Very few market forces influence the U.S. dollar more than the Federal Reserve seems to influence it. Eight times each year, the Fed’s policy-setting committee meets to discuss monetary policy and set interest rates. As we’ve seen time and time again, the Fed’s decisions have a direct impact on the currency markets.
What is the Federal Reserve?
The Federal Reserve is the central banking system of the United States. It has vast powers to set monetary policy to support its dual mandate of economic growth and price stability. Price stability is just another phrase to describe inflation.
How Does the Fed influence the currency markets?
The Fed influences the dollar by controlling the money supply and setting interest rates for the world’s largest economy. When the economy is weak, the Fed lowers interest rates to fuel consumption and growth. When the economy is stronger, the central bank raises interest rates to ensure the market doesn’t overheat.
In deciding whether to adjust monetary policy, officials look at several variables, such as inflation, employment and overall growth. As these numbers improve, officials are likely to conclude that the economy is strong enough to warrant higher interest rates.
The central bank cut interest rates to record lows following the financial crisis. It also implemented a massive stimulus program called quantitative easing to boost the economy. These actions are often referred to as the loosening of monetary policy. Looser monetary policy tends to weaken the U.S. dollar.
The Fed’s impact on the U.S. dollar
The U.S. dollar has gained more than 20% against a basket of world currencies since mid-2014, right around the time the Federal Reserve began signaling for tighter monetary policy. “Tighter” monetary policy simply refers to constricting spending in the economy to ensure inflation doesn’t run above its target rate. The central bank tightens policy by raising interest rates and removing easy money conditions from the economy.
In 2014, the Fed put an end to its quantitative easing program. In December 2015, it raised interest rates for the first time since the crisis. The mere expectation that the Fed was going to tighten monetary policy sent the dollar soaring.
Higher interest rates usually boost the appeal of the greenback because it means investors can earn interest, holding the U.S. dollar. This means that there is a correlation between higher interest rates and a higher dollar. Of course, this relationship isn’t linear, as there are several other economic and market forces influencing the dollar.
The Fed’s divergence
Another important theme to reflect on is the actions of the Federal Reserve relative to other central banks. This also has a direct impact on the currency markets.
As it currently stands, the Fed is the only major central bank raising interest rates. Other central banks are either lowering rates or keeping them at rock bottom to support growth. This so-called divergence is leading the dollar to strengthen against other currencies, which are weaker, on the account of looser monetary policy.
Monetary policy is a fascinating subject, and one the that resonates deeply with traders. Every month, traders actively follow the economic calendar for central bank statements and speeches to predict the future of monetary policy. For the U.S. dollar, the Federal Reserve ‘s actions have the most noticeable implications.
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