Anyone who holds an investment portfolio or watches the financial markets knows how drastically the market reacts to news put out by the Federal Reserve. This is because the Federal Reserve plays a major role in determining the state of the US economy, and thus the world economy. While all central banks function relatively the same the Federal Reserve is particularly important given the fact that the US Dollar is the world reserve currency.
In this article, we will look at what the Federal Reserve does, how it functions, and its roles in financial markets. To begin we must first understand the role of the USD in world trade.
The USD: A recent International Monetary Fund study concluded that 62% of the world’s reserve currency is held in USD. The USD is also the standard currency with which gold and oil are sold in, the latter commonly referred to as the petrodollar.
The status of the USD as the world petrodollar has been very important for the currency’s health. This is because almost all countries in the world import more oil than they produce. By having oil priced in USD all countries need to purchase American Dollars before purchasing oil. This creates a global buying pressure on the USD and ensures it maintains value, even if the country itself runs a trade deficit.
The Federal Reserve: The Federal Reserve is the central bank of the United States and is responsible for determining the money supply of the nation and managing inflation. The goal of the federal reserve is to protect consumers and the value of the USD by ensuring that inflation is always at a healthy level for market conditions.
How The Federal Reserve Operates: The economy is dictated by the market cycle, which includes two states. Market expansion and market contraction. During a market expansion, GDP grows, per capita income increases, unemployment declines, and the overall market trends upwards. During a market contraction, the opposite conditions are present.
When the market is in an expansion the Federal Reserve attempts to curb inflation by increasing the interest rate. This increase in interest rates causes a contraction in the money supply. When the market is in a state of contraction the interest rates are decreased, providing more access to money to encourage consumer spending.
How Does It Function: The Federal Reserve Credits individual banks with credit, which those banks can use to lend to consumers. Everything has its price and the price of money is interest. Because banks receive their deposits from the Federal Reserve they need to lend out money at an interest rate higher than that which they received it.
This is how the Federal Reserve controls the money supply. When the economy is lagging they will create bank deposits at low-interest rates. This allows the banks to subsequently lend out money at lower rates. These lower rates creates easier access to money and encourages spending.
Conclusion: Because the role of the USD is financial markets anyone who is looking to invest must understand the basic role of the Federal Reserve and how it changes interest rates and control the money supply.