Interest Rates and Monetary Policy

The policy rate

Each central bank sets a benchmark rate at scheduled meetings, typically eight a year. The Federal Reserve's is the federal funds rate; the ECB's is the deposit rate; the Bank of England's is Bank Rate. Changes are usually in steps of a quarter of a percentage point and are signalled well in advance. The decisions, the statements and the press conferences are the highest-impact events on the forex calendar.

The differential

What moves a pair is the gap between the two rates and, more precisely, the expected path of that gap. If US rates are 5 percent and euro rates are 3 percent, holding dollars pays 2 percent more, which supports USD against EUR. If the market expects the Fed to cut while the ECB holds, the expected differential narrows and EUR/USD tends to rise even before either bank moves.

Carry and swaps

Buying a high-rate currency against a low-rate one earns the differential daily; that is the carry trade, and the swap on your trading account is the retail version of it. A long AUD/JPY position earns swap when Australian rates exceed Japanese rates. Carry trades work in calm markets and unwind violently in scares, because the low-rate funding currencies, the yen and the franc, are the ones that strengthen when risk appetite fails.

Other tools

• Quantitative easing: buying bonds to push longer-term rates down; usually weakens the currency.
• Quantitative tightening: the reverse.
• Reserve requirements and lending facilities, mostly relevant to emerging markets.
• Intervention: buying or selling the currency directly, which Japan and Switzerland have done.

Key takeaways

• The policy rate is set at scheduled meetings and transmits through the economy.
• The expected path of the differential between two rates drives the pair.
• Carry trades and swaps are the differential paid daily.
• QE, QT and intervention are the other levers.