Federal Reserve Bank is the most powerful central bank in the world. Central banks are the most powerful players in the financial markets and the global economy. Most traders don’t have a clear understanding of what is the role of central banks and how they influence the financial markets. Sometimes it is other way around. Read the post how Reserve Bank of New Zealand was shocked by currency market. In this post I will explain in detail what are central banks and how they influence the financial markets. Central banks have two powerful tools that it uses to affect the economy. These two tools are interest rates and money supply. Both of these tools not only affect the economy but also the financial markets. Most of the time central banks are managing the economy. But whatever decisions the central bank takes also affects financial markets. If you want to understand how this happens you will first need to understand how the central banks works and how they make their decisions.
There are a number of central banks in the world that are considered important. The most important is the US Federal Reserve Bank. After that is the European Central Bank, Bank of England, Bank of Japan, Reserve Bank of New Zealand and Reserve Bank of Australia. I will start by explaining the Federal Reserve System in detail. Once we know how the US Federal Reserve System works, we have a fair understanding of how the central banks operate and achieve their goals. I have developed a course Macroeconomics for Currency Traders. In this course, I explain the macroeconomics behind the monetary policy and how it affect financial markets and how you can use it for better investing and trading.
US Federal Reserve System
You will be surprised to know that Federal Reserve Bank is a quasi private bank and has shareholders. This will be surprising to you as it was to me. Most central banks in the world are not like that. We need to understand the unusual arrangement of Federal Reserve System. For this we need to go back in US history. US founding fathers abhorred giving powers to one central authority instead they believed in divided authority so that a system of checks and balance can develop. So from US independence there was strong resistance of establishing a central bank that could act as a lender of last resort in times of financial panic. The First Bank of the United States was disbanded in 1811. The Second Bank of United States chartered also expired in 1836. Watch this Institute of Trading And Portfolio Management Brazil Documentary.
Throughout the 19th century there were bank panics. Banks had authority to print their own currency. Most of them abused that authority. There was no central authority to police the banks. After every two decades on average throughout the 19th century, there was a bank panic. The most severe bank panic happened in 1907. During the bank panic of 1907, many depositors lost their deposits. Many people in US were now convinced they need a central bank to police the banking system. But they feared Wall Street would gain control over the central bank and through it the whole economy. It was also hotly debated whether to central bank should be a private bank or a government institution.
After long heated debates the Federal Reserve Act of 1913 was passed by US Congress with a number of checks and balances. This is what they did. They created a quasi private institution. US Federal Reserve System is comprised of 12 Federal Reserve Banks that represent the 12 different districs in US. This way big cities like New York cannot dominate the Federal Reserve System. Each Federal Reserve Bank has a president and the board members are from the private sector. Each Federal Reserve Bank represents the interests of its district. This way power was divided along regional lines between the public and the private sector. Watch this Institute of Trading and Portfolio Management South Africa documentary.
Federal Reserve System at its base has around 2,000 commercial banks as member banks. These banks elect six directors to each of the 12 Federal Reserve Banks. At the apex is the Federal Reserve Board of Governors comprising 7 members that includes the Chairman/Chairperson nominated by the US President and confirmed by US Senate. This Board of Governors appoint 3 members each to the 12 Federal Reserve Banks. So each Federal Reserve Bank has 9 members, 6 selected by commercial banks and 3 selected by Board of Governors. Then there is the Federal Advisory Council with 12 members with each member from each district. Each of the Regional Federal Reserve Bank has its main Federal Reserve Bank in the district with branches in different cities. Three important Regional Federal Reserve Banks are New York, Chicago and San Francisco.
Federal Reserve Bank of New York
Federal Reserve Bank of New York is very important . This importance comes from the fact the Wall Street is situated in its jurisdiction. Infact Federal Reserve Bank of New York offices are situated a walking distance from Wall Street. There are a number of very important big commercial banks situated in the New York district. Federal Reserve Bank New York is also actively engaged in the bond and the foreign exchange market. Open Market Desk in the bank is responsible for the sale/purchase of bonds on the directions of the FOMC. The amount of bonds that are sold/purchase determine the reserves required in the banking system. The bank also intervenes in the foreign exchange market on the direction of US Treasury and the Federal Reserve System.
Federal Open Market Committee (FOMC)
The most important for us is the Federal Open Market Committee (FOMC). FOMC comprises 7 members of the Board of Governors and President of Federal Reserve Bank of New York and 4 more presidents of Regional Federal Reserve Banks. FOMC has the power to decide about the open market operations, discount rate and the reserve requirements. FOMC Meeting takes place each month. After the meeting the FOMC Meeting Minutes are released and this is the time, you will see USD pairs going crazy. FOMC is mandated by law to meet at least 8 times in one year. So every six weeks we have FOMC Meeting which falls in the middle of each month on Wednesday. Watch this Million Dollar Mentoring Program Caribbean Documentary.
A few days before FOMC meeting each month, financial media starts speculating about its decisions. So if the rumor gets strong that FOMC is going to increase interest rate, financial markets will start reflecting that interest rate increase in price before the meeting takes place. Market reacts wildly when something unexpected happens like when it is strongly expected that interest rates will get hiked by FOMC votes for no hike. If this happens, whatever price appreciation that took place will be lost in a short time. I personally have seen that just a few hours before FOMC meeting you can get a very good signal that can catch a big move in the market. I have seen times when the currency market moved 400-500 pips just after FOMC Meeting. So as a trader you should watch FOMC Meeting each month every closely. Sometimes market whipsaws after FOMC Meeting when no clear decisions are taken.
Each FOMC meeting makes decisions whether open market operations are required or not. Once the decision on open market operations is taken it is carried out by the Federal Reserve Bank New York as said above. With these open market operations, FOMC has the power to control the money supply in the economy. Sale of bonds means tightening of monetary policy while purchase of bonds means loosening of monetary policy. FOMC meeting also decides on the Federal Funds Rate. Funds Rate is a short term interest rate that banks charge from one another on overnight loans. This short term Funds Rate infact trickles down in the bond market in the coming months and determines the monthly, six monthly and the annual interest rate in the economy. So Funds Rate is also a very important monetary tool at the disposal of FOMC.
As said FOMC Meeting takes place after six weeks around the middle of each month. The day is always Wednesday. The meeting starts by approving the last meeting minutes. After that the manager of open market operations system briefs the committee on the open market operations. After discussion, a vote takes place to ratify the operations.After that the Director of Research and Statistics presents the national economic forecast. After that the current monetary policy comes under discussion. After discussion on the current monetary policy, the chair summarizes the discussion and proposes the changes in the monetary policy and the funds rate. After voting public announcement is made about the monetary policy statement. Watch this Million Dollar Mentoring Program Thailand Documentary.
Why Central Banks Should Be Independent?
Important question is how much FED is independent. FED is remarkably independent in making monetary policy decisions. However, US Congress can hold FED accountable for its decisions. Independence of central bank is very important for conducting an independent monetary policy. But this is not the case in many countries where central banks are just one another government agency. In a democracy politicians are most of the time short sighted. Most of the time politicians are driven by the need to win the coming elections. This desire can result in finding short term fixes that can have severely negative long term impact on the economy.
For example the government may want to print more money so that it can increase it expenditure on building roads and bridges before the next elections. Printing more money means loosening the monetary policy which can have a positive impact in the short run in terms of more expenditure and lower interest rates. But in the long term, a loose monetary policy can heat up inflation in the economy which needs a drastic increase in interest rates. High interest rates are not good for the economic as it lowers investments and makes credit expensive for local businesses. So short term policies can lead to long term consequences which short sighted politicians cannot see. So an independent central bank can pursue policies that are politically unpopular in the short term but good for the economy in the long term. This does not means central banks always make the right policies. Federal Reserve has been blamed for the Great Depression as well as creating many other bubbles in the economy. These economic bubbles on bursting caused a lot of pain.
European Central Bank
European Central Bank (ECB) and the European System of Central Banks was established in January 1999. ECB is headquartered at Frankfurt Germany. Each National Central Bank has a role similar to the Federal Reserve Bank District and the Governing Council is almost similar to FOMC. However unlike Federal Reserve that controls its budge, ECB budget is controlled by the National Central Banks. Open market operations are also carried out national banks. ECB has little control over financial institutions as they are managed by the member countries. Now just like FOMC Meeting is very important for financial markets so is the monthly meeting of the ECB Governing Council. Learn how to trade headline news and magazine cover stories.
This is interesting for you to know. FOMC makes decisions by casting votes. ECB Governing Council makes decisions by consensus. Voting is not allowed as it is believed each national bank will vote for its own agenda.Immediately after each ECB Governing Council monthly meeting a press conference is held to public announce the decisions taken during the meeting. The press conference is very important for financial markets. As a trader, I have seen EURUSD fall heavily after the meeting. EURUSD can also rapidly rise after this press conference. On the economic calendar you should mark ECB Press Conference. This is press conference is watched the financial markets with lot of attention. ECB is mandated with the task of maintaining long term price stability.
Bank of England
Bank of England is a very old bank as compared to the Federal Reserve Bank. Bank of England (BOE) was founded in 1694. Once Bank of England was famous for its gold standard. But gold standard collapsed in the 20th century. Many thing also changed in the 20th century. Until 1997, BOE had very little independence as it did not have the authority to change interest rates. This authority resided with the Chancellor of the Exchequer. In 1997, this authority to set the interest rates was transferred to Bank of England. But the UK Chancellor of Exchequer still has the authority to override the Bank of England interest rate change under exceptional circumstances. Bank of England Monetary Policy Committee (MPC) is responsible for setting the interest rates in UK. MPC meets every month. When it makes its decisions, you will see GBPUSD going wild. As a trader, you should know about this MPC meeting and you should watch it. Inflation rate target for Bank of England is also set by the Chancellor of the Exchequer. So you can see Bank of England has a lot less independence as compared to the Federal Reserve Bank. As a trader, MPC monthly meeting is important for you as the rates decisions are made in it through voting. Always watch MPC meeting every month if you trade British Pound (GBP) pairs.
Bank of Japan
Bank of Japan is also one of the important central banks. Bank of Japan (BOJ) was founded in 1882. Bank of Japan Policy Board makes the monetary policy. Like Bank of England, Bank of Japan also did not enjoy much independence. Ministry of Finance was more powerful than the Bank of Japan. In 1998 a new law got passed by Japanese parliament that gave great independence to Bank of Japan. Bank of Japan is officially tasked with maintaining price stability in the economy.
This was a broad survey of a few major central banks in the world. Central banks are tasked with fighting inflation and unemployment. They have a few policy tools like interest rates and money supply that they use to achieve their inflationary and employment targets. Central banks directly don’t try to influence financial markets. But when they change interest rates or increase or decrease the money supply, these things affect the financial markets. High interest rates are considered good for stock market and the currency market. If US has high interest rates as compared to the rest of the world, capital will flow into the US economy. US Dollar will appreciate as a result and more foreign investors will invest in US stocks. When interest rates are lower than the rest of the world, it works other way around with capital flowing out of the economy to economies that offer better interest rates.