Global interest rates can make or break the Forex market. Learn how they work and why it is essential to stay informed about interest rate changes.
The three-way connection: interest rates - risks – inflation
By interest rates, we understand the costs of borrowing a loan charged by the lender to the borrower. Interest rates are displayed as a percentage of the loan amount (principle), and they are charged periodically depending on the borrowing contract.
Lenders (such as central banks) determine the interest rate value for their loans after assessing several risk factors. The riskier the loans are, the bigger the interest rates will be.
One of the most significant factors influencing interest rates is inflation (the steady increase in prices of goods and services).
High inflation can harm an economy. That is why central banks always keep a close eye on inflation-related economic indicators, such as the #CPI, GDP, employment, and many others.
How interest rates are calculated – keeping inflation in check and economies afloat.
Because they act as lenders of the national currency, central banks decide the minimum interest rates. It is essential to know that central banks make money for the national treasury by lending to commercial banks and charging interest.
Central banks also control the monetary policies and the short-term interest rate at which banks can borrow from one another. The central banks typically hike rates to reduce inflation and cut rates to encourage lending and pour money into the economy. No matter what they choose to do, currencies are affected, and that is one of the main reasons why the interest rate impacts the Forex market.
When central banks raise or cut the interest rates, the commercial banks’ borrowing costs are affected, and they are forced to apply higher or lower rates in their own commercial and retail financial services. The result is that customers pay the price.
As a trader, you can examine the most relevant economic indicators, such as the CPI (Consumer Price Index), as mentioned earlier, employment levels, the housing market, and others, to predict what central banks might do regarding interest rates.
A hawkish approach refers to an economic view promoting monetary policies that usually involve high-interest rates, while a dovish approach refers to an economic view promoting monetary policies that usually involve low-interest rates.
Let us get into more details to help you better understand context.
The hawkish approach vs the dovish approach.
Interest rate hikes are considered hawkish. When interest rates rise, the price of borrowing the national currency goes up as well. Lending might then become more profitable and loans more expensive. So, the national currency gains value.
Interest rate cuts are considered dovish. When interest rates fall, the price of borrowing the national currency also goes down. Loans then usually get cheaper, and lending becomes less profitable. As a direct result, the national currency loses value in the foreign exchange markets. Contrary to higher rates, the interest-paying investments lose their appeal when the central bank cuts the interest rates, and investors might become more prone to risks.