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The Central Bank

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The Central Bank

Post by Jacq Stone on Thu Oct 27, 2011 5:21 am

A central bank's role is to direct the domestic monetary policy and maintain the stability of the national currency of its country. The central bank deals with the flow of money and credit that is provided to the economy under the monetary policy. Its responsibility includes controlling subsidized-loan interest rates and acting as a lender to the banking sector during times of financial crisis. It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently. Market interventions are a part of the total role that central banks exercise in affecting the Forex market.

The Federal Reserve was established at 1913, when Congress passed the Federal Reserve Act. The Act held that role of the Federal Reserve was to provide an elastic currency and establish an effective supervision of banking in the United States. In 1923 the Open Market Investment Committee (OMIC) was establish to coordinate the Reserve Bank operations. In 1930, the OMIC was replaced by the Open Market Policy Conference (OMPC) and it consists of 12 Federal Reserve Banks governors and the members of the Board.

The Banking Act of 1935 had reshaped the structure of the Federal Reserve System and the OMPC's name was switched to the Federal Open Market Committee (FOMC). The Banking Act held that the Board must generate a suitable environment for business stability. Like the other central banks, the Federal Reserve affects the Forex markets in three general ways:

1. The discount rate.
2. The money market instruments.
3. Foreign exchange operations.

The major central banks are involved in the Forex market operations in more ways than intervening in the open market. Their operations include payments between central banks. The major central banks do not engage in speculative trading. Intervention in the Forex markets is toward restoring orderly condition in the market or influencing the exchange rates. The actual intervention is executed by the Foreign Exchange Desk at the Federal Reserve Bank of New York. There are two types of Forex interventions:

1. Naked intervention
2. Sterilized intervention

Naked intervention refers to the sole Forex activity. To be brief, Federal Reserve either buys or sells US dollar against a foreign currency. Besides the impact in the Forex market, there is also a monetary effect on the money supply. If the money supply is impacted, then adjustments will be made in interest rates, prices and all levels of economy. Consequently, a naked intervention results a long term effect.

Sterilized intervention functions to neutralize the impact on the money supply for the reason that there are few central banks want the impact or the intervention in the Forex market to affect all corners of their economy. The impact of sterilized intervention will tend to have only a short to medium term effect.

Here is a case example of market intervention from the Bank of Japan. Japan's economy is mostly depending upon its exports. Thus, Japan's economy benefits from the weaker value of yen because low value yen provide an advantage in its export competitive. So, the yen value is preferred to be remained low relative to USD. When the yen value appreciates, Bank of Japan will try to control it by market intervention either selling trillions of yen to bring down the value or reduce the interest rates. In early 2004, the Bank of Japan intervened in the currency market to keep the exchange rate of USD/JPY above the level of 105.00. Figure 2 shows that this massive intervention pushed the USDJPY from just above 105.00 to above 112.00, a 700 pip gain in just a few weeks.

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Jacq Stone

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