How Does Monetary Policy Affect Forex Price Action?

For forex traders that pay attention to fundamentals, particularly in coming up with longer-term trade setups, monetary policy statements and central bank interest rate decisions are huge factors in predicting future price action. This is because central banks ultimately determine interest rates, which dictate the return on the country’s assets and its currency, and the level of liquidity in the markets. This is the core reason behind the idea of watching economic reports in order to figure out whether a currency is set to appreciate or depreciate.

Strong economic data reflects good economic performance, which can lead the central bank to hike interest rates or reduce the amount of cash circulating in the economy. In doing so, the lower supply of the currency in circulation boosts its value while the increase in interest rates translates to higher returns in holding the currency. All in all, these factors translate to an increase in demand for the currency, therefore increasing its value.

Conversely, worse than expected economic figures are reflective of weak economic performance of the country, which can convince the central bank to lower interest rates or increase liquidity in the economy. As a result, the higher supply of cash in the economy results to a drop in its value while the decline in interest rates means lower return on the country’s assets and currency. With that, there is less reason to hold on to the currency, so the drop in demand also results to a drop in value.

This explains why traders usually monitor monetary policy statements and central bank interest rate announcements. Other than showing if the central bank decided to change interest rates or asset purchases, central bank officials’ assessment and predictions for the economy are also typically included. In fact, some central bank governors hold press conferences right after the actual announcement in order to shed more light on their monetary policy plans. They can even talk about the factors, such as employment or inflation, that can influence their decision to change interest rates or money supply.

In addition, testimonies and media interviews of policymakers also influence forex price action as their remarks could be treated as clues for upcoming monetary policy decisions. A central banker can drop some comments saying that more asset purchases are necessary and this can lead to a strong selloff in the corresponding currency, as traders use these clues to price in their speculations for actual policy decisions. This explains why central bank speeches are typically included in forex economic calendar events.

How exactly does monetary policy drive price action in the forex market? Read this article to learn about the role of interest rate decisions in trading additional info.