Interest Rates and Central Banks

Interest rates are, by far, the most important piece of fundamental analysis. Each currency has its own central bank, which has a duty to set interest rates for borrowers who need its specific currency.

Interest rates are important because they are the price of money. If you were to step into a bank for a loan, and the lending officer were to offer you a 20% annual rate, you probably wouldn’t borrow the money. Twenty percent in annual interest is just too much to pay to borrow money.

But if rates were 0% per year, then you’d borrow all the money you could and spend it like crazy. Money would be so inexpensive that you could find a bunch of really good reasons to borrow at 0% that you couldn’t find at 20%. Investors, business owners, and others like really inexpensive money—they can use it to grow their businesses faster.

Interest Rates vs. Growth and Inflation

Central banks, like the Federal Reserve Bank in the United States, or the European Central Bank in Europe, work to find a careful balance between inflation and economic growth.

Central banks can push rates really low by increasing the amount of capital available for loan. This would boost economic growth, but might cause inflation. On the other hand, a central bank could push rates really high to reduce inflation, but it would come at a cost to economic growth.

Remember this concept:
Rate hikes = Lower inflation, but lower economic growth
Rate cuts = Higher inflation, but faster economic growth

Central banks have to find a good price for money in the form of interest rates. Each central bank responds differently, however, and some central banks are more active than others. Some central banks will increase rates while elsewhere around the world another central bank might decrease interest rates for their currency.

Rates vs. Currencies

Interest rates are very important in helping us understand the future price of a currency. If, for example, the United States is offering only .25% rates for investment capital, but Great Britain is offering .75% annual rates, then investors might sell US dollars to for Pounds so that they can earn a higher rate of interest on their money.

The cumulative power of these transactions greatly affects the currency markets. Imagine if tens of billions of dollars are sold for Pounds. The dollar would fall in value, but the increase in demand would boost the Great British Pound.

Thus, we can conclude that a higher interest rate in Britain is bullish for the GBP/USD currency pair.

Just as you were thrown into the midst of technical analysis with no background information in the early chapters, we’re doing it to you now with fundamental analysis. Don’t sweat it. Learning to analyze the currency markets is one of those things where you’ll read, read, and then read some more before everything just “clicks.”