Central banks and interest rates

If you could follow only one type of fundamental event, it would be this one. Central banks decide the price of money in their country. Every rate change, and even every sentence from their chair, can move a currency by dozens of pips in a few minutes.

What a central bank does

A central bank issues the currency and steers its cost. Its main tool is the policy rate: the rate at which commercial banks borrow from it. When it goes up, credit gets more expensive, the economy slows and inflation eases. When it comes down, borrowing gets easier, which boosts activity.

It also has other tools: large-scale bond buying to push long-term rates down (quantitative easing), shrinking its balance sheet (quantitative tightening), and sometimes direct intervention in the currency market. But for a trader, the policy rate and the message that comes with it are what really count.

The seven central banks to know

The Fed has a quirk: its dual mandate forces it to watch the labour market as closely as inflation. That's why US jobs data moves the dollar so much. The SNB, for its part, has a history of stepping into the currency market to curb what it sees as excessive franc strength.

How a decision unfolds

Decision day almost always follows the same script. At a fixed time, the bank publishes a statement with the new rate and a short text explaining the choice. For the Fed and the ECB, a press conference follows, where the chair takes questions from journalists. Volatility often comes in two waves: at the statement, then during the press conference.

• The statement: the rate, the vote (unanimous or split), and the words chosen to describe the economy.
• The projections: some banks publish forecasts for growth, inflation and rates. The Fed's include the dot plot, the chart showing where each member expects rates to go.
• The press conference: every answer is analysed live. One off-the-cuff remark can reverse the move triggered by the statement.
• The minutes: the detailed record of the meeting, released a few weeks later, can reopen the debate.

Hawkish or dovish: reading the tone

Traders sort central bankers into two camps. A hawkish tone leans toward higher rates to fight inflation: it supports the currency. A dovish tone leans toward lower rates to support the economy: it weighs on the currency.

The decision itself is often known in advance, because the market has already priced it in. What surprises is the tone. A bank that holds rates but hints that a hike is coming can lift its currency more than a hike everyone expected. This is called a hawkish hold: a pause with a firm tone.

Forward guidance

Forward guidance is how a central bank communicates its future intentions. By signalling where rates are heading, it shapes expectations and therefore market rates, before it even acts. It's a powerful tool: a single line about "higher for longer" can push bond yields and the currency higher.

For a trader, the takeaway is direct: speeches between meetings matter too. Appearances by governors and voting members at conferences or in interviews are listed in the economic calendar. An influential member who changes tone is often an early signal.

The interest rate differential

A pair pits two currencies, and so two central banks, against each other. What moves EUR/USD is the comparison between the expected path of the ECB and that of the Fed. If the market expects more cuts in the US than in the eurozone, the gap narrows in the euro's favour and EUR/USD tends to rise.

The differential also explains the carry trade: borrowing in a low-yielding currency to invest in a high-yielding one. The strategy pays while markets are calm, but it unwinds violently in a panic, sending high-yield currencies sharply lower.