FYI | Jan 31 2012
By James Stanley, Trading Instructor, FXCM
Central bankers are tasked with the role of governing an economy in an attempt to ensure financial stability. After The Great Depression was initiated by Black Tuesday (October 29, 1929), it became clear that politicians and policy makers did not want to leave economic prosperity to luck and chance. They wanted to be able to control the economy in an effort to prevent another Great Depression.
From the smoldering ashes of The Great Depression came change.
The Federal Open Market Committee (FOMC) was created within The Federal Reserve in response to The Great Depression with the Banking Act of 1933. The FOMC has been charged with the mandate of setting target interest rates for the United States economy. They do this by modifying the Federal Funds Rate (the rate that banks charge each other for overnight loans). This ‘base,’ interest rate functions in numerous capacities.
If the FOMC desires more growth, they can lower interest rates in an effort to spurn large-scale purchases like homes, automobiles, and real estate.
If, on the other hand, the economy is growing too fast giving rise to fears of future hyperinflation; Central Bankers can look to increase interest rates to make fixed-income investments more attractive. These higher interest rates can often attract capital in an effort to lock-up the higher rate of return. This locked up capital seeps out of the economy, causing growth to slow.
But what happens when this doesn’t work?
We’ve had a really good example of this in The United States over the last two years.
After record-low rates for a record-long period of time, most consumers that wanted to purchase real estate, or automobiles, or homes had already done so. As purchases of these large-ticket items slowed, so did economic growth. As this economic growth continued to slow in the United States, it began to affect other economies as well.
And with rates at near zero percent without the ability to go any lower, the FOMC had to look for creative ways to stimulate the economy, and this is where intervention came into play.
Going into June of 2010 it appeared as though another economic collapse was imminent. Investors, fearful of the reverberations of the 2008 crisis being magnified as this issue was now of a global scale, flocked to ‘safe-haven,’ investments, such as the United States Treasury Bill. Even though the United States had extremely low interest rates below that of many other modernized nations, investors continued to ‘flock-to-safety.’
The beginning of December 2010 saw the EUR/USD currency pair begin trading over 1.50. In very short order we saw the value of the Euro fall 20% as investors sold Euro’s to buy U.S. Dollars.
We can see the June 7th low on the chart above, as the currency pair had lost 3,000 pips, or 20% of value in a little over 6 months.
This isn’t good for either economy. While it may seem logical that the United States would benefit from a higher valued currency, you have to look deeper. The global economy is so inextricably linked that an economic downturn in Europe would surely affect the United States. So, something needed to be done here before the situation got out of hand and the entire world ended up in a recession that made the 2008 financial crisis look desirable.
The FOMC came out with a policy of ‘Quantitative Easing,’ commonly called ‘QE.’ Through Quantitative Easing, the Federal Reserve literally creates money to buy assets (such as long-term bonds) in an effort to inject this newly created capital into the financial system.
This action increases the reserves of banks, allowing them to add liquidity to the system while also increasing demand for the assets they are purchasing. This demand brought on by long-term bond purchases pushes prices higher (and yields lower); liquidity continues to circulate through the system, as banks now have more capital to lend.
And we can see this playing out in the EUR/USD chart for the second half of 2010. After FOMC had intervened in the U.S. Dollar with a policy of Quantitative Easing, the U.S. Dollar begins to weaken as the currency is essentially being diluted with this newly created money.
By the middle of November 2010, the EUR/USD price was back above 1.40; a rise of more than 16% in approximately 5 months. This also prevented the global economic collapse that could have potentially followed had the FOMC chosen not to intervene in financial markets.
The views expressed are not FNArena's (see our disclaimer).
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