Why central banks strongly influence the financial markets

ECB and FED are two of the world's most important central banks

In this article, we want to give you an understanding of why financial markets are so heavily influenced by the central banks, focusing on the Federal Reserve Bank (FED) and the European Central Bank (ECB). Learn about the importance and the regular events of both central banks.

What are central banks?

Central banks are institutions that are set up to monitor the banking system and regulate the money supply in an economy. For this purpose, various instruments such as changes in the money supply or the interest rate are available to central banks. In principle, it is of great advantage if a central bank can act independently of the respective government.

Why and how do central banks steer the financial markets and the national economy?

Central banks use their actions to steer financial markets and economies to make money more expensive by raising interest rates. The same result is achieved if the central bank makes less money available and thus reduces supply. Central banks do not always pursue the same goals globally.

One of the main mechanisms of action is the interest rate decision. With a rise in interest rates, the central bank is making investments more expensive, since loans can only be purchased at a higher price. An increase in interest rates thus indirectly signals a reduction in the economy, which under normal circumstances has a negative impact on the stock markets.

In the case of an interest rate cut, it’s exactly the other way round. With a cut in key interest rates, the central bank is pursuing a looser monetary policy. Market participants can get money more cheaply and invest it, which boosts the economy. Interest rate cuts are often associated with rising equity markets, although a decline suggests a weaker economy that needs to be helped with a rate cut.


Objectives of the FED and the ECB

The goals of both central banks are slightly different. Thus, the ECB’s primary objective is price level stability, which it pursues with an inflation target close to but below 2%. Subordinated support for the goal of healthy economic growth and other EU objectives. With the FED, however, there are 3 goals, which are more or less balanced. The FED’s activities aim to achieve a high level of employment, moderate long-term interest rates and price-level stability.

FED objectives

  1. High level of employment
  2. Moderate long-term interest rates
  3. Price stability

ECB objectives

  1. Inflation of a bit under 2%
  2. Healthy economic growth for EU

How could one anticipate interest rate changes or other actions of central banks?

Assuming that inflation in Europe is above 3%, then it is very likely that the ECB will adopt a more restrictive monetary policy, it will raise interest rates or reduce the amount of money.

Another example is a slowdown in the US, which also leads to increased unemployment. In such a case, it will be more likely that the Fed will lower interest rates to stimulate the economy.

When are the important events of the FED and the ECB?

The most important regular events of both central banks are the announcements of the interest rate decisions and the press conferences and the announcement of the minutes of the meetings.

  • FED: Decisions fall on the Federal Open Market Committee (FOMC). The FOMC makes decisions about the money supply and interest rates. By law, the FOMC has to meet at least 4 times a year, but in practice the FOMC meets around 8 times a year in an interval of 5 to 8 weeks. The exact dates can be viewed here.
  • ECB: ECB decisions are regularly announced with the interest rate decision every second Thursday of the month at 13:45 and the press conference at 14:30.

Why is it worth paying attention to these events?

Interest rate decisions and descriptions of policymakers’ thinking and, in particular, the future prospects of central bankers have a major impact on virtually all financial markets, so that equity, interest rate, currency and bond markets will show immediate reactions, which may be unavoidable, can be violent, as long as something unforeseeable is proclaimed. An interest rate decision can start a trend or lead to a necessary restructuring in a portfolio.

Of course, such events also allow the newstrading for advanced traders. Beginners, on the other hand, should avoid these market phases and close positions completely on the smaller timeframes to avoid the unnecessary risk.

Pay attention to interest rate turns

Particularly interesting are announced interest rate turns, because a turnaround does not happen in a few hours or days, but extends over weeks, months, even years. So if you experience an announced turnaround, must not force to respond quickly. If interest rates rise for the foreseeable future, this will affect interest rates, bonds and the local currency over the medium to long-term.

Where can I learn more about monetary policy and central banks?

Tradimo offers several excellent video courses on fundamental analysis in the Forex market, including monetary policy.


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