Federal Reserve Bank also known as the FED is a very powerful institution that controls the US economy and the world economy to some extent due to the international reserve currency status of US Dollar. FED is responsible for controlling the monetary policy in the US economy meaning setting the interest rates and increasing and decreasing the money supply. FED can affect the credit in the economy which has impact on the businesses, investments and consumption in the economy. FED also has the mandate to regulate the national banks. In short FED has the dual mandate as given by US Congress. This dual mandate is inflation and unemployment. Both have opposite effect. If you control inflation, unemployment goes up and if you control unemployment inflation goes up. FED mandate is to keep inflation below 2% and unemployment below 3%.
Trust me, FED is very powerful. Sometimes even more powerful than the US President and the US Congress. But few people know that FED is a private institution that is not controlled by the US Government. Federal Reserve Bank got created by an Act of Congress in 1913 known as the Federal Reserve Act. US Congress does not control the FED but it has oversight over it and can even repeal the Federal Reserve Act that creates the FED. Federal Reserve Bank has a 7 member Board of Governors. The 7 members have a staggered 14 years term. US President appoints that board members but only 2 in 4 years. There are 12 regional Federal Reserve banks spread across US that provide banking services for the federally chartered banks. All federally chartered banks are members of the Federal Reserve bank. State chartered banks are not required by law but they can also join the Federal Reserve Bank if they want to.
Federal Open Market Committee FOMC
FOMC is a very important arm of the FED that makes the monetary policy decisions on a monthly basis. FOMC has 7 Board Governors as voting members, President of New York Federal Reserve Bank and 4 remaining presidents of the 11 other regional Federal Reserve Banks with a 1 year rotating term. The decisions made by the FOMC cannot be overridden by the US President or the US Congress. As said above FED is responsible for:
- Setting the monetary policy and balancing inflation and unemployment in the US economy.
- Regulation of the banking industry in US with the help of Federal Deposit Insurance Corporation and the Office of Thrift Institution. Banks are supervised to ensure that they are financially sound and don’t take too much risk.
- Ensure financial stability in the economy by providing short term liquidity if the banking system faces a liquidity crisis that developed in the US money markets in 2008.
- Provide clearing services to the national payment systems.
How does FED control the monetary policy? FED controls the monetary policy with the help of a few powerful tools that it has at its disposal. These tools help FED to influence the interest rates and the availability of credit in the economy. How does the FED control interest rate in the economy? FED cannot directly control the interest rate. What it can do is buy and sell the government treasury securities and try to influence the interest rate. When you buy a lot of treasuries you bid the bond prices up which drives the interest rates down. When you sell a lot of securities, you push the security prices down which results in driving the interest rates high. This is what the open market operations means. FOMC is the executive committee that decides how much bonds to buy and sell. This decision is then conveyed to the NY Federal Reserve Bank which is responsible for the open market operations. FED usually targets the short term interest rate known as the Federal Fund Rate. This is the interest rate charged by the members banks for overnight loans.
So the main monetary policy tool at the disposal of FED is the open market operations. FED uses these open market operations to increase or decrease the interest rate to the desired rate. By targeting this short term Federal Fund Rate, FED tries to control the other interest rates in the economy. Changes in the Federal Fund Rate (FFR) gets trickled down to rates charged for the consumer credit cards, business loans and mortgage rates. Changes in these rates affect the credit availability in the economy and eventually the inflation and the unemployment rate in the economy. It takes time for these changes to take place. Nothing is instantaneous. So when the FED thinks that the risk of inflation rising is high, just like now a days, it can increase the FFR and if it thinks that the risk of unemployment is high, it can lower the FFR.
In the above EURUSD H8 chart, you can see a beautiful pattern develops 24 hours before the FOMC Meeting Minutes release. Some people always have insider information and they are anticipating something which results in buying. We just need to trade the chart pattern and forget whether FOMC Meeting will decide on the rate hike or not. Just trade the chart pattern. Keep your nerves and you will reap a good reward. This chart was a 200 pip move. Now if FED had decided on the full dose of interest rate hike we would have seen a big downward move. But since FED did not decide on the full dose and instead decided on only 25 basis point increase market took it as a bullish signal.