In the vast amount of data received and interpreted by forex traders, nothing has as much weight and value as the main interest rate set by a nation’s central bank. In our era of fiat money, central banks are able to create unlimited quantities of credit solely on the basis of public goodwill. By raising or lowering interest rates, they are able to adjust the amount of credit, and hence, money, in the market. And of course, a higher or lowe quantity of money has easily understood results on the supply and demand of each currency, and currency prices as a result (if there’s too much of a currency, it will lose value, and vice versa, as with any commodity.)

Central bank money, or the credit made available to financial institutions by the central bank through the interest rate channel, is often termed “high powered money”. Banks set interest rates on the basis of supply and demand among customers, yet they themselves are subject to these same dynamics in the interbank market where they trade among each other in order to finance short term operations. The central bank is able to determine the cost of the cheapest credit available to financial institutions in this interbank market, and that is why it is so important to traders, economists, and government officials. If banks expand credit vigorously, asset prices will rise, the economy will grow, and the currency will appreciate. The opposite case is through as well.

Interest rate decisions of authorities mostly depend on inflation. If there is too much money being “printed”, and lots of credit being granted, economic buoyancy leads to higher demand for workers, allowing them to press for better wages in negotiations. Companies then pass these costs to the consumer by raising prices, causing inflation. Officials try to keep inflation low when credit is expanding too fast.
If on the other hand, banks are unable to extend credit greatly, falling demand leads to a lower demand for workers, reducing the negotiation power of unions, and leveraging the employer against the employee in the wage setting process. This of course means that companies have costs under control, and in order to remain competitive in a stale economic environment, they choose to keep prices low, or even lower them further. An environment of falling prices is termed deflation, while a case in which price are rising, but with lower speed, is called disinflation. Depending on where inflation stood at first, central banks will try to reduce rates in order to allow banks to expand credit faster in a deflationary or disinflationary environment.

Forex prices are dependent on a nation’s economic performance. An active, growing economy will present greater investment opportunities, and will draw higher amounts of international capital. That then leads to greater demand for the nations’ currency, and its appreciation. Since we have already explained that growth is dependent, to a great extent, on the interest rate policies, of central banks, markets tend to see the future in interest rate announcements of central banks, and trends are created on this basis.

But beyond that, traders can simply exploit the rate gap between nations for short term speculative profit, and most short term trends in forex trading are the result of this fact. Traders seek higher yield by buying currencies with high interest rates, and the resulting patterns of behavior generate much of the action in the currency market on a regular basis.

Next step: Important Economic Indicators