Central bank meetings can have a dramatic impact on currencies as they use regular official meetings to discuss their most crucial policies like the level of interest rates and the size of quantitative easing programs. You need to be prepared to make money from this major piece of forex news. You need to fully understand all the subtleties of the market going on or you will never be able to trade successfully in the fast market aftermath.
Some traders take this very seriously. They specialize in a small group of central banks, including Australia and New Zealand, or Norway and Sweden. After that, they try to develop a superior edge in forecasting and trading them. Other traders attempt to forecast and trade every central bank meeting. You need an expert-level understanding of what is going on to maximize your edge. The main levers used by central banks to influence markets are target interest rates, balance sheet management, and forward guidance.
The target interest rate
The target interest rate is the first and most important variable controlled by the central bank. It is often called the cash rate or overnight and it has a very strong influence on market interest rates such as prime lending rate, TBill rates, and mortgage rates. Central banks generally raise rates to fight inflation and cut rates to battle unemployment, weak growth, or deflation.
The second variable controlled by the central banks is the size of their balance sheet. They increase balance sheet size via asset purchases, usually called quantitative easing or QE. These asset purchases mostly involve domestic bonds but sometimes include domestic stocks or even foreign assets. Central banks can also reduce the size of their balance sheets. This tends to happen slowly and methodically.
QE is a relatively new tool for central banks and is still somewhat experimental. The policy has gained importance since the Global Financial Crisis because many central banks reduced interest rates to zero or below and still needed more stimulus ammunition. While the merits of QE and its supposed impact on the real economy are debated, there is no denying that QE has a massive influence on asset prices. All other things being equal, theory suggests that interest rate cuts and QE should push the currency of a country lower, drive its stock market higher, and increase inflation.
In practice, results have been extremely mixed and as more empirical evidence builds, more questions pile up about the unintended consequences of QE and subzero interest rates. The loose monetary policy creates dependence and also has many side effects. These side effects can outweigh the benefits as the dosage increases and the years go by.
Side effects of prolonged QE include greater wealth inequality and risks to financial stability. Keep in mind that theories say that rate cuts and QE are bad for a currency, but in reality, that is not always true. When the Bank of Japan cut interest rates below zero in January 2016, the yen sold off for just one day, and then it rallied for a year.
The third tool used by a central bank is forward guidance. By telling participants what it plans to do in advance, the central bank can guide behavior in theory and influence markets without actually doing anything. An example of this is when the Fed promised to keep rates at extremely low levels throughout 2012 and 2013. By making this promise, the Fed encouraged market participants to buy riskier assets with higher yields and this pushed the stock market higher. The Fed hoped that a higher US stock market would generate a wealth effect. The wealth effect suggests that people feel richer as stocks rally and so they spend more. The evidence for a wealth effect is mixed.
Like every forex news trade, the most important thing for you to understand from central bank meetings is: what is the price in? To put it simply, what you can expect to happen at the meeting. If everyone expects the central banks to hike rates and they hike rates, financial markets should not move much. On the other hand, if nobody expects the central banks to hike rates but they hike rates, you can expect a massive market reaction.