The U.S. central bank — the “Fed” — is expected to raise interest rates soon, the first monetary tightening in years. Here’s why it matters to all of us.
Wondering what the Fed is? The bank itself has put out a primer that explains its history and how it operates. Worth reading.
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 percent of global central bank reserves.
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 ECB or the People’s Bank of China or the IMF — 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.
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?
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.