{"id":661083,"date":"2025-06-20T15:00:28","date_gmt":"2025-06-20T13:00:28","guid":{"rendered":"https:\/\/ftmo.com\/?p=661083"},"modified":"2025-06-20T10:46:07","modified_gmt":"2025-06-20T08:46:07","slug":"how-central-banks-influence-financial-markets","status":"publish","type":"post","link":"https:\/\/ftmo.com\/en\/how-central-banks-influence-financial-markets\/","title":{"rendered":"How Central Banks Influence Financial Markets"},"content":{"rendered":"

There are a number of factors that influence financial market developments and the movement of investment instrument prices. One of the key players in the market (and not only in the forex market) are central banks. Their primary mandate is currency stability, and they use several fundamental tools to achieve this.<\/em><\/p>\n

Central banks play a key role in stabilising the economy and influencing financial market developments. To do this, they use a variety of monetary policy instruments, which can be divided into several main categories. Although each central bank has a different mandate (price stability, inflation targeting or employment), is based on specific conditions and adapts to different phases of the cycle or different inflationary environments, the instruments used by all central banks are virtually the same. However, investors and traders can use these differences and their understanding to their advantage, as they create diverse trading opportunities.<\/p>\n

Interest rate management<\/h2>\n

One of the central banks’ main and most important tools in achieving price stability is interest rates, or the base rate. Each central bank sets a different primary interest rate, which they can use to directly influence the value of their currencies.<\/p>\n

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For example, the US Federal Reserve sets the discount rate, which is the rate at which commercial banks can borrow money directly from the Fed. The European Central Bank sets the Main Refinancing Operations Rate, the Marginal Lending Facility Rate and the Deposit Facility Rate. The first is the rate at which banks borrow money from the ECB for one week, the second is the rate at which banks can borrow money from the ECB overnight and the third is the rate that banks receive for depositing money with the ECB overnight and determines the lower bound on short-term money market rates.<\/p>\n

Raising rates makes credit more expensive, which should lead to a moderation of high inflation and a cooling of the economy. Conversely, a cut in rates makes credit cheaper in the economy, which should lead to a boost in investment and consumption and consequent growth in the economy. An increase in interest rates in one country relative to those in other countries can make a currency more attractive to investors by offering them higher returns. This in turn can lead to an increase in the value of the currency or an appreciation of the currency against other currencies.<\/p>\n

Open market operations<\/h2>\n

Another powerful tool of central banks is the Open Market Operations. In these operations, central banks sell securities to or buy securities from commercial banks and other entities, usually with the aim of influencing the amount of money in the economy and thereby affecting short-term interest rates.<\/p>\n

When central banks buy securities (short-term government bonds), it increases liquidity in the banking system, which in turn boosts lending and thus the economy. Conversely, when a central bank sells securities, it reduces liquidity in the market in order to slow growth and thus inflation. In the first case, this is expansionary monetary policy and in recent years it has often been used in so-called Quantitative Easing. The second case is restrictive policy and is used by central banks in Quantitative Tightening.<\/p>\n

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Reserve requirements<\/h2>\n

Recently an underused tool of central banks in developed economies. It is now used more extensively by central banks in emerging economies. The basis of this instrument is the determination of the percentage of deposits that commercial banks must hold as reserves with the central bank. An increase in reserves leads to a reduction in the amount of money in the economy because banks have less money to lend, which in turn leads to a dampening of economic growth and inflation. Conversely, a decrease in reserves leads to an increase in liquidity, which results in a boost to credit and consumption and an increase in economic growth.<\/p>\n

Currency intervention<\/h2>\n

This is a rather extreme solution, where central banks directly enter the foreign exchange market in order to influence the exchange rate. They usually use their own reserves or the ability to create a theoretically unlimited amount of their own currency to do so.<\/p>\n

In the first case, they buy domestic currency to achieve appreciation, for example when they want to achieve a reduction in inflation, or, in the extreme case, to defend their currency against speculators (this can happen to some emerging economies).<\/p>\n

More often, however, central banks take the approach of weakening their own currency by buying foreign currencies with their own currency, of which they have a theoretically unlimited amount. In this case, market interventions can last for several years, and central banks seek to boost exports (cheaper domestic currency leads to cheaper domestic products in foreign markets) and achieve higher economic growth. This approach by central banks carries several risks and can significantly reduce the credibility of a central bank that poorly times an intervention or fails to end it, as happened to the Swiss central bank in 2015<\/a>.<\/p>\n

Forward Guidance<\/h2>\n

A much more widely used and more moderate tool than intervention in markets is forward-looking central bank communication, often referred to as froward guidance. Central banks use this verbal tool to influence markets’ expectations about the future path of interest rates or inflation. The aim is usually to increase the effectiveness of other instruments without having to implement or change them. However, the effectiveness of this measure may be limited if it conflicts with actual central bank actions.<\/p>\n

Depending on how the bank’s statement affects markets, it can be characterised as hawkish (when it indicates a tightening of monetary policy) or dovish (easing policy). For example, central bankers may then talk about policy normalisation when it is a return from a state of emergency to typical monetary policy. Other terms favoured by central bankers may then be the \u2018terminal rate\u2019, which denotes the maximum rate and an end to rate increases, or the neutral rate, which in turn denotes a rate that has neither a restrictive nor a stimulative effect on the economy.<\/p>\n

\"\"<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"

There are a number of factors that influence financial market developments and the movement of investment instrument prices. One of the key players in the market (and not only in the forex market) are central banks. Their primary mandate is currency stability, and they use several fundamental tools to achieve this. Central banks play a […]<\/p>\n","protected":false},"author":44,"featured_media":661290,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"inline_featured_image":false,"footnotes":""},"categories":[670],"tags":[],"class_list":["post-661083","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-trading-tips"],"acf":[],"yoast_head":"\nHow Central Banks Influence Financial Markets | FTMO<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/ftmo.com\/en\/how-central-banks-influence-financial-markets\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"How Central Banks Influence Financial Markets\" \/>\n<meta property=\"og:description\" content=\"There are a number of factors that influence financial market developments and the movement of investment instrument prices. 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