Fundamental Analysis – FOMC Componence and Its Role

The biggest and most important central bank in the world, the Federal Reserve of the United States (Fed) can also be considered to be the world’s central bank. While this is not true per se, it can be assumed to be so. The US dollar being the world’s reserve currency, the interest rate and the monetary policy in the United States spark a lot of interest and debate around the world. This policy will influence monetary policies around the world and force some central banks to change their view of the global economy, and traders need to adapt to this.

The Federal Reserve

The Federal Reserve is the central bank in the United States, and was created in  1913. The idea behind it was to have a monetary system to fight a crisis like the one in 1907. In time, the role of the Fed expanded until the present day, when the Fed now has a dual mandate: to keep inflation below or close to 2%, and to create jobs. Both are needed for the monetary policy to shift.

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FOMC – Federal Open Market Committee

The Federal Open Market Committee (FOMC) is the decision-making body of the Fed, and consists of 12 members. There are five regional Federal Reserve Bank presidents, and seven members of the Board of Governors of the Fed. Its componence is not the same all the time, and not all members have voting power. For this reason, it is important to know who is voting and who is not before interpreting a speech or placing a trade from a fundamental point of view. There’s one exception, though: The president of the Federal Reserve Bank of New York is a permanent member of the FOMC. It may not be the same person over time, but the position is there in the committee to be filled. The presidents of the other regional banks rotate on a 2- or 3-year mandate. This algorithm allows the FOMC to have a fresh view all the time, and also allows new approaches to be considered. The recent March 2107 FOMC interest rate decision is the perfect example to illustrate how the FOMC works and how the job is done. The market reaction cannot be anticipated, regardless of how much an FOMC move is in the price or not.
FOMC
The FOMC meets every 6 weeks (eight times per year) and its statement is the primary tool for communicating with investors about monetary policy. The more different the statement is when compared with the previous one, the more aggressive and violent the market reaction will be. At this March 2017 meeting, the FOMC was expected to raise the federal rates to 1%, an increase of a quarter of a base point. While not much, it is still an increase. As a rule of thumb, as mentioned on this Trading Academy multiple times, when a central bank raises/hikes rates, this is a positive move for the currency; and when it cuts/lowers rates, it is usually negative. Following on from the above statement, the reaction on the dollar should have been a positive one, as the Fed did indeed hike the rates. However, the dollar was sold aggressively across the board, with EUR/USD, GBP/USD, AUD/USD and NZD/USD gaining ground, while USD/CAD and USD/JPY fell accordingly. Why did that happen? The answer comes from the FOMC componence, as one member, Kocherlakota, dissented. While the monetary policy decisions must reach consensus, it is not mandatory for them to be unanimous. It is true that a unanimous vote brings more power and trust into a decision, but only consensus is needed. Thus, the hike was interpreted as being a “dovish hike”. As you can see, there are many terms that can be used to describe virtually all the decisions a central bank makes, as well as the market reaction to them.

FOMC reactions in Financial Crisis

Desperate times call for desperate measures. When things are going out of control and there is the danger of the economy derailing, the FOMC will not wait for the next meeting. The classical example is the reaction of the FOMC and the Federal Reserve during the 2008 financial crisis. In an unprecedented move, the FOMC and Federal Reserve decided to slash the interest rate on the federal fund’s rates virtually to zero, in an overnight announcement. For those of you who do not remember those times, it was when the Lehman Brothers bank collapsed, and the whole financial system as we know it was about to collapse as well. The FOMC was proactive; it met and held discussions over teleconferences, reached a consensus, and a decision was communicated. The financial markets were taken by surprise, and immense volatility surrounding the dollar and other currency pairs affected trading. In the end, it proved to be the right thing to do, at the right moment. Other central banks in the world followed suit, and in a matter of a few weeks/months, major central banks around the world started to massively cut rates as well. Suddenly, no one wanted a higher currency anymore. At this point in time, please go back to the start of this article and find the part where it is mentioned that the Fed is, in some ways, the world’s central bank. This example illustrates, beyond any reasonable doubt, that the moves the Fed takes on its monetary policy, or moves on the US dollar, are followed by other central banks.

Another example that further shows the influence and role of the Fed and the FOMC is the tsunami that hit Japan a few years ago. This tragic event resulted in the JPY moving in an uncontrolled fashion, and it threatened to get out of any control. In response, a consortium led by the Fed, and with other major central banks in its componence, such as the European Central Bank and the Bank of England, issued a swap liquidity operation designed to support the JPY. Again, this is just another example to show how central banks act in desperate situations, and why their role is vital for the course of any economy. To sum up, the FOMC and its members make decisions for the US dollar and the US economy, but not only for them. The US dollar is the pillar of the world’s financial system, so the FOMC should be on the watch of every trader, regardless of whether he/she is a retail trader or not.

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