When a Central Bank is scheduled to announce an interest rate decision, market participants generally stop everything they are doing and listen to the announcement live. The immediate price action in most financial markets, directly after a Central Bank rate announcement can be extremely volatile. In this article, we are going to discuss two things:
How a Central Bank decides to raise or lower interest rates
How the market prices interest rate decisions into the price of an asset
Interest Rate Movement
In the United States, the Federal Reserve has a dual mandate to foster a healthy economy that is characterized by stable prices and maximum employment. In order to execute this mandate, the Federal Reserve is given complete control over the supply of money in the United States. Therefore, the Fed controls how many U.S. dollars are in the economy; furthermore, the Fed manipulates the amount of U.S. dollars in the economy in order to bring about certain economic developments.
The Federal Reserve’s primary weapon in manipulating economic growth is interest rates. When the Fed wants to stimulate economic growth, they simply increase the amount of U.S. dollars by lowering interest rates. Conversely, when they want to pull back the reigns on economic growth, they simply decrease the amount of U.S. dollars by raising interest rates. The question is, why would the Federal Reserve, or any Central Bank for that matter, want to slow economic growth? The answer is simple: inflation.
Inflation
As stated, one part of the dual mandate of the Federal Reserve is foster an economic environment as characterized by stable prices. When prices begin to rise too fast, then rapid inflation can set in. If inflation gets out of hand, then prices can literally get out of control. Two extreme cases in recent history have been in Germany and in Zimbabwe. In the 1930’s in Germany, people could not buy a loaf of bread with an entire wheelbarrow full of money. In Zimbabwe, the government actually began printing trillion dollar bills!
When prices begin to rise above target levels, which is usually around 3% per year, a Central Bank will usually raise interest rates in order to curb economic growth and stem inflation. Therefore, as a trader, it is very important to track key inflation data. When inflation data begins moving high, an interest rate hike is most likely coming soon.
Stimulate Growth
When economic growth is showing signs of slow-down, an interest rate decrease will usually be coming from the Central Bank. The lower interest rate will increase the supply of currency available in the economy and hopefully stimulate economic growth. A currency will generally fall in forex trading when these interest rates are lowered.
When key economic data begins to reveal that a Central Bank will be raising or lowering interest rates, then the market will actually price that information into the currency before the announcement is even made. Therefore, if the Reserve Bank of Australia is expected to raise interest rates next month, the market will actually buy the Aussie dollar now in order to price this information into the price of the Aussie. Then, when the announcement is made, the market usually will not move very sharply because it has already been priced in.
When It All Gets Crazy!!
Every once in a while, however, a Central Bank will surprise the market. At times a Central Bank will not raise interest rates or approve working capital loans when the market is expecting it to, or at times a Central Bank will raise interest rates when the market is not expecting it to. In both of these scenarios, wild volatility will usually unfold in the fx market as market participants rush to price in the unexpected news.