The cost of borrowing money, set by central banks as a primary monetary policy tool. Interest rate differentials between countries are the dominant driver of forex exchange rates.
Interest Rates in Forex
Interest rates set by Central Bank institutions determine the return on holding a particular currency. When the Federal Reserve raises rates, USD deposits earn more, attracting global capital and strengthening the dollar. When rates are cut, capital flows elsewhere, weakening the currency. The interest rate differential between two countries is the single most important long-term driver of their exchange rate.
How Rate Changes Affect Currency Pairs
If the Bank of England raises its rate while the European Central Bank holds, GBP strengthens against EUR because British assets now offer higher returns. This principle extends to every currency pair. Traders earn or pay the rate differential daily through swap rates (rollover). A positive carry trade involves buying the higher-yielding currency against the lower-yielding one to collect the daily interest differential.
Beyond the Rate Decision
Markets are forward-looking, so actual rate changes often produce smaller moves than the shift in expectations. Forward Guidance about future rate paths, Hawkish or Dovish language in accompanying statements, and updated economic projections frequently matter more than the rate decision itself. The Forex Trading for Beginners covers how interest rates fit into the broader forex trading framework.
Related Terms
Base Rate
The benchmark interest rate set by a central bank, from which all other lending and deposit rates in the economy are derived. Also called the policy rate, key rate, or bank rate.
Basis Point
A unit of measurement equal to one hundredth of a percentage point (0.01%). Used to express changes in interest rates, bond yields, and other financial percentages with precision.
Central Bank
A national or supranational institution responsible for managing a country's monetary policy, controlling the money supply, setting interest rates, and maintaining financial stability.
Hawkish
Describing a central bank stance or official's tone that favors higher interest rates, tighter monetary policy, and prioritizing inflation control over economic growth stimulation.
Dovish
Describing a central bank stance or official's tone that favors lower interest rates, looser monetary policy, and prioritizing economic growth and employment over inflation concerns.
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