The Federal Reserve Bank: An FX Trader's Handbook

The United States Congress established the Federal Reserve System (the Fed) in 1913. Throughout history, the Fed's decisions and policies wield significant influence on the value of the US Dollar, which, in turn, affects various trades involving the currency. To comprehend the Fed's influence on the USD and engage in trading based on its monetary policy decisions, one must delve into its historical background and understanding its pivotal role in the nation's financial system.

WHAT IS THE FEDERAL RESERVE?

The Federal Reserve, America's primary financial institution, was established with the objective of fostering a steadfast, adaptable fiscal and monetary framework for the country. Its main responsibilities entail formulating monetary policy and supervising the efficient economic functionality, ultimately dedicated to serving the welfare of the public.

To accomplish these high-level objectives, the Federal Reserve undertakes five primary roles:

1. Foster optimal employment, steady inflation, and reasonable long-term interest rates.

2. Mitigate risks to foster a stable financial system.

3. Cultivate security within financial institutions.

4. Safeguard the integrity of payment and settlement systems.

5. Advocate consumer protection through supervisory measures.

To implement day-to-day activities, the country is divided into 12 Federal Reserve Districts, each served by a distinct incorporated Reserve Bank. These districts and member banks function autonomously under the oversight of the Federal Reserve Board of Governors.

Who owns the Fed?

The Federal Reserve is a hybrid entity, embodying characteristics of both a private and public institution. The Board of Governors operates as a government agency, while the banks, in turn, are organized akin to private corporations – member banks possess shares and receive dividends.

Who is the Federal chairman?

As of August 2019, the chief of the Federal Reserve is Jerome Powell, who holds this post since February 5, 2018. He is the 16th individual to have occupied this position and will fulfill a four-year tenure. Prior to his designation, Mr. Powell was a member of the Board of Governors starting May 25, 2012. Additionally, he presently acts as the Chair of the Federal Open Market Committee, entrusted with overseeing monetary policy.

Which banks make up the Fed?

The 12 Federal Reserve Districts, each with their own Reserve Bank, are:

1. Boston
2. New York
3. Philadelphia
4. Cleveland
5. Richmond
6. Atlanta
7. Chicago
8. St. Louis
9. Minneapolis
10. Kansas
11. Dallas
12. San Francisco

How is the Fed held accountable to its functions?

The Federal Reserve is responsible to both the public and the US Congress. The Chair and officials from the Federal Reserve testify before Congress, while the process of determining monetary policy is intentionally transparent and unambiguous. In the spirit of accountability, the Federal Open Market Committee (FOMC) releases statements after each yearly gathering. Moreover, all financial records undergo independent auditing annually, ensuring financial responsibility.

THE MAIN GOALS OF THE US CENTRAL BANK’S MONETARY POLICY

The Federal Reserve bank is responsible for conducting the monetary policy of the US. The Congress has given the Fed the following statutory objectives for this policy:

• Full employment: The Fed’s monetary policy should aim to keep the unemployment rate low, by stimulating the economy when needed so that businesses can prosper, earn profits and expand their workforce
• Stable prices: The Fed defines stable prices as a 2% inflation rate over the long run
• Low long-term interest rates: This is related to price stability – when the economy is stable, long-term interest rates tend to be low The Fed tries to achieve its monetary policy by affecting interest rates and the overall financial conditions. This can cause fluctuations in the US Dollar, before and after the Fed announces and changes its policies.

Federal Reserve System’s Open Market Committee

The Federal Reserve System’s open market committee (FOMC) is in charge of setting the monetary policy of the US. They decide on a target for the federal funds rate at FOMC meetings; this is the interest rate that they want banks to charge each other for loans that last one night. The FOMC does not directly control the rate, but it can affect it in three main ways:

Open market operations. This means the buying and selling of government bonds in the open market – selling bonds reduces the amount of money in the economy, with the goal of raising interest rates. Buying bonds adds money to the economy, with the goal of lowering interest rates Discount rate. This is the rate that banks pay to borrow money from the Fed. When this rate is lower, then it is also more likely that the federal funds rate will be lower too Reserve requirements. Banks need to keep a certain percentage of customers’ deposits to pay for withdrawals – this is the reserve requirement. When these are increased, banks can’t lend as much money and must ask for higher interest rates. When lowered, banks can lend more money and ask for lower interest rates.

THE IMPACT OF THE FED FUNDS RATE ON THE US DOLLAR

The Fed funds rate, also known as the Fed’s interest rate, is determined by the Board of Governors of the Federal Reserve System. The current interest rate and the expectations of future interest rate changes can both influence the value of the US Dollar. If traders expect a change in interest rates based on announcements from the Board of Governors, this can cause the Dollar to increase or decrease in value against other currencies.

This table shows how market expectations and rate changes can affect the value of the dollar:

MARKET EXPECTATIONS	ACTUAL RESULTS	RESULTING FX IMPACT
Rate Hike	Rate Hold	Depreciation of currency
Rate Cut	Rate Hold	Appreciation of currency
Rate Hold	Rate Hike	Appreciation of currency
Rate Hold	Rate Cut	Depreciation of currency

As you can see in the chart below, the Dollar gained strength against the Yen in the period before the Fed’s interest rate announcement in December 2016 because it was widely anticipated that the fed funds rate would rise. The pair reached its highest point at around 118.371 on the day of the announcement, December 14, 2016.

USD/JPY chart before and after Fed hikes in 2016

THE BEST WAY TO TRADE THE US CENTRAL BANK’S POLICY DECISIONS

In order to get ready for Fed rate change decisions, traders should follow these two key steps:

Stay updated with news from the Fed. The FOMC has eight regular meetings a year, where policies and interest rates are discussed and decided. Staying updated with news before these meetings is the best way to make forecasts about interest rates, and whether to buy or sell the US dollar Stay updated with news from the markets. You can be sure that you are not the only one speculating on interest rates – before Federal Reserve meetings and announcements, many forex traders will be paying close attention to what happens. Watch out for others’ predictions and forecasts, and stay well informed enough that you can have your own opinions and add your own logic to that of others No method of forecasting interest rate decisions can ever be completely accurate and surprises do happen. It’s always important to protect yourself when trading forex, so make sure you place stops in advance to ensure you keep your losses to a minimum if the markets move against you.

Remember to stick to your trading plan and never place a trade where you wouldn’t be able to afford the losses. Trades can go both ways. No matter how confident you feel that they will work in your favour, there’s always the chance that they might not.

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