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Level 5 Economics - The Fed

As we have learned, there is a government body that acts as the guardian of every nation's economy - an economic sentinel who implements policies designed to keep the country operating smoothly. The truth is however, most investors do not understand how or why the government involves itself in the economy. So it is especially important for forex to understand how and why these government bodies get involved to effect interest rates and their domestic currencies.






As previously discussed, the Fed's mandate is "to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates." In other words, the Fed's job is to promote a sound banking system and a strong economy. The Fed also issues all coin and paper currency. The U.S. Treasury actually produces the cash, but the Fed Banks distributes it to financial institutions. It's also the Fed's responsibility to check bills for wear and tear and to take damaged currency out of circulation. To achieve its mission, the Fed serves as America's money manager.

Money Manager
The term monetary policy refers to the measures that the Federal Reserve undertakes to influence the amount of money and credit available in the U.S. economy. Changes to the amount of money and credit directly affect interest rates (the cost of credit) and the performance of the U.S. economy, which in turn affects the direction of America's dollar To state this concept simply, if the cost of credit is reduced, more people and firms will borrow money and the economy will heat up.

The Toolbox
The Fed has three major tools at its disposal to manipulate monetary policy:

Open-Market Operations
The Fed is constantly buying and selling U.S. government securities in the financial markets, which consequently influences the level of reserves in the banking system. The Fed's decisions also affect the volume and the price of credit (interest rates). The term open market means that the Fed can't independently control which securities dealers it will do business with on any given day. Rather, the choice emerges from an open market where the different primary securities dealers participate. Open market operations are the most frequently employed tool of monetary policy.


Setting The Discount Rate
The discount rate is the interest rate that banks pay on short-term loans from one of the Federal Reserve Banks. The discount rate tends to be lower than the federal funds rate, although they are very closely related. The discount rate is important because it is a visible announcement of an adjustment in the Fed's monetary policy and allows the rest of the market (forex traders included) some insight into the Fed's plans.


Setting Reserve Requirements
This is the amount of actual physical funds that depository institutions are required to hold in reserve against deposits in their customers' bank accounts. It determines how much money banks can create through loans and investments. Set by the Board of Governors, the reserve requirement is usually around 10%, but can vary. This means that although a bank might hold $20 billion in deposits for all of its customers, the bank lends most of this money out and, therefore, doesn't have that $20 billion on hand. Additionally, it would be extremely costly to hold $20 billion in coin and bills within the bank. Excess reserves are, therefore, held either as vault cash or in accounts with the district Federal Reserve Bank Therefore, while the reserve requirements make certain that depository institutions preserve a minimum amount of physical funds in their reserves.

The Federal Funds Rate


The use of open-market operations is the most important tool that's used to manipulate monetary policy. The Fed's goal in trading securities is to affect the federal funds rate - the rate at which banks borrow reserves from each other. The Federal Open Market Committee (FOMC) sets a target for this rate, but not the actual rate itself (because it is determined by the open market). This is what news reports are referring to when they talk about the Fed lowering or raising interest rates. So be sure you are aware that a change in interest rates is actually just a change in the federal funds rate.


All banks are subject to reserve requirements, but they commonly fall below requirements in carrying out of day-to-day business. To meet the requirements they have to borrow from each other's reserves. This creates a market in reserve funds, with banks borrowing and lending to one another at the federal funds rate. Consequently, the federal funds rate is of such importance because by increasing or decreasing it, over time, the Fed can impact practically every other interest rate charged by U.S. banks.

The FOMC Decision
The FOMC typically meets eight times per year, and at these meetings, the FOMC members decide whether monetary policy should be changed. Before each meeting, FOMC members receive the "Green Book," which contains the Federal Reserve Board (FRB) staff forecasts of the U.S. economy, the "Blue Book," which presents the Board staff's monetary policy analysis and the "Beige Book," which includes a discussion of regional economic conditions prepared by each Reserve Bank.

When the FOMC meets, it decides whether to lower, raise or maintain its target for the federal funds rate. The FOMC also decides on the discount rate. The reason we say that the FOMC sets the target for the rate and not the actual rate itself is because the rate is actually determined by market forces. The Fed will do its best to influence open-market operations, but many other factors contribute to what the actual rate ends up being. A good example of this fact occurs during the holiday season. At Christmas, consumers usually have an increased demand for cash, and banks will draw down on their reserves, placing a higher demand on the overnight reserve market; thus increasing the federal funds rate. So when the media says there is a change in the federal funds rate (in basis points), don't let it confuse you; what they are, in fact, referring to is a change in the Fed's target.
If the FOMC wishes to increase economic growth, it will reduce the target fed funds rate. On the other hand, if it wants to slow down the economy, it will increase the target rate.

The Fed aims to sustain steady growth, without the economy becoming too overheated. When talking about economic growth, extremes are never good. If the economy grows too quickly, we end up with inflation. If the economy slows down too much, we end up in recession.

It is not uncommon for the FOMC to maintain rates at current levels but warn that a possible policy change could occur in the near future. This warning is referred to as the bias. The means that the Fed might think that rates are fine for now, but that there is a considerable threat that economic conditions could warrant a rate change soon. The Fed will issue an easing bias if it thinks the lowering of rates is imminent. Conversely, the Fed will adopt a bias towards tightening if it feels that rates might rise in the future. By paying attention to the language used by the Fed when discussing the economy and interest rates forex traders can get a leg up on the competition for profits.

Why It Works

If the target rate has been increased, the FOMC sells securities. If the FOMC reduces the target rate, it buys securities.

For example, when the Fed buys securities, it has essentially created new money to do this increasing the supply of reserves in the market. Think of it this way, if the Fed buys a government security, it issues the seller a check, which the seller deposits in his or her bank. This check must then be credited against the bank's reserve requirement. Therefore, the bank has a greater supply of reserves, and doesn't need to borrow money overnight in the reserves market, reducing the federal funds rate. Of course, when the Fed sells securities, it reduces reserves at the banks of purchasers, which makes it more likely that the bank will engage in overnight borrowing, and increase the federal funds rate.

To put it all together, reducing the target rate means the fed is putting more money into the economy. This makes it cheaper to get a mortgage or buy a car, which helps to boost the economy. Furthermore, interest rates are related, so if banks have to pay less to borrow money themselves, the cost of a loan is reduced. All this can affect the value of a currency in any number of ways when added to other factors.

The Fed has more power and influence on financial markets than any legislative entity. Its monetary decisions are intensely observed and often lead the way for other countries to take the same policy changes.

Inflation


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