The interest rate is one of the most important factors that directly influences the price of a currency. The changes in the interest rate are a response of monetary policy to the results of other economic indicators on the situation of the economy.
Take into account the changes in the interest rates of the central banks of economies such as the UK, the United States, Europe, Canada, Japan, Australia and New Zealand.
Interest rates impact currencies in the following way: the higher the rate of return, the higher the interest on the invested currency and the greater the profit.
This is why it can be useful to borrow in currencies that have a low interest rate in order to buy currencies that have a higher interest rate (this is known as Carry Trade). However, there is always the risk that the fluctuation in the price of currencies could reduce your profits.
Each Central Bank has a board of directors who control the monetary policy of their country and the short-term interest rate that banks use to borrow from each other.
When the economy is doing well, interest rates can be raised to prevent inflation. In contrast, when an economy is in a tough time, interest rate cuts seek to boost borrowing to inject money into the economy.
A trader can get a good idea of what a Central Bank can do by reviewing various indicators on the situation of the country’s economy. Apart from reviewing economic indicators there are two important aspects to take into account:
Every time a central bank board of directors is held, important comments will be given on the bank’s outlook on inflation and other economic issues.
These announcements often generate expectations about the actions that a central bank might take with respect to its interest rate. A positive outlook on the economy and the currency of the country can generate a rise in the foreign exchange market.
Reviewing the predictions that professional analysts have regarding interest rate decisions is also a good option.
Interest rate movements are often closely scrutinized by large brokers, banks, and other financial institutions, so it helps to stay up to date.
There are times when central banks can make decisions that no one would have foreseen.
When these unexpected changes in the rate occur it is important that you are clear about the direction the market will take.
For example, when there is an unexpected increase in the interest rate, the currency of that country will appreciate. When there is a cut in the interest rate the currency will fall.
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