The biggest and most important central bank in the world, the Federal Reserve of the United States (Fed) can also be considered the world’s central bank. While this is not true per se, it can be assumed it is. The U.S. dollar being the world’s reserve currency, the interest rate and the monetary policy in the United States sparks a lot of interest and debate around the world. This policy will influence monetary policies around the world, force some central banks to change their view of the global economy, and traders need to adapt.
The Federal Reserve
The Federal Reserve is the central bank in the United States and was created in the early 19’s. The idea behind it was to have a monetary system to fight crisis like the one in 1907. In time, the role of the Fed expanded and, to this day, the Fed has a dual mandate: to keep inflation below or close to two percent 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 it is formed out of twelve 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’s voting and who’s 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, in time, but the position is there in the committee to be filled. The presidents of the other regional banks are rotating on a two or three-year mandate. This algorithm allows for the FOMC to have a fresh view all the time and 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 the price in or not.
The FOMC is meeting every six weeks (eight times per year) and its statement is the primary tool to communicate 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 basis 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 is raising/hiking rates, this is a positive move for the currency. When it is cutting/lowering rates, it is supposed to be negative. Following on the above statement, the reaction on the dollar should have been a positive one, as the Fed hiked the rates, indeed. However, the dollar was sold aggressively across the board, with EURUSD, GBPUSD, AUDUSD, NZDUSD gaining ground while USDCAD and USDJPY 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 the 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 virtually describe all the decisions a central bank is making and the market reaction as well.
FOMC reactions in Financial Crisis
Desperate times call for desperate measures. When things are going out of control and there is the danger for the economy to derail, the FOMC will not wait for the next meeting. The classical example is the reaction the FOMC and the Federal Reserve had 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 that 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 be done, at the right moment. Other central banks in the world followed suit and in a matter of a few weeks/months, major central banks in 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 at 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 is taking on its monetary policy, or the moves on the U.S. dollar, are followed by other central banks. Another example that comes to further show 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. Thus, a consortium led by the Fed and having other major central banks in its componence, like the European Central Bank and Bank of England, issued a swap liquidity operation designed to support the JPY. Again, this is just another example to show how central banks are acting in desperate situations and why their role is vital for the course of any economy. To sum up, the FOMC and its members decide for the U.S. dollar and the U.S. economy, but not only. The U.S. dollar is the pillar of the world’s financial system, so the FOMC should be on the watch of every trader, no matter he/she is a retail one or not.
Recommended Further Readings
- Fundamental Analysis – Explaining the U.S. Economic Data – Part 1
– Covering all data that matters from the United States – 1st part - Fundamental Analysis – Explaining the U.S. Economic Data – Part 2
– – Covering all data that matters from the United States – 2nd part - Fundamental Analysis – Explaining the U.S. Economic Data – Part 3
– Explaining the U.S. Economic Data – Part 3 - Fundamental Analysis – Explaining the Eurozone Economic Data
– Covering the economic data that matters for the Eur- pairs - Fundamental Analysis – Explaining the United Kingdom Economic Data
– Covering the economic data that matters for the GBP pairs - Fundamental Analysis – Explaining the Canadian Economic Data
– – Covering the economic data that matters for the CAD pairs
Other Educational Materials
- Federal Open Market Committee. FEDERAL, O.,
- “Integrated strategy: Market and nonmarket components.” Baron, David P. California management review 37, no. 2 (1995): 47-65.
