When there is growth in a country, it will cause a hike in inflation. Consumers bear the brunt of this by paying more for goods. Global central banks have to experience this situation regularly and have devised several methods to reverse the pressure of high inflation. This includes changes to its monetary policy and undertaking derivative transactions. The strategies that are used by central banks curb the price increases. It is these actions that often provide forex traders with clues as to the direction the forex rates will take.
Effect of Interest Rates on Forex Rates
Most central banks opt for a rise in interest rates as soon as they are faced with rising inflation. This simple, quick method often yields the best results when compared with other methods of control. It is an easy system that increases the benchmark for commercial and retail bank loans to customers. The products that these increases affect immediately include student loans, corporate loans, mortgages, personal loans and vehicle financing. As soon as the interest rates are pushed up, the cost of money goes up, and this has an immediate negative effect on individuals and corporations.
Investors are constantly searching for investments that offer them high returns, with low risks. The same rule applies to foreign exchange investors. As soon as a country decides to increase its interest rate, the requirement for that particular currency increases.
This happened during the period from 2009 to 2011 when the Australian central bank decided to increase the rate of interest several times. By the time 2011 came round, the Australian dollar had risen by 26% more than the US dollar. When the global recession hit the country’s economy, its central bank had no option but to increase the interest rate to fight the heightened level of inflation. This decision by the Australian central bank caused an increase in the demand for the Australian dollar, particularly when compared to the US dollar.
An alternate strategy that is used to stabilise forex rates is for the central bank to increase the reserve requirements of the banking community. This causes a limitation on the monetary base in the country. By increasing this reserve limit, the central bank is simply increasing the minimum cash reserve that should be held by banking institutions. This prevents the banks from using all their cash on loans. This restriction that the central bank places on the distribution of funds means there is less money in the economy to buy the more expensive goods which causes price increases to be halted.
This is a very effective method to curb the forex rates of a country. The decision to do this often causes the value of the currency to rise, which increases demand for the currency.
By an adjustment in the bank’s reserve requirement, the country is acknowledging the need to curb their inflation rate and is using various methods to do so. This causes speculation among forex traders as they wait for the next round of adjustments.
As soon as the supply of money has begun slowing down because of the higher reserve levels required by the banks, forex speculation will cause the currency to increase and this will cause the inflation rate to decrease.