Interest rates: why do they matter so much?

There is nothing new about it. You’ve heard about it. We’ve heard about it. The Federal Reserve, the European Central Bank, the Bank of England, the Bank of Japan… a common term? Of course, interest rates. That’s totally right. But why do they matter in Forex trading?

No worries. There is no shame in asking. Actually, it is better to get on with these things before you end up watching a screen full of candles going up and down the chart and realising you understand ZERO about what is going on.

Interest rates are relevant to Forex traders because they are probably one of the most influential factors central banks use to control the economy. When they set their monetary policy, an interest rate dictates whether they are supporting it or letting it ride on its own.

Last week, the Federal Reserve decided to keep its benchmark rate in a range between 1.25 percent and 1.50 percent, while reassuring its forecast of three rate hikes for 2018.

The US regulator has already started what is commonly described as a “monetary normalization process”, which in other words means reducing monetary stimulus and letting the economy runs on its own without intervention. An intervention that was needed following the 2008 crisis.

Interest rates are a useful way to keep the economy running healthy, without overheating or getting cold. Rates can help pair growing inflation or prevent deflation (like in the EU).

Due to the close relation between interest rates and inflationary pressure, measures such as the Consumer Price Index (CPI) or the Personal Consumption Expenditures (PCE) are carefully monitored by policymakers in order to justify rate adjustments.

In the United States, labor market conditions also play an important role in defining the monetary policy configuration and its development.

Important to understand:

Rising interest rates: increases the cost of borrowing money (credits), pushing consumers and business to spend less and therefore, slowing down the economy. The dollar benefits from this scenario because people tends to sit on their savings.

Lowering interest rates: reduces the cost of borrowing money, pushing consumers and business to take more credits and therefore, accelerating economic growth. The dollar falls in this scenario because people tend to get rid of their cash more easily.