How Central Banks Influence Exchange Rates: Monetary Policy and Currency Markets

Central banks are among the most powerful institutions in the global financial system. Their decisions about interest rates, money supply, and direct market intervention can move exchange rates dramatically, affecting everything from the cost of your vacation abroad to the price of imported goods at your local store. Understanding how central banks influence currencies helps you anticipate exchange rate movements and make better decisions about when to convert your money.

This guide explains the key tools central banks use to influence exchange rates and examines how the world's most important central banks approach currency management.

What Is a Central Bank?

A central bank is a national institution responsible for managing a country's monetary policy, overseeing its banking system, and maintaining financial stability. Unlike commercial banks that serve individual customers and businesses, central banks serve the government and the broader economy.

Most central banks have a mandate that includes some combination of the following goals:

• Price stability: Keeping inflation low and predictable
• Economic growth: Supporting sustainable economic expansion
• Employment: Promoting maximum employment
• Financial stability: Preventing banking crises and systemic risks
• Exchange rate stability: Maintaining an orderly foreign exchange market

The emphasis on each goal varies by institution. The US Federal Reserve has a "dual mandate" of price stability and maximum employment. The European Central Bank's primary mandate is price stability. Some central banks, like the Monetary Authority of Singapore, use the exchange rate itself as their primary policy tool.

Key Tools Central Banks Use to Influence Exchange Rates

1. Interest Rate Policy

Setting the benchmark interest rate is the most widely discussed and impactful tool in a central bank's arsenal. Interest rates affect exchange rates through several channels:

Capital flow channel: Higher interest rates attract foreign capital seeking better returns. Investors buy the country's currency to invest in its bonds and savings instruments, increasing demand for the currency and pushing it higher.

Expectation channel: Even before a rate change occurs, market expectations about future rate decisions can move currencies. If traders expect a rate hike, they may buy the currency in advance, causing it to appreciate before the decision is announced.

Growth channel: Interest rates also affect economic growth. Higher rates can slow the economy by making borrowing more expensive, which may eventually weaken the currency if growth slows too much.

How Rate Decisions Move Markets

Central bank meetings are among the most closely watched events in financial markets. The announcement itself, the accompanying statement, press conferences, and forward guidance all provide information that traders use to adjust their currency positions.

For example, when the Federal Reserve signals it may raise rates faster than previously expected, the dollar often strengthens immediately. When it signals a pause or cut, the dollar tends to weaken. The Bank of Japan's historic shift away from ultra-loose monetary policy in 2024 caused significant yen appreciation after years of weakness.

2. Open Market Operations

Central banks buy and sell government securities in the open market to control the money supply and influence short-term interest rates. When a central bank buys securities, it injects money into the banking system, increasing the money supply. When it sells securities, it absorbs money from the system.

Quantitative easing (QE): During economic crises, central banks may engage in large-scale asset purchases, buying government bonds and sometimes corporate bonds or mortgage-backed securities. QE increases the money supply significantly and tends to weaken the currency by reducing interest rates across the yield curve and increasing the supply of the currency.

Quantitative tightening (QT): The reverse process, where the central bank reduces its balance sheet by letting securities mature without replacement or actively selling them. QT reduces the money supply and tends to support the currency.

3. Direct Currency Market Intervention

Some central banks buy or sell their own currency directly in the foreign exchange market to influence the exchange rate. This tool is more common among central banks that operate managed float or fixed exchange rate systems.

Buying the domestic currency: When a central bank wants to strengthen its currency, it sells foreign currency reserves (typically US dollars) and buys its own currency. This increases demand for the domestic currency and reduces supply, pushing the exchange rate up.

Selling the domestic currency: When a central bank wants to weaken its currency (to support exporters, for example), it buys foreign currencies and sells its own. This increases the supply of the domestic currency, pushing the exchange rate down.

Sterilized vs Unsterilized Intervention

• Unsterilized intervention: The central bank intervenes without offsetting the impact on the domestic money supply. This has a more lasting effect but can conflict with domestic monetary policy goals.
• Sterilized intervention: The central bank offsets the intervention by conducting opposite open market operations. For example, if it sells dollars and buys domestic currency (reducing domestic money supply), it simultaneously buys domestic bonds (increasing money supply). Sterilized interventions have a more limited and often temporary effect on exchange rates.

4. Reserve Requirements and Capital Controls

Central banks can influence currency markets indirectly through banking regulations:

• Reserve requirements: Changing the amount of cash banks must hold in reserve affects how much money circulates in the economy, which can influence the exchange rate.
• Capital controls: Some central banks restrict the flow of money in and out of the country. These controls limit how freely the currency can be traded, affecting supply and demand dynamics. China's capital controls, for example, are a key reason the renminbi is not yet fully freely traded.

5. Forward Guidance and Communication

What central bankers say can be as powerful as what they do. Through speeches, press conferences, meeting minutes, and official statements, central banks communicate their policy outlook to markets.

Jawboning: Sometimes central bankers make verbal statements aimed at influencing the exchange rate without actually changing policy. A central bank official saying the currency is "too strong" or expressing concern about rapid appreciation can cause traders to sell the currency in anticipation of future action.

Forward guidance about the future path of interest rates is particularly influential. If a central bank signals it will keep rates low for an extended period, the currency is likely to weaken even if current rates are unchanged.

Major Central Banks and Their Currency Approaches

US Federal Reserve (Fed)

The Fed does not have an explicit exchange rate target. Its policies influence the dollar primarily through interest rates and the money supply. As the issuer of the world's primary reserve currency, the Fed's decisions affect not just the dollar but global financial conditions and exchange rates worldwide.

European Central Bank (ECB)

The ECB manages monetary policy for the entire eurozone. Like the Fed, it does not target a specific exchange rate but monitors the euro's value as part of its assessment of monetary conditions. The ECB has used negative interest rates and massive QE programs in past years, both of which weakened the euro.

Bank of Japan (BOJ)

The BOJ has been notable for its ultra-loose monetary policy, including negative interest rates and yield curve control (targeting specific interest rates on government bonds). These policies contributed to significant yen weakness. The BOJ has also intervened directly in currency markets on multiple occasions to slow rapid yen depreciation.

People's Bank of China (PBOC)

The PBOC manages the renminbi through a combination of daily fixing rates, trading bands, capital controls, and direct intervention. Each trading day, the PBOC sets a reference rate for the yuan, and the currency is allowed to trade within a band around that rate. This makes the renminbi one of the most actively managed major currencies.

Swiss National Bank (SNB)

The SNB has been one of the most active central banks in currency markets. It maintained a floor on the EUR/CHF exchange rate from 2011 to 2015 and has intervened repeatedly to prevent excessive franc appreciation, which hurts Swiss exporters.

Bank of Korea (BOK)

The BOK operates a managed float system, occasionally intervening in currency markets to smooth excessive volatility in the Korean won. The BOK's interventions are typically aimed at preventing disorderly moves rather than targeting a specific exchange rate level.

How This Affects You

Central bank actions have direct implications for anyone who exchanges currency:

• Before traveling or transferring money: Check whether any relevant central bank has a meeting scheduled. Rate decisions can cause immediate exchange rate swings.
• For large transactions: If a central bank is expected to change policy direction (for example, shifting from rate hikes to cuts), this can signal a turning point in the currency's trend.
• For regular senders: If you send money abroad regularly, central bank policy trends can help you decide whether to lock in current rates or wait for potentially better ones.

Conclusion

Central banks wield enormous influence over exchange rates through interest rate policy, open market operations, direct intervention, regulation, and communication. While no one can predict exchange rate movements with certainty, understanding how central banks operate and what signals they send gives you a significant advantage in timing your currency exchanges. Pay attention to central bank announcements, follow monetary policy trends, and use a currency converter with rate alerts to act when conditions are favorable. The more you understand about the forces moving exchange rates, the more money you can save on your international transactions.