The Fed is the Federal Reserve System, the central bank of the US. It is tasked with regulating the USA’s monetary policy. It’s charged with achieving the country’s economic goals of minimal unemployment, stable exchange prices, and moderate interest rates. It also stabilizes the USA’s financial system and regulates all its commercial banks.
Other functions of the Fed include protection of consumers, community development, and ensuring the stability of the dollar system of payment.
Who does the Fed consist of?
The Fed is made up of three main entities:
- The Federal Reserve Board of Governors: This board consists of 7 members who control the federal funds rate and reserve requirements.
- 12 Federal Reserve Banks scattered across different cities in the country. These oversee the commercial banks in their districts independently but under the aforementioned Board of Governor’s supervision.
- The Federal Open Market Committee (FOMC). This committee is responsible for all open market operations (OMO). OMO refers to the buying and selling of government bonds.
How does the Fed control interest rates?
The Fed sets the federal funds rate. The rates that individuals get for mortgages, personal loans, credit cards, and the like are all obtained from this base rate. This federal funds rate is the rate charged to commercial banks when they borrow from the Fed on an overnight basis. The commercial banks, in turn, charge a higher interest rate from individuals looking to borrow from them.
Nowadays, banks need to comply with a form of banking called Fractional Reserve Banking. They need to hold enough money to service daily withdrawals and lend to businesses and other investors that need the capital. By charging their clients a higher interest than they get from the Fed, banks make a profit, and that’s how they stay in business.
The Fed states the percentage of their deposits that commercial banks are supposed to have at all times. If a bank falls short of this, it can borrow the balance from the Fed at the federal funds rate.
These federal funds rates can have a significant effect on the forex market. Investors keep track of interest rates, which translate to yields. Thus, if a country’s interest rates drop, said investors will take their business to countries with higher interest rates.
It follows then that changes in the federal funds rate affect several sectors of the economy, such as employment, prices of goods and services, even the country’s output. It also affects foreign exchange rates and long-term interest rates.
The Fed also acts as a lender of last resort. When the government’s debt is not so far above its GDP, and it fails to raise enough money by selling bonds, the Fed steps in and lends the shortage. Having the Fed ready to solve the country’s liquidity shortage boosts investor confidence that the government can pay its debts. This, in turn, lowers the cost of government borrowing.
Fed decision’s impact
The Fed’s policy depends on the state of the economy. When the economy is expanding, GDP grows. This means consumers are earning more, which leads to increased spending. Soon, there is plenty of money but few goods, which drives prices up. This causes inflation to rise. To reduce this inflation, the Fed increases interest rates that make borrowing expensive. This, in turn, reduces spending and inflation.
In a contracting economy, the Fed lowers interest rates, which encourages spending and investment. Industries borrow to invest in projects, which increase growth and employment, hence reducing negative inflation.
The way these interest rate changes affect the forex market is through a change different from what investors expect. Let’s analyze this in a table.
|Investor expectations||Fed decision||Result on the forex market|
|Rate increase||Rate held constant||USD depreciates.|
|Rate decrease||Rate held constant||USD appreciates.|
|Rate held constant||Rate increase||USD appreciates|
|Rate held constant||Rate decrease||USD depreciates|
Predicting the direction of a Fed rate change; how will it impact the forex market?
Fed funds futures are traded on the Chicago Mercantile Exchange. They represent the market’s expectation of where federal funds rates are expected to be. Your role as a trader is to predict any deviations from these expectations.
Central bankers vary their interest rates depending on various economic data. This is the data contained on the economic calendar. Releases such as inflation numbers, unemployment, GDP are some such data points. By analyzing these fundamental indicators, you can tell the direction the Fed is aiming to take with interest rates.
Additionally, the FOMC holds eight meetings every year. In these meetings, members discuss the economic and financial conditions of the country and their resultant stance on monetary policy. They also discuss any threats to exchange rate stability and economic growth. The minutes of these meetings act as clues to future US interest rate policy.
If the Fed hints at increasing interest rates, it’s said to have taken a hawkish stance. By increasing interest rates, investors will be incentivized to buy US bonds. With this increased money inflow, the economy flourishes, increasing the value of the USD.
If the Fed hints at lowering interest rates, it is said to have taken a dovish stance. With lowered lending rates, the USD is supplied in surplus to the economy. This stimulates the economy, but it has a negative effect on the value of the dollar.
It is clear that the Fed decision is a huge determinant of the strength of the greenback. Therefore, investors try to predict this decision so as to stay ahead of any price changes. When the Fed goes contrary to the market expectation, it tends to cause drastic USD price changes. A hawkish Fed drives up the price of the dollar, while a dovish stance from the central bank devalues the greenback.