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The biggest influence that drives the foreign-exchange market is interest rate changes made by any of the eight global central banks. These changes are an indirect response to other economic indicators made throughout the month, and they possess the power to move the market immediately and with full force. Because surprise rate changes often make the biggest impact on traders, understanding how to predict and react to these volatile moves can lead to quicker responses and higher profit levels. (Read Get To Know The Major Central Banks for background on these financial institutions.)


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Interest Rate BasicsInterest rates are crucial to day traders on the forex market for a fairly simple reason: the higher the rate of return, the more interest accrued on currency invested and the higher the profit. (Read A Primer On The Forex Market for background information.)Of course, the risk in this strategy is currency fluctuation, which can dramatically offset any interest-bearing rewards. It is worth stating that while you may always want to buy currencies with higher interest (funding them with those of lower interest), it is not always a wise decision. If trading on the forex market were this easy, it would be highly lucrative for anyone armed with this knowledge. (Read more about this type of strategy in Currency Carry Trades Deliver.)That isn't to say that interest rates are too confusing for the average day trader, just that they should be viewed with a wary eye, just like any of the regular news releases. (Read Trading On News Releases to learn more.)How Rates Are CalculatedEach bank's board of directors controls the monetary policy of its country and the short-term rate of interest at which banks can borrow from one another. The central banks will hike rates in order to curb inflation, and cut rates to encourage lending and inject money into the economy. Typically, you can have a strong inkling of what the bank will decide by examining the most relevant economic indicators, namely:
The Consumer Price Index (CPI)
Consumer spending
Employment levels
Subprime market
Housing market (Read more about the CPI and other signposts of economic health in our Economic Indicators tutorial.)Predicting Central Bank RatesArmed with data from these indicators, a trader can practically put together an estimate for the Fed's rate change. Typically, as these indicators improve, the economy is going well and rates will either need to be raised or, if the improvement is small, stay the same. On the same note, significant drops in these indicators can mean a rate cut in order to encourage borrowing. (Read more about the factors that influence interest rate changes in Forces Behind Interest Rates.)Outside of economic indicators, it is possible to predict a rate decision by:
Watching for major announcements
Analyzing forecasts Major AnnouncementsMajor announcements from central bank heads tend to play a vital role in interest rate moves, but are often overlooked in response to economic indicators. That doesn't mean they are to be ignored. Any time a board of directors from any of the eight central banks is scheduled to talk publicly, it will usually give an insight into how the bank views inflation. On July 16, 2008, Federal Reserve Chairman Ben Bernanke gave his semiannual monetary policy testimony before the House Committee. At a normal session, Bernanke reads a prepared statement about the U.S. dollar's value, as well as answers questions from committee members. At this session, he did the same. (Read more about the head of the Fed in Ben Bernanke: Background And Philosophy.)Bernanke, in his statement and answers, was adamant that the U.S. dollar was in good shape and that the government was determined to stabilize it even though fears of a recession were influencing all other markets. The 10am session was widely followed by traders, and because it was positive, it was anticipated that the Federal Reserve would raise interest rates, which brought a short-term rally by the dollar in preparation for the next rate decision.