How do Fed interest rates work?
Let's talk about Federal Reserve interest rates and how they affect the situation in the foreign exchange market using the example of the banking system in the United States.
The U.S. Federal Reserve requires each U.S. bank to hold a certain amount of cash reserves. These funds are intended for transactions with customers. If at some point customers want to get their deposits in their hands and the bank does not have the funds to do so, we could be witnessing another banking crisis. That is why FED sets specific requirements for the amount of reserve funds.
Every day banks conduct a huge number of operations, and each bank is interested in increasing the volume of its operations for more profits (on commissions, etc.). There are cases when one of the clients unexpectedly asks the bank to withdraw a significant amount of money. In such a case, the bank's reserves are reduced and do not meet the requirements of the Federal Reserve System, which may ultimately bode well for such a bank.
Fed interest rate
Fed interest rate - is the interest rate at which the U.S. central bank lends to commercial banks. Thanks to the Fed's loans, banks increase their reserves in order to meet the Fed's own requirements.
Usually commercial banks borrow from each other, but if the bank wanting a loan cannot find money from its "peers," the U.S. Federal Reserve comes to the rescue. But a loan from the U.S. central bank has to be paid back the very next day. Moreover, US FEDERAL RESERVE does not welcome such behavior by banks, and if it becomes too frequent, the requirements for bank reserves may be tightened.
Interest for a loan to individuals
You can't assume that the Fed is just lending to commercial banks to lend to the public. This approach is wrong and is often the cause of misperceptions about the functioning of banks and discredits the banking system itself. This is why the banking system needs to be given the attention it deserves.
So, the importance of the Fed's discount rate is that it is the basis on which all other interest rates in the country are calculated. Meanwhile, the Fed's loans to commercial banks are the lowest-risk loans. The fact is that they are granted only overnight and go only to financial institutions with an excellent credit history. Then, depending on the type of loan, different premiums are added to the discount rate - in accordance with the terms and conditions of the loan.
Why is the Fed's interest rate important?
This is exactly the case with bank lending. In answer to the question, Why is the Fed's discount rate so important?It is important to understand which securities we are talking about. If we are talking about stock markets, high rates lead to an increase in the cost of capital of a company - i.e. for companies whose shares are listed on stock exchanges, this is not good. With bonds, the opposite is true, because high rates reduce the risk of inflation.
The situation on the foreign exchange market is more complicated, the interest rate affects exchange rates at several levels. Undoubtedly, there is a course swapwhich are used to make foreign exchange transactions. But this is only a small part of the equation. Global financial flows, which account for the majority of foreign exchange market transactions, are capital flows driven by investors' search for greater returns on investment. Depending on the state of the stock, bond, and real estate markets, as well as the level of inflation in any given country, rising interest rates can affect investment returns both positively and negatively.