates are headed in the future. Familiarizing yourself with what makes the central banks tick will give you a leg up when it comes to predicting their next moves, as well as the future direction of a given currency pair. 1. U.S. Federal Reserve System (The Fed) Structure - The Federal Reserve is probably the most influential central bank in the world. With the U.S. dollar being on the other side of approximately 90% of all currency transactions, the Fed's sway has a sweeping effect on the valuation of many currencies. The group within the Fed that decides interest rates is the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board plus five presidents of the 12 district reserve banks. Mandate - Long-term price stability and sustainable growth Frequency of Meeting - Eight times a year Key Policy Official - Ben Bernanke, Chairman of the Federal Reserve. Following former chairman Alan Greenspan's retirement in January 2006, former U.S. President George W. Bush tapped Bernanke to head the Federal Reserve, given his four years of experience on the Fed board of governors. His views differ from Greenspan's in that he believes in inflation targeting and printing money to avoid deflation. The historic change of power at the U.S. central bank marks the first time in two decades that an academic, who may focus more on mathematical and econometric models, is chairing the Fed. Note: The global economic recession and banking crisis that started in 2007 has led the Fed to take unprecedented actions to try to stimulate the U.S. economy, including: - A rapid reduction in short-term interest rates to encourage consumers to borrow money. - An increase in the money supply to free up the frozen banking system. - Taking major steps to prop up bank balance sheets to enable banks to lend more money in an effort to make credit available. During the later half of 2008, these changes have strengthened the U.S. dollar. However, in the long term, the rapid expansion of money supply could be inflationary, which will lead to a weakening of the dollar. 2. European Central Bank (ECB) Structure - The European Central Bank was established in 1999. The governing council of the ECB is the group that decides on changes to monetary policy. The council consists of the six members of the executive board of the ECB plus the governors of all the national central banks from the 12 euro area countries. As a central bank, the ECB does not like surprises. Therefore, whenever it plans on making a change to interest rates, it will generally give the market ample notice by warning of an impending move through comments to the press. Mandate - Price stability and sustainable growth. However, unlike the Fed, the ECB strives to maintain the annual growth in consumer prices below 2%. As an export-dependent economy, the ECB also has a vested interest in preventing excess strength in its currency in order to minimize the risk to its export market. Frequency of Meeting - Bi-weekly, but policy decisions are generally only made at meetings where there is an accompanying press conference, and those happen 11 times a year. Key Policy Official - Jean-Claude Trichet, president of the European Central Bank. Prior to succeeding Wim Duisenberg as ECB president in November 2003, Trichet was the president of the Bank of France. He has a reputation for being a cautious and forthright banker, though many criticize his slow response to European economic stagnation and high unemployment. Typically seen as a hawk with a bias toward making preemptive moves to ward off inflation, Trichet has the huge responsibility of managing the monetary policy of 12 nations. Note: Due to the global recession, and in concert with the U.S. and the other G-7 countries, the ECB has also reduced interest rates and expanded the money supply. A strong euro has the effect of limiting the attractiveness of European exports, and thus a weakening of the euro is seen as a helpful development for large European exporters. The euro has weakened substantially from a high of 1.60 in April 2008 to a level around 1.28 in February 2009. 3. Bank of England (BoE) Structure - The monetary-policy committee of the Bank of England is a nine-member committee consisting of a governor, two deputy governors, two executive directors and four outside experts. The BoE is frequently touted as one of the most effective central banks. Mandate - To maintain monetary and financial stability. The BoE's monetary-policy mandate is to keep prices stable and to maintain confidence in the currency. To accomplish this, the central bank has an inflation target of 2%. If prices breach that level, the central bank will look to curb inflation, while a level far below 2% will prompt the central bank to take measures to boost inflation. Frequency of Meeting - Monthly Key Policy Official - Mervyn A. King, governor of the Bank of England. Prior to assuming the role of BoE governor on June 30, 2003, King was a professor at the London School of Economics. Initially joining the BoE in 1990, he became an executive director and chief economist in March 1991 and was promoted to deputy governor in 1997. King's "Goldilocks" monetary policy, which is neither too restrictive nor too accommodative, has propelled the U.K.'s economy into its longest streak of uninterrupted growth in 200 years. Note: Due to the current global recession, the Bank of England has also had to deal with severe economic disruption and has acted in concert with the other major central banks to reduce interest rates, expand money supply and even nationalize banks in order to stimulate the British economy. 4. Bank of Japan (BoJ) Structure - The Bank of Japan's monetary-policy committee consists of the BoJ governor, two deputy governors and six other members. Because Japan is very dependent on exports, the BoJ has an even more active interest than the ECB does in preventing an excessively strong currency. The central bank has been known to come into the open market to artificially weaken its currency by selling it against U.S. dollars and euros. The BoJ is also extremely vocal when it feels concerned about excess currency volatility and strength. Mandate - To maintain price stability and to ensure stability of the financial system. This makes inflation the central bank's top focus. Frequency of Meeting - Once or twice a month Key Policy Official - Masaaki Shirakawa is governor of the Bank of Japan. His nomination to the post was approved on April 9, 2008. After graduating from high school in Kokura, Shirakawa entered the University of Tokyo, graduating with a degree in economics. He joined the Bank of Japan in 1972, subsequently earning a master's degree in economics from the University of Chicago. His posts at the Bank of Japan have included the head of the ?ita branch and an overseas assignment in New York. Shirakawa joined the faculty of the graduate school of public policy at Kyoto University in 2006 and returned to the BoJ in 2008. Note: As the global economy has faltered, investments in carry trades involving the Japanese yen have been significantly reduced. This has had the effect of strengthening the yen as investors around the world have bought back the yen in the process of liquidating their positions. The consequent strengthening of the yen is applying pressure to the Japanese economy, which relies on large-scale exports for its growth. The BoJ often intervenes to weaken the yen to make exports more affordable. 5. Swiss National Bank (SNB) Structure - The Swiss National Bank has a three-person committee that makes decisions on interest rates. Unlike most other central banks, the SNB determines an interest rate band rather than a specific target rate. Like Japan and the eurozone, Switzerland is also very export dependent, which means that the SNB also does not have an interest in seeing its currency become too strong. Therefore, its general bias is to be more conservative with rate hikes. Mandate - To ensure price stability while taking the economic situation into account Frequency of Meeting - Quarterly Key Policy Official - Jean-Pierre Roth, chairman of the Swiss National Bank. Roth has spent most of his professional career at the SNB, starting in 1979; he assumed the role of chairman of the governing board in 2001. Roth is also a member of the board of directors of the Bank for International Settlements and is governor of the International Monetary Fund for Switzerland. 6. Bank of Canada (BoC) Structure - Monetary-policy decisions within the Bank of Canada are made by a consensus vote by the Governing Council, which consists of the Bank of Canada governor, the senior deputy governor and four deputy governors. Mandate - Maintaining the integrity and value of the currency. The central bank has an inflation target of 1-3%, and it has done a good job of keeping inflation within that band since 1998. Frequency of Meeting - Eight times a year Key Policy Official - Mark J. Carney is the governor of the Bank of Canada. He was appointed on February 1, 2008 for a term of seven years. He is the youngest of any central-bank governor within the G-8 nations. Carney completed a bachelor's degree in economics from Harvard University in 1988. He attended Nuffield College, Oxford, where he received a master's degree in economics in 1993 and a doctorate in economics in 1995. 7. Reserve Bank of Australia (RBA) Structure - The Reserve Bank of Australia's monetary policy committee consists of the central bank governor, the deputy governor, the secretary to the treasurer and six independent members appointed by the government. Mandate - To ensure stability of currency, maintenance of full employment and economic prosperity and welfare of the people of Australia. The central bank has an inflation target of 2-3% per year. Frequency of Meeting - Eleven times a year, usually on the first Tuesday of each month (with the exception of January). Key Policy Official - Glenn Stevens, governor of the Reserve Bank of Australia. Stevens has been with the RBA since 1980. Prior to succeeding Ian Macfarlane, Stevens held a variety of positions at the RBA, from head of the Economic Analysis Department to deputy governor in December 2001. As with his predecessor, he is expected to keep a close eye on inflation, which is expected to be a challenge as the Australian economy continues to boom. 8. Reserve Bank of New Zealand (RBNZ) Structure - Unlike other central banks, decision-making power on monetary policy ultimately rests with the central bank governor. Mandate - To maintain price stability and to avoid instability in output, interest rates and exchange rates. The RBNZ has an inflation target of 1.5%. It focuses hard on this target, because failure to meet it could result in the dismissal of the governor of the RBNZ. Frequency of Meeting - Eight times a year Key Policy Official - Alan Bollard, governor of the Reserve Bank of New Zealand. Before his appointment as governor of the RBNZ in September 2002, Bollard served as secretary of the treasury, chairman of the NZ Commerce Commission and director of the NZ Institute of Economic Research. Known as a strong inflation hawk with extensive economic training, Bollard has condemned large current account deficits and raised New Zealand interest rates to a high level of 8.25%. Putting It All Together Now that you know a little more about the structure, mandate and power players behind each of the major central banks, you are on your way to being able to better predict the moves these central banks may make. For many central banks, the inflation target is key. If inflation, which is generally measured by the Consumer Price Index, is above the central bank's target, then you know that the bank will have a bias toward tighter monetary policy. By the same token, if inflation is far below the target, the central bank will be looking to loosen monetary policy. Combining the relative monetary policies of two central banks is a solid way to predict where a currency pair may be headed. If one central bank is raising interest rates while another is sticking to the status quo, the currency pair is expected to move in the direction of the interest rate spread (barring any unforeseen circumstances). Examples Take the performance of the NZD/JPY currency pair between 2002 and 2005, for example. During that time, the central bank of New Zealand increased interest rates from 4.75% to 7.25%. Japan, on the other hand, kept its interest rates at 0%, which meant that the interest rate spread between the New Zealand dollar and the Japanese yen widened a full 250 basis points. This contributed to the NZD/JPY's 58% rally during the same period.
On the flip side, we see that throughout 2005, the British pound fell more than 8% against the U.S. dollar. Even though the United Kingdom had higher interest rates than the United States throughout those 12 months, the pound suffered as the interest rate spread narrowed from 250 basis points in the pound's favor to a premium of a mere 25 basis points. This confirms that it is the future direction of interest rates that matters most, not which country has a higher interest rate.
Another example is EUR/GBP in 2006. The euro broke out of its traditional range-trading mode to accelerate against the British pound. With consumer prices above the European Central Bank's 2% target, the ECB was clearly looking to raise rates a few more times. The Bank of England, on the other hand, had inflation slightly below its own target and its economy was just beginning to show signs of recovery, preventing it from making any changes to interest rates. In fact, throughout the first three months of 2006, the BoE was leaning more toward lowering interest rates than raising them. This led to a 200-pip rally in EUR/GBP, which is pretty big for a currency pair that rarely moves.
Ongoing Adjustments The ongoing global financial crisis, which become prominent in the later half of 2008, is occurring as a result of the deleveraging of global investments and a devaluation of bank assets. In light of the crisis, central bankers around the world have been forced to focus on the stimulation of their economies by taking extraordinary measures. Thus, FX traders must follow any changes made by central banks on an ongoing basis. Currency valuations will adjust on a relative basis, and traders will have to determine which currency is likely to appreciate, or depreciate, faster than its counterpart in order to be profitable. Useful links: |
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