Modern states influence economic processes through various structures, including the Central Bank. The priority objectives of monetary policy are real GDP, economic growth, the balance of payments and the base interest rate.
The central bank regulates the circulation of the entire money supply, budget, and credit in the country. The main goal of the state is thus to achieve stable economic growth, the most complete employment of the population, an acceptable level of prices for vital goods and services.
GOALS AND METHODS OF MONETARY POLICY OF THE STATE
Depending on the state of the economy, various regulatory methods are used. If the level of production and economic activity are falling, then the scale of lending is increasing, and the conditions for issuing loans are softened (soft monetary policy). In the period of economic recovery, excess money is a negative phenomenon and monetary policy tightens.
In practice, central banks use a number of specific measures:
- Reduction or increase in the discount rate;
- Liquidity supply for banking institutions;
- Selective regulation of certain types of loans;
- Regulation of the obligatory minimum of bank reserves, other standards;
- Issue of securities, their sale in open markets;
- Installation of credit ceilings;
- Managing money supply growth.
HOW THE FED’S INTEREST RATE IS USED TO REGULATE
United States monetary policy is determined by the Federal Reserve. On the basis of the base rate, another is established, called the federal funds rate, and affecting the cost of loans. In the event of a worsening economic situation, this rate is reduced, and if there is a threat of “overheating” of the economy, it is raised.
The change in the discount rate is used by the Federal Reserve System as a reaction to the actions of the driving forces of the market. This measure is applied after the movement of prices in one direction begins. This primarily refers to government bond prices. After falling futures prices of treasury bills, an increase in the discount rate occurs. Before lowering rates, these prices rise.
MARKET REACTION TO INTEREST RATE CHANGES
With an increase in the discount rate, the national currency becomes more attractive for investment. Income paid on bank deposits grows following the rate. The growth of such income attracts investors from other countries.
The inflow of investor funds revives the national economy, but money becomes expensive for domestic businesses, which reduces the number of loans issued. This circumstance reduces the multiplier effect (frequency of money circulation). Local capital also attracts high interest on deposits, which causes money to be “tied up” and inflation to decline. The cost of government debt is also reduced.
Theoretically, a decrease in the rate should activate the economy due to cheaper loans. But the effectiveness of this measure is not immediately apparent, and inflation is also increasing. Therefore, decisions to reduce interest rates are made very carefully. A frequent change may scare off investors. In the early 2000s, this happened in the United States. After a ten-fold reduction in the rate, huge amounts of foreign investment left the country.
The stock market is not so clearly dependent on changes in the discount rate. The rate affects the terms of lending, and hence the growth or decline in production. Accordingly, the demand for stocks of companies listed on the stock exchange rises or falls. This is clearly seen in the dynamics of the S & P500 index, which reflects the aggregate price of shares of major US companies. After the US rate drops to zero, this index is constantly growing.
THE FLURRY OF US INTEREST RATES ON THE GLOBAL ECONOMY
Most international settlements use the American dollar. In the reserves of banks around the world, the national currency of the United States ranks first. It is clear that the impact of the dollar on the global economy is very large. Global capital and commodity markets are closely linked to the US economy. And its development is regulated, in particular, by the discount rate. Therefore, participants in all markets monitor everything related to changes in rates. The most noticeable rate changes occurred in the eighties of the twentieth century and after the 2008 crisis. In 1981, the rate rose to 20% to fight inflation, and after 2009 it dropped to zero in order to revive the economy.
Oil is the most important commodity of the world economy, quoted in dollars. The entire history of rate changes is linked to oil prices. And this affects the budgets of oil-producing countries. While in the USA the rate was at zero levels after 2008, oil rose above $ 100 per barrel, but as soon as the rate was raised, oil fell to $ 20.
Due to changes in rates, the dollar is rising or falling. This causes an increase or decrease in international trade, which painfully affects the economies of the countries of the dollar zone. Such countries include about 60% of total GDP. Most dollar-denominated countries issue bonds in dollar terms. As a result, the value of government debt also depends on the interest rate.
IMPACT OF FED DECISIONS ON MARKETS
The Fed, which serves as the Central Bank of the United States, consists of a large number of fairly independent units and banks. The Governing Council manages the system. Rate decisions are made by the Federal Committee (FOMC) at regular meetings. These meetings are held eight times a year according to a predetermined schedule. 12 members of the Committee discuss the economic situation of the country for two days and make a decision by voting. After the meeting, economic forecasts are published and the chairman holds a press conference.
Financial markets usually react violently to FOMC decisions and the Fed Chairman’s address. The prices of government bonds and stock indices are changing dramatically. The dollar exchange rate to all currencies varies widely. Usually, before publishing a solution, Forex brokerage companies, including from the updated rating of Forex brokers , expand the spread, because they don’t know where the price will go and how sharply., So the well-known company Alpari, and to be precise – its English representative office – did not predict a sharp increase in the franc 3 years ago, because of which it went out of business. (At the same time, the main Russian company did not suffer any losses.) The Chairman’s statement often changes the initial reaction of the market. Usually, in his speech economic forecasts and prospects of monetary policy are voiced.