What a central bank actually sets
Most major central banks target a short-term policy rate — the rate at which commercial banks lend to each other overnight. Everything else in the yield curve is the market's guess about where that rate goes next.
- Fed — the federal funds target range; dual mandate (employment and inflation).
- ECB — the deposit facility rate; primary mandate is inflation.
- BoE — Bank Rate; inflation target with a secondary growth consideration.
- BoJ — the policy rate; decades of unconventional policy make this the least conventional of the group.
Why the decision is usually a non-event
By the time a well-telegraphed decision is announced, the market has usually priced it with high probability. A 25bp hike that was 95% expected produces almost no move from the decision itself. The move comes from everything else in the release:
- The statement — changes in wording signal shifts in thinking. One changed word can move a currency more than the decision.
- The projections — the Fed's dot plot and the ECB's staff forecasts show the committee's own path expectations.
- The press conference — the chair's tone often overrides the written statement entirely.
Rate differentials drive currencies
For FX, what matters is not one country's rate but the difference between two. Capital flows toward higher real returns, so a widening differential tends to support a currency — all else equal, which it rarely is. The cleanest expression is to compare two economies' expected policy paths over the next year, not their current rates.
Tightening and easing cycles
Markets trade the path, not the level. What matters is whether the next move is up or down and how fast. A central bank holding at a high rate while the market prices cuts is effectively easing expectations — and that is what moves assets.
The honest caveat
Central banks are not omnipotent and their own forecasts are frequently wrong. Chair commentary is deliberately ambiguous. Do not build a framework that requires you to know what a committee will do in nine months.
How to check this yourself
Write down today's policy rate for the US, the euro area, the UK, and Japan, and compute the gap between each pair. Then find the same gaps from twelve months ago. The level of a differential matters far less than the direction it is moving — currencies trade the change, not the gap.