A currency’s interest rate is probably the most significant factor in determining the perceived value of a currency. So, knowing how a country’s central bank sets its monetary policy, such as interest rate decisions, is crucial to wrap your head around. One of the biggest influences on a central bank’s interest rate decision is price stability or “inflation.” Inflation is a steady increase in the prices of goods and services. It’s generally accepted that moderate inflation comes with economic growth. However, too much inflation can harm an economy, so central banks always watch inflation-related economic indicators, such as the CPI and PCE.
List of countries and Banks responsible for Interest rate Decisions
Central banks will likely increase interest rates to keep inflation comfortable, resulting in lower overall growth and slower inflation. This occurs because setting high-interest rates typically forces consumers and businesses to borrow less and save more, damaging economic activity. Loans just become more expensive while sitting on cash becomes more attractive. On the other hand, when interest rates are decreasing, consumers and businesses are more inclined to borrow (because banks ease lending requirements), boosting retail and capital spending, thus helping the economy to grow.
Interest Rate Expectations
Markets are ever-changing with the anticipation of different events and situations. Interest rates do the same thing – they change but don’t change as often. Most forex traders don’t focus on current interest rates because the market has already “priced” them into the currency price. What is more important is where interest rates are EXPECTED to go. It’s also important to know that interest rates tend to shift in line with monetary policy, or more specifically, with the end of monetary cycles. If rates have been going lower and lower over a period of time, it’s almost inevitable that the opposite will happen. Rates will have to increase at some point.
While interest rates change with the gradual shift of monetary policy, market sentiment can change suddenly from just a single report. This causes interest rates to change more drastically or even in the opposite direction as initially anticipated. So you better watch out!
Interest Rate Differentials
Pick a pair, any pair.
Many forex traders compare one currency’s interest rate to another currency’s interest rate as the starting point for deciding whether a currency may weaken or strengthen.
The difference between the two interest rates, known as the “interest rate differential,” is critical to watch.
This spread can help you identify shifts in currencies that might not be obvious.
An increasing interest rate differential helps reinforce the higher-yielding currency, while a narrowing differential is positive for the lower-yielding currency.
Instances where the interest rates of the two countries move in opposite directions often produce some of the market’s most considerable swings.
An interest rate increase in one currency combined with an interest rate decrease in the other is the perfect equation for sharp swings!
Nominal vs. Real Interest Rates
When people talk about interest rates, they refer to the nominal or the real interest rate.
What’s the difference?
The nominal interest rate doesn’t always tell the entire story. The nominal interest rate is the rate of interest before adjustments for inflation.
Real interest rate = Nominal interest rate – Expected inflation
The nominal rate is usually the stated or base rate you see (e.g., the yield on a bond). On the other hand, markets don’t focus on this rate but rather on the real interest rate.