An announcement from the Federal Reserve of the United States can send investors around the world into a frenzy. We went to our experts to find out why.
The gold vault of the Federal Reserve Bank of the United States. (Photo courtesy the Federal Reserve Bank)
Editor’s note: On 20 March 2024, the Dow Jones Industrial Average, which is an index of the stock of 30 U.S. corporations that is used to measure the health of the stock market, rose to an all-time high based on news from the Board of Governors of the Federal Reserve that it expects inflation to slow. As a result it would likely raise interest rates later this year.
Investors in the stock market often react wildly to announcements from the Federal Reserve. Why is that? What even is this institution that people commonly call “The Fed” that is sort of public and sort of private? Why should anyone care about it? To help answer these questions we decided to republish a story we first published back in 2015 in which three of our correspondents, who each covered The Fed in different ways, help us decode it.
We launched Decoder Replay to help readers better understand current world events by seeing how our correspondents decoded similar events in the past.
Tiziana Barghini has worked as a correspondent and editor in Europe and the United States for more than two decades reporting on popes, mobsters and political crises. At the Reuters news agency she led coverage of the euro crisis in southern Europe before moving to New York where she tackled the U.S. political economy including Detroit’s bankruptcy and the U.S. public pension system.
This is her take on the Federal Reserve.
Looking at all the attention the media devote to the Federal Reserve, it seems self-evident that its decisions are important for our lives. Given how financial markets all over the world react to those decisions, the impact that all central banks, not just the U.S. Fed, have on the economy is often considered a given.
But how does this influence play out? How does the central bank’s decision about the level of short-term interest rates affect the cost of capital for corporations and investments? How much are the yields we pay on a 30-year, fixed-rate mortgage affected by the Fed? Does the cost of having our homes, building a bridge or starting a company depend on the decision of the Fed?
Maybe not.
The simple story is usually told this way: The central bank establishes how much it costs to borrow for one night. This cost is transmitted to longer-term borrowers along the so-called yield curve — two days, a month, up to a century and longer — by lenders who assume the risk that monetary policy can change in the future.
But long-term yields depend on the expectations of the public. They reflect what people think the cost of capital should be at a given point of time. Long-term yields depend more on what people predict to be the return on capital than on the short-term cost of money. So they have little to do with the policy followed by Fed.
What matters most is signaling: As the Fed’s leaders are trusted, their views on the economy matter. And so what they say and do suggests to others what the economy will do in the future.
An interest rate increase suggests Fed leaders think the economy is probably going well. It is more what they say than what they do that matters to the market and to the economy.
Trillions of dollars at stake
Alan Wheatley is an economics writer and editor based in London. Until recently, he was Reuters’s global economics correspondent, reporting from more than 40 countries and living in London, Frankfurt, Paris, New York, Washington, Tokyo, Singapore and Beijing. He is co-author of the book “The Power of Currencies, Currencies of Power”, which explores the consequences of looming challenges to the dollar’s status as the world’s leading reserve currency. Here’s what he thinks we need to know about the Federal Reserve.
Few lives on Earth are unaffected by what the Federal Reserve does because the world is on the dollar standard.
The U.S. currency dominates global finance. It is the currency most used in trade, cross-border payments and offshore debt sales. Oil and many commodities — and their derivatives — are traded in dollars.
More than $800 trillion in securities and loans are linked to the London Interbank Offered Rate (Libor), one of the world’s most important interest rates. So the slightest movement in Libor affects investment returns and borrowing costs the world over for car loans, mortgages and credit card advances.
Guess which currency’s Libor rate is most used? The dollar. And what is the biggest influence on Libor? That’s right, the Fed.
Some countries, such as Hong Kong and Saudi Arabia, peg their currencies to the dollar. Many other central banks try to make sure their exchange rate does not become too cheap or expensive relative to the dollar.
For that purpose (and for other reasons) they hold foreign currencies in reserve. The dollar is easily the most important currency, accounting for 62% of global central bank reserves.
Flight of capital
Influences on the dollar’s movements vary depending on economic circumstances, but often expectations of changes in Fed policy are the driving force.
That’s why anticipation of an increase in Fed interest rates — now firmly expected in December — is projected to cause $540 billion in capital to flee emerging markets this year in search of higher returns elsewhere.
The Fed — not the European Central Bank or the People’s Bank of China or the International Monetary Fund — is also the global lender of last resort. It was the Fed that prevented world markets from gumming up in 2008 by extending nearly $600 billion in credit to partner central banks to lend to dollar-starved banks.
At the outbreak of World War One in 1914, the dollar was not used as a reserve currency and the Fed — born amid great controversy — had reached the ripe old age of one. A century later, it is without dispute the most important financial institution in the world.
Yes, times have changed. The fun went out of Fed-watching for me when it started to announce a target for the Fed funds rate.
Covering the Federal Reserve
Going down to the New York Fed in the 1980s every Thursday afternoon for the H41 report and having to analyse its balance sheet was great fun.
I remember writing stories about how winter storms were delaying the transport of checks across country and so bloating float. Then there were dodgy goings-on in Cook County, Illinois, involving huge cash transfers that affected the level of reserves and the fed funds rate.
Once the Fed failed to add reserves via system repos at the expected time around 11:35 which was always a couple of minutes before a “customer repo”— a repurchase agreement carried out by the Federal Reserve on behalf of foreign central banks who hold dollar securities
The Fed funds rate immediately rose ¼ point. Then the Fed did come into the market to add reserves. It turned out that the manager of the Fed’s New York money market desk had needed to answer an urgent call of nature, delaying the Fed’s move. A story too good to check.
When I moved to Washington at the end of the 1980s, the investment banks used to hire psychologists to interpret patterns of then-Federal Reserve Chairman Alan Greenspan during Congressional hearings for hints as to his thinking.
I reckon the Fed and other central banks nowadays let too much daylight in on magic.
Back in the day
Betty Wong was global managing editor of Reuters from 2008 to 2011, with 29 years of experience at the Wall Street Journal and Reuters. She covered white collar crime on Wall Street in the 1980s and led U.S. corporate news coverage from the dot-com bubble to rubble.
Fed watching evolved with the advent of the Internet, financial cable television programming and the birth of a legion of amateur day traders.
More than 20 years ago, there was no formal Fed communication, no hordes of journalists surveying Wall Street experts ahead of fixed-date Federal Open Market Committee (FOMC) meetings on whether the Fed would stand pat, raise or lower rates. No on-air business journalists jockeying to report the real-time news of a Fed decision and scour the guidance forecast for the U.S. economy.
The first FOMC statement issued right after a meeting was on 4 February 1994, in a sparse 99-word release. Before then, market participants had to decipher what the FOMC decided by watching open market desk transactions.
Fed funds traders from that era used to have to watch repo (repurchase) buybacks, used to trade Fed funds, every day. The Fed could signal a tightening by doing matched sales, driving money out of the system, or add money by accommodating. In a bid for more transparency, the Fed started giving forward guidance in 1999.
As business cable TV news sprouted, interesting visuals came into play. CNBC popularized around 2000 the “Greenspan Briefcase Watch,” sizing up the heft of the briefcase that then-Fed Chairman Alan Greenspan carried into FOMC meetings. If the briefcase was bulging, the belief was he carried enough paperwork to argue for an interest rate change, while a slim briefcase might indicate no change. That was before laptops and Fed pundits became commonplace.
Around 2000, when the Street was focused on two, main real-time news outlets — Reuters and DJ-Telerate — an irate trader in short-term interest rates demanded to know why one agency trailed the other by some 20 minutes on a surprise, intraday Fed move.
He said he didn’t change his position after seeing only one of the two news outlets with the news because he always waited for both as double confirmation on unexpected developments.
Turns out the wire reporter for the lagging agency had gone to the bathroom.
Questions to consider:
- What is “The Fed”?
- Why do so many people look to the Federal Reserve before deciding whether to buy or sell stocks?
- Do you think one small group of people like the governing board of the Federal Reserve should have so much power to influence world markets? Why?
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