Lesson 58 – An Introduction to the Federal Reserve

Topic Progress:

In our last lesson we finalized our discussion on the importance of interest rates and introduced the Federal Reserve. In this lesson we’re going to continue our discussion on the Federal Reserve by looking at the parts of the Fed which are relevant to us as traders so we can begin to understand how this one institution is able to create drastic moves in the markets.

The Federal Reserve has many responsibilities which include regulating banking activity, playing a major role in operating the nation’s payments system, and maintaining the stability of the financial system. The role that is most important to us as traders and therefore the role in which we will concentrate on in our lessons, is its role in conducting the nation’s monetary policy.

***As a side note here the Federal Reserve is also the Central Bank of the United States. I say this here because most countries have something which operates in much the same way as the Fed which is many times referred to in other countries as the Central Bank. While these institutions may be structured differently from the Fed, from a broad perspective many of the things you learn in our lessons on monetary policy will apply to any central bank.

While the Fed’s objectives are set by law, its day to day activities are not subject to government approval. This is an important point to understand as it means that unlike Fiscal Policy, which must be approved by both Congress and the President, monetary policy can be enacted as the Fed pleases. This gives the Fed much more control over the economy at least in the short term, and is the reason why some people consider the chairman of the Federal Reserve to be more powerful than even the President.

There are many interesting details about The Fed and its structure that I encourage everyone to explore, however the primary components which move markets, and are therefore the ones that we will focus on, are:

  1. The Board of Governors: Located in Washington DC the Board of Governors is at the top of The Fed’s food chain. It is made up of 7 members who are appointed by the president and confirmed by the Senate. To help keep The Fed from being influenced by political factors, 5 of the Fed Governors are appointed to staggered 14 Year terms.
    The Chairman and the Vice Chairman are appointed to 4 year terms and can be reappointed should the President wish to have them.
  1. The Regional Federal Reserve Banks: This is a network which includes the 12 regional Federal Reserve Banks, and 25 Branches. As most of you already know, different areas of the United States are comprised of different industries. As an example the New York area economy is influenced heavily by what is going on in financial services, while the San Francisco area economy is influenced heavily by what is happening in the technology sector. As this is the case, each of the regional banks are strategically located throughout the country so that the can stay abreast of current economic conditions in each area.

The 12 Regional Banks are Located In:

New York
St. Louis
Kansas City
San Francisco

  1. The Federal Open Market Committee: Normally referred to as the FOMC, this part of the system is made up of The Board of Governors and the 12 Presidents of the Regional Reserve Banks. The FOMC is the most important part of the Federal Reserve from a trading standpoint, as this is the entity that is responsible for Monetary Policy.

Under Normal Circumstances the members of the FOMC meet 8 times a year to discuss economic conditions and to vote on what, if any, monetary policy actions should be taken. The voting members of the FOMC are:

• The Board of Governors
• The President of the Federal Reserve Bank of New York
• 4 Presidents from the other Regional banks (who vote on a rotating basis)

As we’ve discussed in previous lessons, there is no greater mover of markets than changes in peoples anticipation of interest rates, and as the FOMC has the most control over interest rates, one could say that there is perhaps no greater mover of markets than the FOMC. It is for this reason that markets can go quiet for days in anticipation of an FOMC interest rate announcement or important speech by the Chairman or other voting member, and then explode with volatility shortly after.

So, now that we have an understanding of its structure we can begin to discuss how the Fed goes about enacting monetary policy, what this means for the economy, and therefore how market’s are likely to move in different scenarios.