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Central Banking: A Study of Policy and Market Effects

By , Forex Trading Instructor
16 January 2012 17:19 GMT

Previous: Interest Rates and the FX Market

Central Banking

Central Banks are institutions are utilized by nations around the world to assist in managing their commercial banking industry, interest rates and currency. The idea of a Central bank is not a new one though. The first examples of a central banking authority were seen in China with the first issuance of paper money nearly 1000 years ago. Other examples date back to the Knights Templar, looking for credit to finance their crusades. Many of the processes being tested in the past have been refined over hundreds of years of practice resulting in today’s modern banking systems.

Examples of Central Banking today include the Federal Reserve of the United States, European Central Bank (ECB), Bank of England (BOE), Bank of Canada, and the Reserve Bank of Australia. There sphere of influence of a central bank may range from a single country such as the Reserve Bank of Australia or, represent policy created for a region or group of countries such as the ECB. To show the effects of Central Banking in a modern society, we will focus on the Federal Reserve of the United States and their policy decisions.

The Fed

The origins of Central Banking developed in the United States as far back as the Revolutionary War. In 1775 the Continental Congress met with the intention of developing a national currency and a plan to finance the developing war effort. The sole value of the “Continental” relied on the future tax collection of the future independent nation. As the revolution drew on with no conclusion, overprinting and counterfeiting brought about the devaluation and ultimate demise of the Continental currency. When the constitutional convention of 1787 convened, one of the first priorities was the discussion of the current financial system. As of 1791 the First Bank of the United States was issued its original charter.

Much has changed since 1787! The Central Banking system of the United States is now known as The Federal Reserve, or simply the “Fed”. The modern Fed was created in 1913 by congress with the intent of providing the United States with a safer and consistently stable monetary system. The Federal Reserve achieves its goals by conducting monetary policy, and supervising and regulating banks.

Central_Banking_a_Study_of_policy_and_market_effects_body_central_bank_SS.png, Central Banking: A Study of Policy and Market Effects

Bank Regulations

The primary reason for the creation of the modern Federal Reserve System was to stave off banking panics in the United States. This issue came to a head in 1907 during what has been dubiously called the “Bankers Panic”. During this time, stocks on the New York Stock Exchange fell nearly 50% from their 1906 highs. The end result of this crisis is that many banks and business were forced to either close or declare bankruptcy. As people worried they funds were unsafe at local banks, they would rush to withdrawal funds creating a massive shortage of capital.

The Federal Reserve is setup to avert a crisis such as the one experienced in 1907. A system is set in place where short term needs of small local banks can be handled if a “run” on deposits occurs due to unexpected withdrawals or regional emergencies. The Federal Reserve can easily loan money to small regional banks at a nominal charge called the discount rate. Once a run has been met, banks can then return their obligation back to the Federal Reserve. This policy is one of many tools the fed utilizes assuring the solvency of financial markets and bank depositories.

What Exactly is Monetary Policy

Monetary policy is another tool directly at the Feds disposal to achieve its goals. Monetary policy describes the actions that the Fed takes to control the money supply inside of the United States. Depending on the state of the economy, the fed may select to either take an expansionary or contractionary policy, with the supply of money being influenced by two specific methods.

During times of economic slowdown, the Fed often selects to peruse an expansionary policy in the market. This process begins by expanding the monetary base and decreasing interest rates. The theory behind expansionary policy is to make money more available to banks and businesses in an attempt to increase growth and development. As a byproduct of an expansionary policy, fundamental indictors such as GDP are expected to grow and unemployment decline.

As the economy heats up, the Fed will consider taking on contractionary measures. At this point, the monetary base may begin to be restricted and interest rates can begin to increase. These actions make excess investment capital scares, and place a higher premium on lending. With less capital circulating, the economy is expected to contract and slow down. During a time of contraction, GDP is expected to decline and unemployment to contrarily increase.

Effects on Currency Rates

By controlling the money supply, and interest rates, the decisions mandated by the Federal Reserve System have a direct influence to the strength / weakness of the USD. Previously, we discussed that when an expansionary policy is put in place, the monetary base is increased and interest rates decrease. By supplying more money to the market and banks than what is demanded values increase. This over supply of funds creates a flood of cheap dollars onto the open market, effectively diluting their value. The same holds true with Interest rates in an expansionary environment. As interest rates move lower, it becomes easier to borrow funds and the value of a currency tends to decline.

The opposing scenario holds true when the Fed assumes a contractionary monetary policy. A decrease in money supplied on the open market make capital scare. Scarcity drives up value for remaining funds and increases the value of currency. Increasing interest rates also has the same affect. Higher rates make funds more expensive to borrow, the barrier for lending decreases the availability of funds. Again as capital becomes scarce, currency prices are expected to appreciate.

What this Means to Traders

Knowing which policy cycle a central bank is taking can be a fundamental asset to currency traders. One recent example of a bank taking expansionary measures is the European Central Bank. One policy the European Central bank has employed is the lowering of interest rates. From their peak levels of 4.25% in 2008, the rates have declined 3.25% to an effective rate of 1.00%. Factor this in with an expanding monetary base as new debt is extended and refinanced, the Euro has been in a state of decline versus most major currency pairs. Below we can see the Euros descent against the Australian Dollar from 2008 – present. So far this pair has produced a maximum trend of over 8000 pips. We can use this directional bias in the market to then proceed and trade the strategy of our choice.

Central_Banking_a_Study_of_policy_and_market_effects_body_Picture_2.png, Central Banking: A Study of Policy and Market Effects

Next: The Fundamentals of the European Debt Crisis

---Written by Walker England, Trading Instructor

To contact Walker, email WEngland@FXCM.com . Follow me on Twitter at @WEnglandFX.

To be added to Walker’s e-mail distribution list, send an email with the subject line “Distribution List” to WEngland@FXCM.com .

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16 January 2012 17:19 GMT