The Federal Reserve - US Dollar

The U.S. Federal Reserve is the U.S. central bank responsible for determining what is arguably the most important variable defining forex trends and currency values: the main interest rate. Established in 1907 in response to a particularly severe banking crisis with bankruns and many failures, the institution was further strengthened with successive legislations, and made independent in 1913, and as such, its decisions do not need the approval of the Congress, the President, or any other authority. After the U.S. abandoned the gold standard in 1971, it acquired even greater influence and power under the successive administrations of Paul Volcker and Alan Greenspan.

The purposes of the Federal Reserve

The role and goals of the Federal Reserve are set out in the Federal Reserve Act where it is stated that the FOMC (the Federal Open Market Committee) must aim “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. Since stable prices are generally accepted to be a precondition for sustainable growth and moderate interest rates, the FOMC implicitly targets an inflation level of close to, but below two percent while determining its main lending rate.

Most importantly, the U.S. Federal Reserve does not have a predetermined exchange rate target, nor does it aim to influence forex price fluctuations with its interest rate decisions. The Fed admits the importance of the stability of the exchange rate for inflationary expectations and domestic welfare, but explains that since the causes of currency fluctuations can be difficult to determine, targeting them with policy action would be misleading and counterproductive.
Federal Reserve Rates

The Federal Reserve sets its main rate during meeting of the FOMC which are always anticipated with great excitement by market participants and the news media.

Federal Funds Rate

As part of the fractional reserve system, banks are required by law to hold a percentage amount as a deposit with the Federal Reserve to ensure liquidity in the system, and as an implicit sign that they are solvent. The Fed’s main rate, the Fed Funds Rate, is the interest rate at which banks are expected to trade these deposits among themselves. This is also the main rate which markets devote great attention to, since it is the cheapest money in the economy in terms of interest rates. The lower it is, the easier it is to pay loans, and the greater risk tolerance of borrowers.

Discount Rate

As the lender of last resort, the Fed also offers to lend to financial institutions which are unable to acquire the necessary amount in the market due to temporary liquidity shortages. Ideally, the Federal Reserve is only expected to extend this aid to firms that are solvent, but illiquid, in that they are financially solid, but are temporarily constrained due to temporary problems, but this principle can be contravened in times of crisis. The discount rate is usually set about a hundred points above the Federal Funds Rate, but the Fed is authorized to reduce this difference in response to liquidity shortages.
Open Market Operations

The Federal Reserve’s main tool in maintaining interest rates close to the value declared at its monthly meetings (the Fed Funds Rate) is the “open market operations” tool used by Federal Reserve Bank of New York on a regular basis. By increasing or decreasing the amount of overnight liquidity in the market through repurchase agreements (repos or reverse repos), the Federal Reserve ensures that banks have access to liquidity at the cost determined at FOMC meetings.

Reserve Requirements

The reserve requirement is another way of controlling the amount of credit available to the private sector. It is a somewhat more blunt tool in comparison to open-market operations, since it influences many financial institutions at the same time. As such it is used less often than the main tool and when used it is for purposes other than the management of liquidity.

In response to the economic turmoil of 2007-2009, the Federal Reserve has activated many supplementary programs and lending facilities in a bid to increase liquidity in the markets and prevent the financial markets from seizing-up. These new facilities are numerous, and are mainly used to expand the type and term of collateral accepted by the Federal Reserve beyond the risk-free government paper such as Treasury Bonds.