How the Fed Affects the Forex Market

Even a casual news viewer knows that the statements of the Federal Reserve are always being closely monitored by businessmen and investors, and the markets react, positively or otherwise. An overview of the Fed's functions is necessary to understand why the forex is so sensitive to its policies.

Established in 1913, the primary objective of the Federal Reserve is to oversee the monetary policy and the financial security of the United States. Through the years the tasks and functions of the Fed have expanded. Today it also provides financial assistance to government institutions and aids banks in case of "bank runs".

Through the FOMC (Federal Open Market Committee), the Fed determines the financial currency reserves of U.S. banks. The Federal Funds Rate, on the other hand, decides the interest rate at which banks lend to one another. Of the numerous policies by the Fed, its decisions on the rates affect the forex currency markets the most.

Simply put the rate that the Fed chooses to implement is followed by banks, bond yields, housing and mortgage rates. Ultimately these factors affect the U.S. economy and consequently the performance of the dollar in the forex.

A confluence of issues affect the Federal Reserve's decision to raise or lower rates, and the results also have wide ranging consequences. A simple illustration will suffice: if the Fed decides to cut the rates, the banks will follow suit. People will opt to withdraw their money and spend or invest in stocks. As consumer spending increases and the stock market moves, the economy will be revitalized.

This however, has the effect of lowering the value of the U.S. currency in the forex, as traders swap their dollars for currencies with higher rates. Also, very low rates might lead to inflation.

If the Fed raises rates, the effect will be the opposite: the U.S. currency will strengthen in the forex as traders try to take advantage of higher bond yields. But it will hurt the export business and it could lead to an economic slowdown.

Through the years the Federal Reserve has used interest rates to stabilize the U.S. economy and prevent financial disasters. The S&L troubles in the late 1980s and early 1990s was stopped by rate cuts. From October 1990 to September 1992 the Fed lowered the rates from 18 pip to 3 pip.

Today the Fed is expected to take the same action in dealing with the housing and credit woes afflicting the economy. While this will have negative consequences for the U.S dollar in the forex, it may help avoid a recession.

As a forex trader, it is imperative that you follow the speeches and statements by the Federal Reserve. By analyzing the economic situation you will have an idea of what the Fed policy statement might be, and this will help you make the right decisions.