How Major Central Banks Influence the Forex Market

Ever wondered what truly dictates the fluctuating values of currencies in the forex market?

Spoiler alert: it’s those mysterious institutions with the boring buildings but enormous power: central banks!

If you’ve ever watched your perfectly positioned trade get obliterated because some Fed chair cleared their throat during a press conference, you’re about to discover why your pips went poof! 🎭

The Core Function of Central Banks

A central bank’s primary mandate typically centers on price stability (controlling inflation) and supporting economic growth.

But the tools they use to achieve these goals directly impact currency values in several key ways:

1. Interest Rate Management

Interest rates are a key tool in a central bank’s arsenal, often considered one of the most direct for influencing currency values.

When a central bank raises its interest rates relative to other central banks’ rates, it can generally make its currency more attractive to investors seeking higher returns compared to what they can get elsewhere.

This increase in demand can often contribute to strengthening the currency against others. Conversely, lowering rates may tend to weaken a currency as investors might seek better yields elsewhere.

For example, the significant interest rate hikes by the Federal Reserve from near-zero to over 5% during 2022-2023 were a contributing factor to the considerable strengthening of the U.S. dollar against many major currencies.

This occurred partly because the U.S. offered higher interest rates compared to many other major economies at the time, creating a wider positive interest rate differential.

However, it’s important to remember that currency values are influenced by a multitude of factors beyond just interest rates, and the relationship is not always guaranteed or linear.

2. Inflation Targeting

Most modern central banks operate with explicit inflation targets (commonly around 2%).

When inflation rises above target, they typically tighten policy (raise rates); when it falls below, they ease (lower rates).

These actions affect currencies both directly through interest rate differentials and indirectly through economic performance expectations.

The Bank of England’s response to post-pandemic inflation illustrates this relationship clearly. When UK inflation surged to 11% in 2022, the BoE raised rates from 0.1% to 5.25% over 14 consecutive hikes. This aggressive stance helped strengthen the pound after an initial period of weakness.

3. Economic Stability Signaling

A central bank that maintains a reputation for competence and consistency tends to foster confidence in its currency.

Markets reward predictable, transparent policy approaches and punish perceived incompetence or erratic decision-making.

The Swiss National Bank exemplifies this effect. Despite Switzerland’s relatively small economy, the Swiss franc maintains its status as a premier safe-haven currency partly because the SNB has established a long-term track record of maintaining price stability and protecting the currency’s value.

Modern Monetary Policy Tools

Gone are the days when central banks just tweaked interest rates. The 2008 GFC crisis and COVID-19 pandemic forced them to get creative and expand their toolkits.

They developed new intervention methods that each impact currencies differently:

1. Quantitative Easing (QE)

QE, also known as Large-Scale Asset Purchases (LSAPs), involves a central bank creating money electronically and using it to purchase financial assets, typically government bonds. This process:

• Injects liquidity into the financial system
• Lowers longer-term interest rates
• Generally weakens the currency by increasing the money supply
• Encourages borrowing and investment
• Stimulates economic activity

During pandemic-era QE, the Federal Reserve was purchasing $120 billion in bonds monthly, dramatically expanding its balance sheet and contributing to dollar weakness during that period.

The Bank of Japan’s long-running QE program similarly contributed to persistent yen weakness over many years.

2. Quantitative Tightening (QT)

QT represents the opposite approach, where central banks reduce their balance sheets by allowing bonds to mature without replacement or by actively selling assets. This:

• Removes liquidity from the financial system
• Puts upward pressure on bond yields
• Generally strengthens a currency by decreasing the money supply
• Discourages borrowing and investment
• Slows down economic activity

The Federal Reserve began its quantitative tightening (QT) program in June 2022, initially allowing up to $47.5 billion in bonds to roll off its balance sheet monthly. This cap was later increased to $95 billion per month in September 2022, consisting of $60 billion in Treasury securities and $35 billion in mortgage-backed securities (MBS).

Similarly, the Bank of England reduced its QE-acquired assets from £895 billion toward £652 billion through 2023-2025, supporting the pound’s relative stability.

3. Forward Guidance

Modern central banks heavily utilize communication as a policy tool.

By signaling future policy intentions, they shape market expectations and often influence currency values before actual rate changes occur.

This explains why currencies sometimes move counter to what rate decisions alone might suggest.

When the Reserve Bank of Australia hiked rates in November 2023 but simultaneously indicated it might be their final increase, the Australian dollar actually fell because markets focused on the implied future direction rather than the immediate action.

4. Yield Curve Control (YCC)

This less common but powerful tool involves a central bank targeting specific longer-term interest rates rather than just short-term rates. The Bank of Japan pioneered this approach, capping 10-year government bond yields near 0% for years.

It’s like telling the market, “You can have any yield you want, as long as it’s the one WE want.”

YCC contributed significantly to yen weakness by ensuring Japanese yields remained extremely low even as global rates rose.

When the BoJ finally adjusted its YCC parameters in 2023 (allowing yields to rise to ~1%), the yen briefly strengthened as markets interpreted this as a step toward policy normalization.

5. Direct Currency Intervention

In extreme cases, central banks buy or sell their own currency directly in forex markets.

The Swiss National Bank famously maintained a 1.20 floor for EUR/CHF from 2011-2015 by creating unlimited amounts of Swiss francs to prevent appreciation.

Japanese authorities intervened in 2022 to support the yen when it reached multi-decade lows against the dollar.

These currency interventions can cause dramatic short-term price moves but may have limited long-term impact unless aligned with broader monetary policy.

The Divergent Paths of Major Central Banks (2022-2025)

Central banks operate with different policy cycles, adapting to their specific inflationary environments and economic conditions. Understanding these policy divergences creates trading opportunities:

Federal Reserve (Fed)

• Mandate: Dual focus on price stability (2% inflation target) and maximum sustainable employment.
• Recent Path: Implemented an aggressive hiking cycle, raising interest rates from 0-0.25% in March 2022 to 5.25-5.50% by July 2023.
• Current Stance: Began easing monetary policy with the first rate cut in September 2024. The federal funds rate now stands at 4.25-4.50% as of March 2025. The Fed is currently maintaining a cautious approach, with many policymakers suggesting that rates could remain at restrictive levels if the economy remains robust and inflation stays elevated
• USD Impact: The U.S. dollar strengthened significantly during the hiking phase, reaching multi-decade highs against several major currencies. It has since moderated as rate cuts began, but remains relatively strong due to comparatively high U.S. interest rates.

European Central Bank (ECB)

• Mandate: Maintain price stability with a 2% inflation target.
• Recent Path: Raised the deposit facility rate from 0% in July 2022 to 4% by July 2023. Began rate cuts in June 2024; now at 2.5% as of March 2025.​
• Current Stance: Adopts a data-dependent approach. Acknowledges economic uncertainties, including trade tensions and increased defense spending. Future policy adjustments will align with incoming economic data.
• EUR Impact: Strengthened during rate hikes; moderated with rate cuts.Remains relatively stable due to cautious monetary policy and solid economic fundamentals.

Bank of England (BoE)

• Mandate: The Bank of England’s primary mandate is price stability, defined as a 2% inflation target, with a secondary focus on supporting the government’s economic policy, including growth and employment.
• Recent Path: The BoE raised interest rates from 0.1% in December 2021 to 5.25% by August 2023, marking 14 consecutive rate hikes before pausing.
• Current Stance: The BoE adopted a “higher for longer” approach to tackle inflation, with the first rate cut occurring in August 2024, reducing the base rate to 5.0%. Additional cuts followed in late 2024 and early 2025, bringing the current base rate to 4.5% as of March 2025.
• GBP Impact: The British pound experienced significant volatility during the tightening cycle, including a near-parity scare with the U.S. dollar (USD). However, it has since stabilized as markets adjusted to the BoE’s restrictive stance and subsequent easing measures.

Bank of Japan (BoJ)

• Mandate: Price stability with a 2% inflation target, after decades of battling deflation.
• Recent Path: Maintained an ultra-loose monetary policy, including negative interest rates (-0.1%) and yield curve control (YCC) to cap 10-year government bond yields.
• Current Stance: Remains the most dovish among major central banks, but has begun gradual steps towards policy normalization.
• JPY Impact: The Japanese yen experienced significant weakness due to policy divergence with other major central banks. It reached 32-year lows against the US dollar in October 2022. While the yen has regained some ground since then, it remains relatively weak as the BoJ’s policy normalization process is still in its early stages.

Reserve Bank of Australia (RBA)

• Mandate: Triple focus on price stability (2-3% inflation), full employment, and economic prosperity.
• Recent Path: Raised rates from 0.1% to 4.35% between April 2022 and November 2023, in response to rising inflation pressures.
• Current Stance: In February 2025, the RBA implemented its first rate cut since 2020, reducing the cash rate by 0.25% to 4.1%. This decision was influenced by a significant decline in inflation.
• AUD Impact: Weakened against USD during Fed’s more aggressive hiking, with brief support during hawkish RBA surprises. Remains sensitive to global risk sentiment and commodity prices.

Reserve Bank of New Zealand (RBNZ)

• Mandate: Dual focus on price stability (1-3% inflation) and maximum sustainable employment.
• Recent Path: Early mover in hiking cycle (October 2021), raising OCR from 0.25% to 5.50% by May 2023. Then, the RBNZ began easing, cutting the OCR to 5.25% in August 2024, 4.75% in October 2024, and 4.25% in November 2024.
• Current Stance: First major central bank to pivot to easing. Continued easing with a 50 basis point cut to 3.75% in February 2025.
• NZD Impact: Initial strength during early hiking phase; weakening as markets anticipated and then saw rate cuts.

Bank of Canada (BoC)

• Mandate: Price stability (1-3% inflation range with 2% midpoint) with support for economic growth.
• Recent Path: Raised overnight rate from pandemic low of 0.25% to 5.0% by July 2023. It  began easing monetary policy, cutting the rate in October 2024
• Current Stance: Reduced its target for the overnight rate to 3% in January 2025. Indicated that the central bank anticipates a more gradual approach to monetary policy if the economy evolves broadly as expected.
• CAD Impact: Experienced depreciation against the U.S. dollar, due to economic uncertainty and global factors, though its impact is somewhat mitigated by potential future policy adjustments.

Swiss National Bank (SNB)

• Mandate: Price stability (under 2% inflation) with attention to economic developments.
• Recent Path: Moved from negative rates to 1.75% by mid-2023, then pivoted to cutting.
• Current Stance: Rapid easing cycle (125 bps of cuts in second half of 2024). As of March 2025, the SNB maintains a policy rate of 0.5%, with officials indicating readiness to implement further cuts, including the potential reintroduction of negative interest rates, should economic conditions warrant such measures.
• CHF Impact: Weakened after the rate cuts but still benefits from safe-haven flows.

People’s Bank of China (PBOC)

• Mandate: Focuses on multiple objectives, including promoting economic growth, ensuring financial stability, and maintaining a managed currency exchange rate.
• Recent Path: Easing bias through 2023-2024 amid growth challenges.
• Current Stance: “Moderately loose” monetary policy. Remains prepared to adjust its policies based on economic conditions, using tools such as reserve requirement ratios and interest rates to ensure ample liquidity and support the economy.
• CNY Impact: Managed depreciation with intervention to prevent excessive weakness.

Trading Strategies Based on Central Bank’s Monetary Policy

Are you interested in leveraging central bank policy shifts for trading opportunities? Below are some foundational trading strategies to get you started.

1. Policy Divergence Trading

One of the most reliable forex strategies involves identifying central banks moving in opposite policy directions.

When one bank is hiking while another is cutting, the currency pair typically moves in favor of the tightening bank’s currency.

How to use it: Chart out the expected rate path for major central banks and look for the ones moving in opposite directions. When you find them, that currency pair is likely to trend.

Example: This explains why USD/JPY climbed dramatically in 2022-2023 (from ~115 to ~150) as the Fed aggressively hiked while the BoJ maintained negative rates. Similar divergence opportunities emerged between various currency pairs throughout this period.

2. Forward Guidance Analysis

Since markets price in expectations, analyzing the tone and forward guidance of central bank communications often proves more valuable than reacting to the rate decisions themselves.

What to look for:

• Changes in language from previous statements
• Shifts in inflation or economic growth forecasts
• Voting patterns among monetary policy committee (MPC) members
• Press conference tone and emphasis

Example: Sometimes a 0.25% rate hike with dovish language (hinting at a pause) can actually weaken a currency. The RBA’s November 2023 “dovish hike” sent the Aussie dollar down despite the rate increase.

Beware the Consensus Trade: When “everyone” expects the same central bank move, the market reaction might be underwhelming. The surprise factor matters!

3. “Data-Dependent” Trading

Most central banks now emphasize their “data dependent”.

This means that their decisions on monetary policy, particularly interest rate adjustments, are based on the evolving economic data rather than a predetermined schedule or commitment.

This approach allows the central bank to maintain flexibility in their decision-making process and respond to changing economic conditions.

Data dependency involves:

Analyzing a wide range of economic indicators, including:

• Inflation measures (CPI, PPI, PCE)
• Employment/unemployment figures
• GDP growth
• Wage statistics
• Labor market conditions (quits vs. hires)
• Consumer sentiment (how people feel often matters more than how they’re actually doing)

Estimating key economic variables:

• r* (the neutral interest rate)
• u* (the natural rate of unemployment)

Avoiding overreaction to individual data points:

• Central bank officials aim to extract meaningful signals from the noise of economic data1
• They consider the overall economic outlook rather than focusing on single indicators

Maintaining credibility and managing inflation expectations:

• By emphasizing data dependency, the central bank can adjust policies as needed without committing to specific targets or timelines

4. Intervention Awareness

Particularly for currencies like the Japanese yen and Swiss franc, recognizing potential intervention points is crucial.

Warning signs:

• Officials commenting on “excessive volatility”
• The phrase “disorderly markets” suddenly appearing in speeches
• Currency moves becoming front-page news
• Historical intervention levels being approached

Central Bank Terminology for Forex Traders

Understanding central bank jargon helps interpret policy signals. It’s like learning a new language where everyone speaks in code: Make sure you’re familiar with these terms:

• Hawkish: Favoring tighter monetary policy (higher rates, QT).
• Dovish: Favoring looser monetary policy (lower rates, QE).
• Forward Guidance: Communication about likely future policy direction.
• Policy Normalization: The process of returning from emergency settings to more typical monetary conditions.
• Inflation Targeting: Setting monetary policy to achieve a specific inflation rate (usually around 2%).
• Terminal Rate: The expected peak interest rate in a hiking cycle.
• Neutral Rate: The theoretical interest rate that neither stimulates nor restricts the economy.

Financial Stability: The Secret Third Mandate

While not always explicitly stated, financial stability has become central banks’ unofficial obsession.

Financial stability exists when the financial system—including its intermediaries, markets, and infrastructure—is resilient to shocks and the correction of financial imbalances.

Financial stability has gained prominence in central bank operations and policy-making for several reasons:

1. Historical context: Many central banks, including the U.S. Federal Reserve, were originally established with financial stability as a key concern
2. Post-crisis reforms: The 2007-09 financial crisis led to significant reforms, such as the Dodd-Frank Act in the U.S., which assigned the Fed with new responsibilities in promoting financial system stability.
3. Macroprudential approach: Central banks have adopted a “macroprudential” approach to supervision and regulation, looking across the entire financial system for risks.

A macroprudential approach refers to a set of policies and frameworks aimed at safeguarding the stability of the financial system as a whole, rather than focusing on individual institutions. It seeks to mitigate systemic risks that could disrupt the broader financial system and negatively impact the real economy.

The Role of Central Banks in Promoting Financial Stability

To mitigate systemic risks, central banks might implement measures that can influence currency demand and supply, thereby affecting exchange rates.

Aside from managing interest rates, central banks contribute to financial stability through various means:

• Financial Supervision and Regulation: Some central banks are responsible for supervising and regulating financial institutions to ensure their safety and soundness, thereby contributing to the overall stability of the financial system. ​
• Lender of Last Resort: In times of financial distress, central banks may provide emergency funding to financial institutions to prevent systemic crises and maintain confidence in the financial system.

While “financial stability” may not always be an official mandate for central banks, just know that it has undoubtedly become an unofficial third mandate alongside price stability and supporting economic growth.

If/when the sh*t hits the fan, don’t be surprised when it becomes the primary mandate!

Bottom Line

Central banks remain the single most influential force in forex markets, with their policy decisions potentially impacting currency values faster than you can say “stop loss”:

The post-pandemic monetary cycle has demonstrated the power of these institutions, as they first deployed unprecedented stimulus and then orchestrated one of the most aggressive tightening campaigns in modern financial history.

For forex traders, developing a nuanced understanding of central bank objectives, tools, and communication patterns is not merely advantageous, it’s essential!

By monitoring the evolving policy stances of major central banks and recognizing how they interact with one another, you can identify potential currency trends before they fully develop.

As we move through 2025 and beyond, central banks will continue adjusting their approaches in response to evolving economic and inflationary conditions.

Success in the forex market will depend significantly on anticipating these shifts and understanding their implications for currency valuations.

Remember: Central banks aren’t trying to help or hurt traders. While you might think their job is to create chaos in your trading account at the most inconvenient times. their real job is focused on managing their economies. As retail forex traders, we’re just along for the ride, trying to anticipate their next moves!