Federal Reserve (Fed)



The Federal Reserve (Fed) is the Central Bank of the United States of America.

As such, it issues and manages the supply of the American Dollar (USD).

Approximately 80% of the world’s international trade is conducted in USD.

On top of that, USD is the world’s reserve currency (more on this in another page).

Since USD is such a dominant currency, staying a top Fed moves is of utmost importance.

But how can we stay tuned to the Fed?

Let’s start by seeing what the Fed’s objective is.

Federal Reserve's Mandate

The Fed’s mandate is different from most other Central Banks.

Most Central Banks, such as the ECB, or the BoE care about inflation first and foremost.

However, the Fed is more like the Reserve Bank of Australia (RBA) in that it cares about the whole enchilada.

According to the Fed’s website:

“…to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.”

This means the Fed cares about inflation, employment, and growth (moderate rates).

Since inflation often follows labor market tightening, the big difficulty in practice, is maintaining both low inflation, and moderate growth.

The Fed has been very successful at doing so.

The Fed and other Central Banks do a great deal to avoid recessions. And it works (for most autonomous Banks anyways).

Since the time of the Great Depression in the 1930s, the US economy has experienced far fewer recessions.

And the ones it has had, such as the Great Recession of 2008, was relatively short-lived when we compare it to previous crises.

Such a phenomenon is what economists call the Great Moderation.

Essentially, the economy has become much more resilient than before. This is both due to improvements in monetary policy practice by the Fed (and Central Banks globally) and the diversification of economic activity.

With this in mind, let’s jump into governance.

Fed's Structure

The Fed is a three-part system composed of:

1.    Federal Reserve Board

2.    Federal Reserve Banks (there’s twelve regional banks)

3.    Federal Open Market Committee (FOMC)

But what we really care about is the third one, the FOMC, since it is the monetary policy decision-making body.

Cleveland’s Federal Reserve Bank is one of the twelve regional banks.

The FOMC is composed of twelve members, all seven members of the Federal Reserve Board, and five Federal Reserve Bank Presidents.

The New York Reserve Bank President has a permanent seat at the FOMC, while the other four slots are rotated among the other eleven Reserve Bank Presidents.

FOMC meets eight times per year to decide on policy.

Decisions are made through votes.

So you have a chance at making pips if a voter appears to have changed his or her bias while speaking to the press.

The Fed and FX Markets

Now that we’ve covered the basics of the Fed, what can we say about trading USD?

Since the Fed cares about those three big variables (inflation, employment, and growth), you get at least three data releases which can strongly influence the markets.

These are:

CPI (inflation);

GDP (growth); and

NFP (employment).

The market-moving power of these three varies depending on what the Fed is most focused on.

But wait, don’t we have many more economic indicators which can move the markets?

Yes, but for the most part, they do very little.

Indicator going up, should markets follow? Not really, no. It depends. You hate that answer? Sorry, but that’s life.

The only chance of something like trade balance (a so called tier 1 indicator, no less) causing a strong move is if the Fed (and the markets) are paying very close attention to it.

As in, if a rate decision depends on the outcome of such data, then it will affect price. Otherwise? Maybe you’ll get a 20 pip move, if you’re lucky…

Of these three, NFP has traditionally been a powerhouse release, bringing a ton of volatility to USD pairs, even when the Fed isn’t too employment heavy.

This of course, depends on how the results come out.

Mixed results = less effect. But a strong (or weak) report will almost always shake things up.

Aside from watching data and implementing the usual rate change monetary tool, Central Banks can sometimes have something different up their sleeve.

They can come up with anything... really.

For example, at time of this writing, the Federal Reserve is planning to start shrinking its ballooned balance sheet (a result of all the QE they did post recession).

This reduction, while not a direct shift in interest rates, still constitutes a tightening of USD supply.

Which means USD will most likely appreciate as a result.

You have to stay on top of these and other types of moves by checking the news and doing your research.

Don’t trade without knowing what’s going on.

Peace,

Emil Christopher,

The Forex Economist

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