eToro – Forex Trading Forum

[djsheckie]

Obviously the Fed is a big deal. No not K-Fed, The Federal Reserve Bank, or Fed for short. You’ll hear it talked about almost incessantly, but what is it, what do they do, and why should you care?

So, the Federal Reserve Bank is responsible for many things namely - regulating all US banking activity, maintaining the stability of the financial system, as well as being a major part in operating the nation’s payments system. In regards to trading and Forex, the role which you most need to understand and worry about is the Fed’s role in determining and regulating monetary policy.

[djsheckie]

While the Federal Reserve has a lot of interesting aspects which are definitely worth learning about and understanding for the sake of brevity I’ll just highlight the primary components responsible for the movement of the markets:

First of all you have the Federal Reserve’s Board of Governors. The Board is located in Washington DC and is at the very top of The Fed’s pecking order. It’s comprised of 7 members who are first appointed by the president and then have to be confirmed by the Senate. However, in an effort to keep the Federal Reserve from being influenced too much by any particular political party or era, 5 of the Fed’s Governors are appointed to 14 year terms which are staggered. Chairman and Vice Chairman of the Federal Reserve are appointed to 4 year terms but they can be reappointed if the President wishes to have them re-appointed.

[djsheckie]

Secondly, you have the 12 Regional Federal Reserve Banks. Aside from the regional Federal Reserve Banks there are 25 branches. Since, different regions of the US are involved in different industries (i.e. - the New York area is more involved in financial services, whereas the San Francisco area economy is more economically dependant on Silicon Valley.) the regional banks are strategically distributed throughout the United States in order to focus on the specialized and current economic conditions in each of the regions.

So, in case you're wondering these are the cities where Regional Banks are located:

New York
Boston
Philadelphia
Richmond
Cleveland
St. Louis
Dallas
Chicago
Minneapolis
Kansas City
Atlanta
San Francisco

[djsheckie]

The third component of the Fed is the Federal Open Market Committee which is usually abbreviated and referred to as the FOMC. The FOMC is comprised of both the board of governors as well as the presidents of each of the 12 regional reserve banks. The Federal Open Market Committee is the most critical part of the Fed – at least from a trading standpoint as the FOMC is the body responsible for determining US monetary policy.

Generally the FOMC meets 8 times a year to discuss the current economic conditions and to vote on any monetary policy changes or actions, if any, they’d like to make.

The voting members of the Federal Open Market Committee are:
The Board of Governors
The President of the Federal Reserve Bank of New York
4 Presidents from the other Regional banks (who vote on a rotating basis)

[djsheckie]

Anticipation of interest rates has one of the greatest impacts on market movement, and seeing as the FOMC has the most control over interest rates, you could say the FOMC has the greatest power to move markets. Oddly enough before an announcement the markets can go quiet for days in anticipation of an FOMC interest rate announcement and then suddenly explode with volatility shortly after.

How the Fed Moves Interest Rates

So, in speaking about the Fed we keep mentioning monetary policy, but what exactly is it? Monetary policy is basically anything that relates to the actions taken by the Fed which influences the amount of money and/or credit available in the economy. Before you can understand the concept of money or credit available you must first understand something known as a fiat money system.

[djsheckie]

In the United States, like most major economies, the monetary system used is a fiat money system. No don’t worry it has nothing to do with cars. Very simply a fiat monetary system is one in which a monetary unit (in this case the US Dollar) is used which is not linked to some commodity, in general a precious metal such as gold. The US monetary system used to be a gold standard meaning that for all the money in circulation there had to be an equivalent amount of gold in storage. Obviously this limited the amount of money somewhat but also at the same time meant that the money had a specific value backing it.

[djsheckie]

So fiat money as it is known operates on the idea that all you need to back the money is the credit of some entity, usually a government, and the value derived from its regulated and enforced relative scarcity as well as the faith placed in it by the population of the country or people who use it.

So why is it significant that the US economy operates on a fiat money system and what does that have to do with the Fed? It is important to know, especially as a Forex trader for the simple fact that the dollar is no longer a convertible currency based on a commodity such as gold. Since it is fiat money that gives the Federal Reserve Bank the ability to increase or decrease the money supply as it sees fit, or in other words to enact US monetary policy as it sees fit.

[djsheckie]

So how does the Fed enact monetary policy? Basically there are 3 tools available to the Federal Reserve when it wants to enact monetary policy. They are:
Open Market Operations
The Discount Rate
Reserve Requirements

Most commonly the Fed will rely on open market relations, and so that’s the first tool that we’ll focus in on. Since it’s also the most commonly used tool we’ll spend the most time discussing it. Once you understand how open market operations increase and decrease the supply of money, etc. it’ll be easier to explain what the other two tools are as well as how and when they’re used.

[djsheckie]

Open market operations are carried out through the Federal Open Market Committee which we discussed earlier. To increase or decrease the supply of money the Federal Reserve buys and sells US Government securities.

When for whatever reasons the Fed wants to reduce the interest rates they’ll increase the available supply of money by buying government securities. They do this using money which was not in circulation before the purchase was made. Once the additional supply is added and all other factors are held constant the price will normally fall. So, in this instance the price which we’re referring to is the cost of borrowing money or interest rates.

[djsheckie]

However, when the Federal Reserve decides that the interest rates need to be increased they’ll tell the Federal Open Market Committee (FOMC) that it should sell government securities. What this means in plain English it that the FOMC will be taking the money they made on the proceeds of those sales out of circulation and thereby effectively reducing the available money supply.

So, now that the FOMC has decreased the amount of money in circulation while allowing all other regular factors in the market to remain constant the price (or in this particular case the interest rates) will naturally be forced to rise.

[djsheckie]

So what does it mean when the Federal Reserve decides to increase or decrease the supply of money in circulation?

When the Fed changes the rates, they’re doing so in order to change something which is known as the Fed funds rate, or the interest rate. This is the rate which banks charge each other for overnight loans. So, now when you hear that the Federal Reserve wants to lower or raise the Fed funds rate by a quarter of a percentage point, for example, it means that what has actually happened is an increase or decrease in the amount of money available in circulation.

[djsheckie]

So, now that we’ve learned how the Federal Reserve enacts US monetary policy by increasing and decreasing the money supply now we’ll look at how the Fed reacts to different points in the business cycle and what effect has on the markets.

As was no doubt drilled into you in your intro to Economics classes, assuming you paid attention ;), the economy goes through both regular periods of growth as well as periods of constriction which tend to repeat over time. Economies are cyclical and will go though these periods on a regular basis. These repeating periods are what is known as the business cycle.

[djsheckie]

The government tries to manage the business cycle as best it can and aims to maximize economic growth, employment, as well as price stability. As mentioned previously the primary tool which the Federal Reserve uses (at least from a monetary policy standpoint) to manage the business cycle is varying the fed funds rate. As explained earlier this means either increasing or decreasing the money supply in order to change the rates.

Moving on we’ll now take a peek at the business cycle and try to understand the balancing act that the Federal Reserve must play in trying to keep economic growth at its full potential, while at the same time sticking to its goal of price stability.

[djsheckie]

During an economy’s expansion the employment rate is usually high and growing. Obviously, when people are earning more and job prospects are good people are a lot more willing to spend their hard earned paychecks on various goods and services. This increased spending will also encourage businesses to expand in order to take advantage of the increased growth in the economy. For example, in a growth period rather than save consumers are often willing to spend a little extra on daily luxuries like take away coffees. A company like Starbucks may then decide to capitalize on this trend and add cafes seemingly everywhere - in bookstores, grocery stores, and airports. Seriously, at one point I thought Starbucks was actually going to try to open a franchise in my kitchen.

[djsheckie]

During these periods of economic growth The Fed must maintain a careful balancing act. They need to drive the economic growth while keeping prices stable but when push comes to shove the Fed normally shifts towards the keeping prices stable side of the equation. In the early stages of economic expansion there isn’t a problem with the supply of goods and services keeping up with the demand, and therefore the prices are likely to remain in check. However, as the economy continues to gain momentum demand may start to outpace production and that will contribute to a rise in inflation and therefore you’ll see higher prices.