Forex Education: Forecasting Interest Rate Decisions

Forex Education:  Forecasting Interest Rate Decisions

For traders looking to implement fundamental trading strategies, it is important to have an understanding of how interest rate policy is determined.  “Any changes in these areas will have a significant impact on all asset classes –stocks, bonds, and commodities,” said Haris Constantinou, an analyst at TeleTrade.  “But it can be argued that the largest impact of these types of changes will be seen in  and in the decisions made by forex traders.”

Like most economic news releases, central bank meeting are scheduled in advance and it is more than clear to any trader with an economic calendar that interest rate decisions will be released from certain countries at certain times.  There are also market forecasts by experienced trading analysts that will give investors a clue as to whether the central bank will choose to raise interest rates, lower interest rates, or leave interest rates at the same level.  But how are these forecasts made?

Assessing the Policy Outlook

When assessing the potential for changes in interest rate policy, market analysts look for evidence of progress or decline in certain aspects of the economy.  These analysts make their estimates based on the economic reports most critical for the country at that moment.

Individual traders looking to make forecasts for the next interest rate moves that could be seen by a central bank will need to make an assessment of the broad strength or weakness seen in the economy.  If we look at basic economics, we can see that central banks tend to raise interest rates as a means for slowing down economic activity.  This often seems strange to most people.  Why would a central bank ever want to slow down economic activity?  Isn’t economic progress always a good thing?

Knowing When to Raise or Lower Rates 

Economists are generally of the view that strength can be either sustainable or unsustainable.   If economic progress is viewed to be growing too quickly, a central bank might look to slow this “progress” in order to make it more viable from a long term perspective.  The last thing a central banker wants to see is a large huge boom or bust.  From the perspective of a policymaker, economic volatility is one of the worst things a country can experience.  So, in these cases, voting members at central banks might actually vote to raise interest rates in order to make lending more expensive — slowing economic activity to a more manageable level.

You know from personal experience that if the interest rates on your credit card are higher, there is less of a chance you will use it to make large purchases.  The same thing applies when making housing purchases or taking out car loans.  Once higher interest rates are in place, economic activity tends to slow down.  It is the job of a central bank to make sure that the economy is proceeding at a sustainable level.  Raising interest rates might be one of the tools that is used to make sure this happens.