Forex Trading Articles

FUNDAMENTAL ECONOMIC INDICATORS ARE ESSENTIAL FOR PREDICTING FOREIGN EXCHANGE (FOREX/FX) CURRENCY MARKET PRICE ACTION

By Larry Litchfield for Forexmentor.com
©2007, Currex Investment Services Inc.

Jan. 11, 2007

Before becoming serious about economic indicators, traders also need to learn more about the “gatekeeper” of the US economy; the US Federal Reserve System, also known as the Fed. The Fed is the central bank of the US government.

Keep in mind that all nations have central banks. Amongst a plethora of financial responsibilities, central banks form monetary policy, provide financial supervision and manage its currency payment systems. The Fed as well as other central banks also intervene in foreign exchange to help achieve dollar-exchange-rate policy objectives.

Originally the Fed was set up in the United States to stabilize a monetary system that had consisted of thousands of other systems. It had to establish "liquidity" of its money supply so banks could honor withdrawals from customers. It also needed to come up with a way to create currency "elasticity", meaning it had to control inflation by making sure prices didn't climb too quickly.

The Fed also needed a way of increasing or decreasing the country's supply of money to control inflation that slows down economic growth. For example, when inflation is high, goods and services cost more. People spend less money. They also do less long-term planning that involves spending money on building houses and investing. Businesses are also affected in the same way. When inflation is high, business tends to fluctuate quite a bit. This uncertainty makes people wary of spending money. The implication is that inflation will increase more and they won't be able to pay their bills. High inflation also adds additional costs to long-term interest rates. These costs are to offset the risk associated with inflation. The additional costs make borrowing money less attractive. When people don't buy things (when demand is down), then the supply of goods gets too high, production has to decrease, and unemployment increases -- in other words, recession hits.

When recession hits, the Fed will lower interest rates to encourage people to borrow money and make purchases. This works in the short run, but it has to be handled carefully so that in the long run inflation isn't impacted. The Fed has to carefully balance the short-term goals of increasing output and employment with the long-term goals of maintaining low inflation.

In other words, the Fed’s primary control is the raising and lowering of short-term interest rates, which indirectly influences demand, which then influences the direction of economy. Increases in inflation or slow-downs in the economy enable the Fed to increase or decrease the supply of money.

One of the more important events for the Fed and consequently for currency traders is the periodic FOMC (Federal Open Market Committee) interest rate announcement, which simplistically is the net result of watching the following economic indicators all with an eye toward managing inflation and recession and/or setting monetary policy.

At this point the astute reader is beginning to gain some perspective of the interactions and understand the Fed’s delicate balancing act of using interest rates to control inflation and recession by increasing or decreasing the money supply.

For a more in depth understanding please visit the Federal Reserve Bank of New York web site at http://www.newyorkfed.org/ . It is suggested that you pass your mouse over all items on the Header Menu Bar and select those areas that appeal to you for more detailed information especially concerning Foreign Exchange.

Proceed to Part II: Economic Indicators

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