The Federal Reserve is by far the most influential central bank in the world at the time of this writing in mid-2022. Its currency is involved in an estimated 70% of all FX transactions that take place every single day. Because of this, the actions that the Fed takes can have a strong impact on most of the world’s currency valuations. This is because the USD is one-half of most all major currency pairs.
In this Wiki, we will explore The Federal Reserve out of the United States of America, its primary functions and its importance on the global financial markets.
The Federal Reserve
Fed Structure
Within the Fed, there is a group of people called the Federal Open Market Committee or FOMC for short. This group consists of 1 chair, 7 governors from the Federal Reserve Board and 5 presidents from 5 of the 12 district reserve banks. The 5 presidents rotate through the 12 district reserve banks every couple years ensuring all districts get a voting seat within a 4 years cycle.
All these people combined make up the Federal Open Market Committee (FOMC) and they are definitely a big deal to the FX market so FX traders need to listen to what they say and do very carefully.
Fed Mandate
The Fed’s mandate is to achieve long-term price stability of the U.S. Dollar and ensure sustainable growth within the United States economy. Under normal circumstances, they meet to discuss and change monetary policy 8 times per year. They then release the “Minutes” from the meeting to the public one month later.
Fed Minutes
The meeting minutes are a summary of the key topics discussed and the views expressed by the individual FOMC members on those topics. These minutes are something that the market pays a lot of attention to because there are potential clues in the wording of the minutes that can give traders insights as to what type of moves the Fed might make on interest rates in the near future.
The FOMC discusses and prepares the wording of the minutes very carefully because they want to communicate very specifically to the market what they are thinking and what their intentions are. Adding or dropping certain key words can have a huge impact on market expectations of future interest rate policies. They communicate with the market in this way to try and keep price volatility as low as they can. This communication style is a form of forward guidance.
Forward Guidance
The Fed uses something called forward guidance very specifically. This simply means that they like to give the market lots of little clues and hints about what potential changes to the policy they will make and when they plan on making these changes. The idea is to minimize aggressive market reactions and control price volatility by stating things over time rather than hitting the market all at once. They do this because the more known something is to the market the less violent the reaction will be when the data is released. Remember, part of their mandate is price stability for the US Dollar so this forward guidance is an attempt to accomplish price stability.
You can read all about what the Fed is currently up to and concerned about on its website.
What Does the Fed do and How do they do it?
There are 4 main actions that the Fed takes as part of its regular operations. There are other tools and actions the Fed can take but these are the most common that they use during "normal" economic environments.
1. Reserve Requirements
As a general rule, all commercial banks that most people deposit money into and do banking with are mandated by law to keep a certain percentage of all their client deposits physically in their actual banks. They do this so that they have money available for those people who would like to take money out. This is called the reserve requirement. The Fed sets the reserve requirement for all banks in the United States.
The term reserve requirement is sometimes used interchangeably with reserve ratios. They are referring to the same thing.
By “decreasing” the reserve requirements, less money has to be held back by commercial banks. This means that they can loan out and inject more money into the economy. This is a simple and effective way for a central bank to increase the money supply circulating throughout the economy. This is something you would see happen if the Fed wants to stimulate or jump-start the economy.
Conversely, if the Fed wants to reduce the money supply then they would “increase” the reserve requirements on banks. This would mean that banks have less money to lend out because they need to hold onto more cash at their banks. The Fed would do this if they wanted to try and slow down an economy, perhaps because inflation is getting to the upper limit of what they would like to see for example.
Most countries’ central banks will manipulate reserve ratios the same way that the Fed will. If you want to know what the current reserve requirement for a particular country you can check that info out on the following website that we have found to be helpful.
The other alternative is to go check out each of the individual central bank websites. They will have this information and much more freely available.
2. Interest Rates
Interest rates are what the entire [FX market] obsesses about on a daily basis.
Contrary to popular belief, the amount of control the central bank has on the interest rate differs around the world. For example, the Fed does not set the interest rate that U.S. consumer pays on their mortgages simply because it has no power to do that. The process is a bit more complicated than this so let’s look at it a bit closer.
First, commercial banks need to borrow money from the central bank. Second, commercial banks then must go out and loan money to other businesses or individual people. They can literally charge whatever interest rate they want to as long as someone is willing to pay it.
The rate that a commercial bank would charge a borrower is typically based on how risky the individual person or business is. The more risk involved in the loan, the more interest they will charge to compensate them for taking on that higher level of risk. They may also choose to be competitive with the overall market and charge whatever the going rates are for commercial loans and personal mortgages at the time.
What the central bank does have control over is the Discount Rate which is the rate that the Fed charges to commercial banks to borrow money from it. This interest rate will always be much lower than personal consumers will get for personal loans. After all, the commercial bank needs to make a profit to survive! And the central bank needs commercial banks to take on the risk of loaning out money because the central bank would otherwise have to take on the risk itself which could be pretty destabilizing if there were some financial crisis on the horizon.
The Fed also has control over the federal funds rate. This is the interest rate that other banks charge each other for overnight federal loans. For example, if the Fed reduces the discount rate then more banks would take money to re-loan out. This has the net effect of more money injected into the economy.
This works because interest rates are basically the cost of money. When rates are lowered the cost of money and doing business goes down. This means that the money supply will naturally increase. If rates are moved higher than the cost of money and doing business goes up which at a certain point would naturally reduce the money supply.
The problem with interest rates and reserve requirements is that their results can take longer to filter through to the economy than the central bank would like. This is where the third core area comes in.
3. Open Market Operation
Open market operations are a way of affecting the money supply by buying or selling securities. These securities would mostly be government securities such as treasuries and bonds.
If the Fed wants to inject money directly into the financial markets then they will literally go out into the financial market and buy back government bonds from commercial companies that own them. When the Fed buys these bonds it gives the sellers of these bonds money in return. The idea is that this fresh injection of money will make its way back into the economy because the sellers of the bonds have more cash to do other things.
When the Fed wants to decrease the money supply it does so by selling bonds into the market. This is the same as removing money from the financial markets in exchange for these new government bonds. Companies will buy these bonds because the Fed promises a guaranteed annual rate of return to these companies who bought the bonds
4. Overnight Repurchasing Agreement
Open market operations have traditionally been reserved for times when urgent action is needed for fast results. However, the Fed does also engage in a more common form of operation. This is known as the overnight repurchase agreement. It is called REPO for short.
A Fed REPO basically alters the money supply for a very short period of time by temporarily buying or selling government bonds overnight.
Most central banks around the world do not limit themselves to only buying government bonds. There are many historical ways in which central banks have intervened. For example, in 2007 during the Great Financial Crisis, the Fed bought hundreds of billions of dollars worth of subprime mortgages. This increased the money supply and added a huge amount of badly needed liquidity to the savaged subprime market at the time.
Most traders do not pay much attention to the Fed’s daily REPO but the fact is that these types of operations can have a huge impact on the finances of investors and companies so it’s definitely worth at least knowing what they mean because they are a regular routine.