FOMC and the Fed's interest rate

People interested in economic and financial topics use to deal at least with these words: FOMC, FED, interest rate. Even for neophytes, it is interesting to understand the root meaning of these words, to clarify what to expect from and to know how to deal with them.

One of the components of the Federal Reserve System (usually called "Fed") is the Federal Open Market Committee. That committee is aimed at making key decisions about the US monetary policy and the interest rate by specifying short-term objective for the Fed's open market operations as a target level for the federal funds rate (the rate that commercial banks charge between themselves for overnight loans). Hence, the FOMC is the principal organ of the United States national monetary policy. It's constituted 12 members:

  1. The governor of the NY's Fed (the most prominent of regional banks)

  2. Four other regional governors. Rotating annually for the seat

  3. Seven members of the council of governors

As you may know, the US market is the leading one in the world and is highly followed by all traders and investors. The impact of the FOMC's decisions and comments of its members have mostly a significant impact on financial markets, usually offering great trading opportunities.

Let's back on the understanding of the Fed's interest rate

It's a reference for the households and companies lending rate from commercial banks:

  • By reducing, the Fed encourages the granting of credits. Commercial banks will be getting credit from the Fed at a low price. Thus, they will grant credits to households and companies at a low price. That boosts the economy.

  • By increasing, the Fed slows the economic activity down. That allows to avoid a overheating of the economic activity.

Any decision of the Fed via the FOMC generally creates volatility on financial markets.

How to interpret the Fed's interest rate

  • If the rate is higher than the previous, it means that the central bank wants to slow the activity down. It's a signal of a current well being of the US economic activity. Generally the US dollar soars.

  • If the rate is lower than the previous, it means that the central bank wants to boosts the activity fearing a deceleration.

  • If the rate stay steady, it means that the central bank wants to maintain the "status quo". The impact is limited.

Coupled with the previsions of analysts, the impact of the decision could be exaggerated:

  • If analysts are expecting a "status quo" and the Fed's decision delivers a higher rate, the markets will react strongly and the Dollar's increase could be stronger than normal.

  • If analysts are expecting a "status quo" and the Fed's decision delivers a lower rate, the markets will react strongly and the Dollar's fall could be stronger than normal.

  • If the Fed's decision joins the anticipation of markets (increase or fall), their reaction will be more limited.

What happens when the decision is published

As a prominent announcement, when the Fed's rate is published their are two key happenings on the markets:

  • A peak of volatility observed exactly after the publication. Usually markets are surprised on the decision.

  • Enlargement of spread. But usually just for a short time.

The news in general, and the publication of the Fed's interest rate particularly, represent a moment during which markets are in await and they will act accordingly. Thus, it's so important for traders to know how to manage those moments.


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