A pillar of the financial system: the Fed

Few institutions preoccupy investors as much as the Fed. Whatever the US central bank – or rather its representatives – with their registered office in Washington does, it becomes the subject of endless discussion on the financial markets.

A decision, such as the one taken a week ago to raise the interest rate corridor by a quarter of a percentage point – or sometimes even just a single word from the Fed Chair – moves billions. In this respect, the central bank can easily hold its own against the US President, who, after all, also attracts a great deal of attention. But why is the Fed actually so important?

Nothing works without the dollar

The Fed’s importance stems primarily from the currency. The US dollar is the world’s most widely used currency. Specifically, just under 60 per cent of global foreign exchange reserves are held in dollars. These are reserves held by central banks to enable them to fulfil their remit regarding economic stability and monetary policy. The euro, as the second most important currency, accounts for only 20 per cent.

Furthermore, the dollar is the most important currency in international trade. Commodities are also traded in dollars, from oil and copper to gold. In addition, the US financial markets are the largest – and therefore the most liquid – in the world. Whether debentures issued or equities, nowhere else is the supply as vast as it is in the US or in US dollars. This is also evident to investors in the global equity index, over two-thirds of which consists of US equities. Anyone who buys into it is also buying a great deal of dollars.

Everyone needs dollars, so that’s why the Fed is so important, isn’t it? Interestingly, however, the Fed does not concern itself all that much with the dollar, but leaves it to the market. It is entirely focused on price stability and maximum employment in the US. It pays little attention to the dollar, because the currency’s global significance ensures there is automatic demand from central banks, companies and investors who ‘export’ their savings to the US. Not least those who make a profit from foreign trade with the US.

The eurozone does not enjoy this luxury. The euro is much more dependent on cross-border trade. The external value of the euro plays a much greater role for the economy and price stability – in other words, inflation – in the eurozone than it does in the case of the US.

A role only recently established

When the Fed was founded in 1913, its great significance was not a given from the outset. Its establishment stemmed from internal developments. Previously, private banks had been putting dollars into circulation and thus controlling the money supply. This led to several banking crises. When one of the largest banks went bankrupt in 1907, it triggered a panic in which many people withdrew their money.

A private initiative led by the banker John Pierpont Morgan (founder of J.P. Morgan) ensured sufficient liquidity to restore confidence. However successful it may have been, politicians were determined not to have to rely on private financiers acting as ‘lenders of last resort’ in the event of a future crisis. And so the Fed was born.

One argument has so far been overlooked. Since the Fed’s foundation, the US has risen to become the world’s largest economy. Many companies therefore look to the US as their market. The Swiss central bank holds a large proportion of its balance sheet in dollars, whilst private investors buy US assets. And so what the Fed decides is important for everyone.

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