When the Federal Open Market Committee (FOMC) announces an increase in interest rates, the stock and the crypto market respond accordingly by taking a bearish decline. Investors and financial observers watch out for the FOMC meeting because it may affect their position in the financial market. This article explains what the FOMC does and how the outcome of its meetings has a heavy weight on the cryptocurrency market.
- The FOMC is an arm of the Federal Reserve System (the Fed)
- The FOMC sets the Federal funds rate through Open Market Operations
- The Federal funds rate affects all other rates and dramatically influences the employment rate, price stability and inflation rate in the United States
- The Fed’s successive interest rate hikes have caused cryptocurrencies to plummet and have exposed them as risky assets that are not inflation-proof
What is FOMC
The Federal Open Market Committee (FOMC) is a branch of the U.S. Federal Reserve System (The Fed) responsible for Open Market Operations. The FOMC is a 12-member committee that meets eight times a year to review economic and financial conditions and decide on the federal funds rate, employment rate and price stability.
What is the Federal Reserve System?
The Federal Reserve System (The Fed) is the Central Bank of the United States created to ensure a safe, stable and flexible financial system. The Fed sets and oversees the regulation of banks, the maintenance of financial stability, economy-friendly monetary policies and the provision of banking services to commercial banks, the U.S. government and international organizations. The Fed has three monetary policy tools it uses to control the economy:
1. Reserve requirements
2. Discount rate and
3. Open market operations
The FOMC controls Open Market Operations and uses them to meet the Federal funds target range.
Let’s understand the Federal Funds Rate
The Federal Funds Rate is the interest rate banks charge on the money they lend to other banks overnight. You may want to know why banks have to lend money to other banks. Here’s why:
In the United States, banks have a reserve requirement they must meet. The reserve is a specific percentage of the money in their deposits with the Federal Reserve Bank. Some banks sometimes fall short of this requirement; therefore, they borrow from other banks that have more than the required reserve rate. This loan is mostly an overnight loan with no collateral. It has a guaranteed interest rate called the Federal funds rate.
Banks cannot be compelled, by the Fed, to pay the Federal funds rate. Two banks may agree on what rate they want to charge on an overnight loan, thereby sidelining the Fed’s funds rate. So, the Fed sets a target range for the federal funds rate and uses tools at its disposal to keep it within the set range. This step will help ward off a possible clash between the Federal funds rate and possible bank rates.
When the FOMC meets to make a decision, it is guided by the Consumer Price Index (CPI) data. The CPI is monthly data released by the United States (U.S.) Bureau of Statistics detailing the level of inflation and deflation in the U.S. economy. Based on the inflation or deflation rate, the committee will decide on the course of action to take. The committee will likely increase interest rates when inflation is high. If deflation is in view, the committee will probably lower interest rates. They do this through the Federal Funds Rate, which affects other interest rates- short-term interest, business loans, consumer loans and long-term debt. Therefore, a rise in the Federal funds rate will correspondingly increase these other interest rates. As these interest rates rise, price stability and employment rates will be affected.
The FOMC uses Open Market Operations to keep the Federal funds rate within the target range set by the FOMC.
How Do Open Market Operations Work?
The Federal Open Market Committee (FOMC) uses Open Market Operations (OMOs) to control the money supply in the U.S. economy. It does so based on its goal, which may be expansionary or contractionary at any given time.
The Fed supplies new money to the economy when its goal is expansionary. The Fed purchases treasuries and securities on the ‘Open Market’. Through this purchase, new money will flow into the economy, and interest rates will drastically drop. Banks will have enough liquidity to give out low-interest loans to their customers. Additionally, individuals and businesses will be more willing to take these low-interest loans. The purchasing power of the middle class will rise, companies will grow dramatically, the employment rate will increase, and the country will experience economic growth.
Whenever the Fed’s goal is contractionary, it reduces the amount of money circulating. It sells Treasury Bills and Securities on the ‘Open Market’ to achieve this. When there is less money in circulation, the interest rate becomes high, demand for goods and services declines, and the purchasing power of consumers drops dramatically. Individuals will become frugal with spending, and businesses will cut out excess spending and lay off employees as economic activity slows down.
The Impact of The FOMC Decision On The Crypto Market
In response to the inflation caused by COVID in 2020, the Fed printed and supplied over $3.3 trillion in new money into the economy. It contributed to the bull run in the cryptocurrency market in 2020. As of this time, the interest rate was at a record low of 0.25%. It was easy for individuals to access loans during this time because the idea was that they would spend money on goods and services that would help boost economic growth.
However, the Fed’s announcement about a possible interest rate hike in November 2021 led investors to shift their liquidity from risky assets, including crypto assets, to safer investment vehicles. As a result of this, crypto assets started losing value. Then, when the Fed eventually increased interest rates to save the economy from high inflation caused by excess money in circulation, it became a headwind for the crypto market as assets lost significant value. In 2022 alone, the Fed has increased rates five consecutive times, and this interest rate hike will likely persist throughout the year.
While the interest rate hike is directly a U.S. problem, it indirectly becomes a global problem because of the Almighty Dollar, the world’s reserve currency. You now know why the FOMC decision profoundly impacts the crypto market at any given time. Hence, intelligent investors keep an eye on the FOMC meeting to know which action to take if the Fed takes a Hawkish or Dovish stance.
So long as the Fed keep increasing interest rates, cryptocurrencies and other risky assets will drop in value.Share & like