Currencies are, at heart, a relative price of money. When a central bank raises interest rates, holding that currency earns more, which tends to attract capital and strengthen it. When it cuts rates or signals easier policy, the opposite happens. This is why monetary policy is the single most important driver of exchange rates over the medium term.
But markets are forward-looking. By the time a rate decision is announced, much of it is already priced in. What moves a currency is usually the surprise — a decision or, more often, guidance that differs from what traders expected.
The three main levers
First, the policy rate itself: the benchmark interest rate that anchors money-market rates across the economy. Second, forward guidance: the central bank's communication about the likely future path of policy, delivered through statements, projections, and press conferences. Third, balance-sheet policy: quantitative easing (buying assets to add liquidity) and quantitative tightening (shrinking holdings to remove it).
Of these, forward guidance often moves currencies the most, because it reshapes the entire expected path of rates rather than just today's setting. A central bank can hold rates unchanged and still trigger a large currency move purely through a shift in tone.
Divergence is what trends
Because exchange rates are relative, what matters is not one central bank in isolation but the divergence between two. EUR/USD trends on the gap between the ECB's and the Fed's expected paths; USD/JPY on the gap between the Fed and the Bank of Japan. Tracking relative policy expectations — often via short-term government bond yield spreads — is the core of fundamental FX analysis.