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.
(Wikimedia Commons)
Wondering what the Fed is? The bank itself has put out a primer that explains its history and how it operates. Worth reading.
Alan Wheatley
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.
Tiziana Barghini
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.
Too Much Daylight on Magic?
Covering the Fed as a journalist is vastly different today than it was just a few years ago. Financial markets have grown and become more complex and global, and relations between the Fed on the one hand and markets and news organizations on the other have evolved. Below, Betty Wong and Alan Wheatley reflect on some of the changes and how even short bathroom breaks could lead to big consequences.
Betty Wong
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 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 February 4, 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.
Alan Wheatley
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.
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 so the fed funds rate …
Once the Fed failed to add reserves via system repos at the expected time around 1135 (always a couple of minutes before a customer repo). The Fed funds rate immediately rose ¼ point. Then the Fed did come into the market to add reserves, and 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 Greenspan’s body language, facial gestures and speech patterns 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.