Central Banks Unveil Forex Secrets

For effective forecasting of exchange rates, you should get into the heads of regulators

Central banks not only contribute to the formation of economic cycles but also tell investors where to invest. In this regard, the beginning of the study of fundamental analysis with monetary policy seems logical. Seeing the acceleration of inflation, the regulator raises interest rates, increases the cost of borrowing in the economy, which increases the risks of a recession. During a recession, on the contrary, it weakens monetary policy, reduces the cost of credit, which ultimately allows the economy to come to life. During the period of monetary expansion, liquidity increases and demand for securities grows. In times of restriction, on the contrary, it is customary to sell them in the secondary market and seek happiness at auctions.

If the activity of central banks is so important for forecasting exchange rates, then the question should be asked, what drives them? Most regulators cite inflation targeting as their main goal. It is understood as setting targets and monitoring their implementation using monetary policy instruments. In most developed countries, the 2% mark is used as a target (the USA, Eurozone, Britain, Japan, and others). For Australia, this figure is 2.5%, the Bank of Canada applies the target range of 2-3%.

The most effective tool for regulating CPI and other similar indicators is bid. If inflation is below the target and the central bank predicts that it will continue to do so, then it should lower the rate. Rumors of this are a bearish factor for the currency. For example, the talk of launching a European QE amid lowering the ECB refinancing rate in 2014 led to a drop in the EUR / USD quotes.

On the contrary, if inflation goes much higher than the target, then the central bank is forced to resort to the help of a restraining monetary policy. Thus, a rise in consumer prices in Britain to 3% made the Bank of England raise the repo rate, which became a strong argument in favor of the pound strengthening in the second half of 2017.

Thus, in order to understand which path a particular central bank will take, inflation needs to be monitored. However, financial markets are often more responsive to employment statistics than to consumer price data. Why?

The fact is that indicators such as unemployment and average wages are leading for CP I. The higher the wage, the more opportunities the consumer has to spend money. An increase in demand for goods leads to higher prices. According to the Phillips curve, the lower unemployment falls, the higher inflation rises. Indeed, in full employment, employers are forced to raise salaries in order to retain employees.

Interestingly, unlike most other central banks, the Fed officially targets both inflation and unemployment. There were times when there was a lively discussion about the automatic increase in the federal funds rate based on the mathematical relationship between the two key indicators. It is called the Taylor rule. In accordance with its formula, the Fed rate should currently be at 4%.

Thus, for the effective forecasting of exchange rates, the worldview of central banks should be clearly understood. It is based on the dynamics of indicators such as inflation and unemployment. Moreover, their deviations from the forecasts of the regulator are important. If the European HCPI at the end of 2018 exceeds the ECB estimate (+ 1.7%), then the central bank may raise the rate earlier than September 2019, which is a “bullish” factor for the euro. Conversely, the inability of inflation to reach the forecast will keep the regulator’s commitment to ultra-soft monetary policy, thus weakening the position of the bulls in EUR / USD.

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