Getting into the heads of regulators is what it takes to effectively forecast the exchange rates

Central banks not only contribute to the formation of economic cycles, but also give investors hints on where to invest. In this regard, one should start studying fundamental analysis with monetary policy. Seeing the acceleration of inflation, the regulator raises interest rates, increases the cost of borrowing in the economy, which increases the risks of recession. During the recession, on the contrary, it weakens monetary policy, reduces the cost of loans, which ultimately allows the economy to come back to life. In the period of monetary expansion, liquidity is increasing and the demand for securities is growing. At the time of restriction, on the contrary, it is customary to sell them on the secondary market and seek your fortune at auctions.

If the activity of central banks is so important for forecasting exchange rates, we should ask ourselves: what motivates them? Most regulators consider inflation targeting as their main goal. It is defined as the setting of targets and monitoring of their implementation with the help of instruments of monetary policy. In most developed countries, a 2% mark is used as a target (US, Eurozone, Britain, Japan, and others). For Australia, this figure is 2.5%, the Bank of Canada uses a target range of 2-3%.

The most effective tool for regulating CPI and other similar indicators is the rate. If inflation is below the target and the central bank predicts that it will continue to be so, then it should cut the rate. Rumors about this are a bearish factor for the currency. For example, talks about the launch of the European QE against the background of a decrease in the ECB refinancing rate in 2014 led to a drop in the EUR/USD quotes.

On the contrary, if inflation grows much higher than the target, the central bank is forced to resort to restraining monetary and credit policy. The increase in consumer prices in Britain to 3% forced the Bank of England to raise the repo rate, which became a strong argument in favor of strengthening of the pound in the second half of 2017 .

Thus, in order to understand which way a particular central bank will go,you need to monitor inflation. Nevertheless, financial markets often react more readily to employment statistics than to consumer price data. Why?

The reason is that indicators such as unemployment and average wages are leading for the CPI. The higher the pay, the more opportunities the consumer has to spend money. Increased demand for goods leads to higher prices. According to the Phillips curve, the lower unemployment falls, the higher inflation rises. Indeed, in conditions of full employment, employers are forced to raise their salaries to keep employees.

Curiously, unlike most other central banks, the Fed is officially targeting both inflation and unemployment. There were times when there were lively discussions about the automatic increase in the federal funds rate based on the mathematical relationship between the two key indicators. It is called Taylor rule. In accordance with its formula, the Fed rate should now be at the level of 4%.  

Thus, for an effective forecasting of exchange rates, one must clearly understand the worldview of central banks. It is based on the dynamics of such indicators as inflation and unemployment. In this case, their deviations from the regulator's forecasts are important. If the European HCPI surpasses the ECB's estimate in 2018 (+ 1.7%), the central bank may raise the rate earlier than September 2019, which is a bullish factor for the euro. Vice versa, the inability of inflation to reach the forecast will keep the regulator's commitment to ultra-soft monetary policy, thus weakening the positions of the EUR/USD bulls.

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Central bank are revealing Forex secrets

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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