The Federal Reserve (also known as the Fed) is, quite simply, the world’s most important financial institution. It is the central bank of the United States, which is the world’s largest and most important economy in the world. It governs the money supply of the US dollar, which is the world’s primary reserve currency.
The Federal Reserve uses monetary policy to stabilise the US economy. Here is how we can expect the Fed to react to various economic conditions:
- Overheating economy (inflation is too high) - the Fed will tighten monetary policy (raise interest rates and/or sell bonds on the balance sheet)
- Contracting economy (inflation is too low and/or unemployment too high) - the Fed will loosen monetary policy (lower interest rates or buy bonds)
Decisions on monetary policy are taken via a vote by the rate setting committee, the FOMC.
The Fed’s “Dual Mandate”
The Federal Reserve is mandated by law to provide stability to the US financial system. It should,
“promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
Source: The Federal Reserve
This means the Fed needs to:
- Keep inflation low and stable – with an inflation target of 2% over time.
- Pursue the highest level of employment that the economy can sustain over time.
The Fed also promotes financial stability by supervising and regulating financial institutions, while also promoting consumer protection and community development.
The Fed ‘s decision making committee is known as the Federal Open Markets Committee (or the FOMC).
Seventeen member committee (7 board members plus 12 regional bank heads) decides on interest rate (known as the Fed Funds rate) and the size of assets on its balance sheet (which can be adjusted by either buying or selling bonds).
The 7 board members cast a permanent vote on policy, along with 5 of the 12 regional heads. The regional voters change every year.
The FOMC meets every six weeks.
Why is the Federal Reserve important?
The Fed sets monetary policy for the US. This forms the basis of how US Treasury bonds are priced.
US Treasuries are seen as a “risk free” asset and are considered to be a benchmark around which many financial instruments (such as loans, mortgages and corporate debt) are priced. This applies both in the US and also around the world.
The decisions of the Fed also directly impact the strength of the USD. According to the latest data from the Bank of International Settlements, the USD is involved in 88% of all foreign exchange transactions (such as EUR/USD, USD/TRY, USD/INR) around the world. As of 2019, the global forex market was worth over 6.5 trillion USD per day.
US bond yields, the USD, commodities such as gold, copper and oil, and Wall Street indices will all be impacted by the Fed’s decision.
Look out for hints of what the Fed might do at the coming meetings. The speeches FOMC members also have the power to move markets.
Trading the Fed
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