Several market indicators move the Forex market, including inflation and unemployment rate. But there’s one that plays a more significant role behind market moves: interest rates.
When interest rates rise, traders see a higher demand in a currency. Due to a higher rate of interest, investors tend to follow currencies with higher rates.
Yes, interest rates can have a significant influence, but of course, it’s not the only factor that matters in the Forex market. Investors also look at other factors like the overall stability of the economy and geopolitical issues, among others. Take note that in major developed countries, in recent years, their interest rates haven’t increased by more than 3 percent.
Developing countries, on the other hand, have higher interest rates, which can be as high as 5 percent.
Developing countries attract investors by setting higher interest rates. The capital gained from this policy helps in financing their infrastructure spending and debt financing. But investors must be wary before jumping in. Developing countries, in general, have shaky geopolitical situations. These can pose a severe risk to investors, so they should be careful in choosing a country to invest in.
For those looking for lower-risk but with a slightly higher return, they tend to lean towards currencies with higher rates.
Factors that Influence Interest Rate Decisions
Typically, central banks have the command in interest rate decisions. They make sure the unemployment rate is low, and that price stability is maintained. But in the case of the U.S. Federal Reserve, it has the dual mandate to maintain both jobs and inflation.
Usually, central banks start with setting agreed inflation and unemployment rate; then, it can begin influencing interest rates. When the central bank sees that rates are low, they implement measures that encourage borrowing in the economy, resulting in rising demand and more job creation.
When GDP and unemployment rate are going as expected, higher inflation is expected. Higher inflation happens when investors have more money to purchase goods. Thus, higher demand results in high prices.
To arrest inflation, central banks use their power to increase interest rates to lower the demand for goods. The lower demand will result in lower inflation. Central banks can maintain inflation and unemployment rates by carefully hiking and cutting their country’s interest rates.
Also read: Best Time to Day Trade EUR/USD Pair