Lesson 3: How a Central Bank Makes its Decision

So a Central Bank’s objectives are to  maintain 1. High Employment, 2. Steady Growth and 3. Low Inflation. So obviously it needs a way to measure each of these areas. To measure employment it uses the monthly/yearly unemployment figures. In the US they are confusingly called NFP’s (non farm payrolls) which records all those employed, but not at a farm, so the entire service sector of the US (80% of its economy!). Thankfully the rest of us manage to call them unemployment figures. To measure growth they view the monthly/yearly GDP figures (gross domestic product), which is the gross income from a country's goods and services. Finally to measure inflation it uses the monthly/yearly CPI figures (consumer price index), which is an index that records price increases/decreases from a set basket of consumer products. Are there other ways to measure these figures? Absolutely, dozens but none are as respected as the ones mentioned. Do you really need to know this stuff? Well, you don’t need to be a mechanic to drive a car, but it’s not a bad idea to know how to fill up your radiator fluid. Having said that, it’s important to remember that you’re a trader not a central banker. Some will swear you should monitor these figures religiously but I would argue that they’re non of our business. We don’t trade employment, growth, or inflation figures, We trade money. The only thing that can affect the supply of money is it’s central bank, so ultimately I only follow their decisions. CPI can go up warning of inflation and possible IR hikes but until the central bank does something, the supply of money hasn’t changed. The decision is always based on the 3 objectives of the central bank, never one factor. This is why predicting what a central bank may do should be avoided.

Lesson 2. The Central Bank

Each country has it’s own Central bank with the exception of Country’s in the EU whom are governed by the ECB (European Central Bank). The Central Bank has 3 objectives. 1. High Employment, 2. Growth 3. Manage Inflation (2% per year) . It does this by increasing the supply of money in times of recession to encourage spending and decreasing supply in times of growth, to reign in spending. It has 3 tools to do this. 1: Interest Rates: It can raise or lower its interest rate to make its currency cost more or less to borrow. A low IR makes borrowing it cheap, so there's plenty of supply in the economy.  While a high IR makes money expensive (a luxury) so there will be far less supply. 2: It can set the minimum amount of cash retail banks must hold in their bank vaults, this is called the Reserve Requirement. This essentially dictates to "barclays" how much they can loan out. A low reserve requirement means they can make lots of loans, increasing the supply of money in the economy. A high reserve requirement means they can only loan out a limited amount of money, decreasing the supply. Tool 3: Open Market Operations (buying bonds): Sounds terrifying but is the easiest to understand. In this scenario the Central bank enters the market place and loans money to either businesses or the government, injecting cash into the economy. Of course it is a little harder to get the money back because it all depends on when the borrower can pay it back ;). So it's not so good at reducing supply! The basic concept is this... If the central bank is lowering interest rates & reserve requirements and buying lots of debt, it is making money affordable, to try to stimulate the economy. If it is raising interest rates and reserve requirements, it is making money expensive, to try to cool an overheated economy where the price of basic necessities are so inflated the poor are struggling to afford them. If you can get this you're well on your way.

Lesson 1. The Carry Trade

Currencies are valued through interest rates. The Central Bank of a country ( Bank of England / Bank of Japan / Federal Reserve / European Central Bank etc) sets an interest rate at which retail banks (Barclays etc) can borrow and deposit money from it, just like the retail banks (Barclays etc) do for us. However it is far simpler as central banks can only set one interest rate for both deposits and loans. Ie the Bank of Japan let's you borrow and deposit Yen for 0.1%, the ECB's rate for the Euro is 0.75%. All one then does is borrow cheap money (Yen) from a Central Bank with a low interest rate (BoJ) , then deposit it (as Euros) at a Central Bank offering a high interest rate (ECB). You then profit from the difference in interest rates (0.75 - 0.1 = 0.65%) and as the demand for the high interest rate currency (Euros) increases it will of course further increase in value. Thus when you eventually sell your Euros, you will be able to buy back more yen and be richer. This is called the Carry Trade it is the most important currency strategy and all investment banks do it.