As the most powerful financial institution in the world, the provider of global funds and trade liquidity, the Federal Reserve is actually the world's central bank. Every move directly affects the cryptocurrency market or US stocks. We need to understand the Federal Reserve's framework and operating mechanism:

◽️The Federal Reserve has the right to apply for the printing of money, but does not have the power to order the printing of money;

◽️The Ministry of Finance has the power to approve the printing of banknotes, but does not have the right to apply for it;

◽️The federal government has the right to apply to borrow money (that is, to sell treasury bonds), but it does not have the power to force the Federal Reserve to subscribe.

◽️After all, the center of power is Congress, that is, the people of the country, and each institution only has certain authorizations from Congress.

1️⃣ The organizational structure of the Fed.

According to U.S. law, the Federal Reserve is an independent entity and not a subordinate or component of the federal government. In terms of its power source, the Fed is authorized by Congress and is also subject to congressional oversight.

The Fed consists mainly of three components.

🔸1/ The Fed Board of Governors

The Fed Board of Governors is the core decision-making body of the Fed, located in Washington, D.C. There are a total of 7 members on the board, including the Fed Chair, Vice Chair, and 5 governors (there can sometimes be vacancies). All 7 governors are nominated by the president and confirmed by the Senate, serving a term of 14 years.

Here, careful readers might question that while the Fed is said to be an independent decision-making body, the Chair of the Fed and even each member of the Board of Governors are appointed by the president. How can they make independent decisions? The key point is that the 14-year term of the Board of Governors members exceeds that of the U.S. president, who can only serve 8 years even if reelected. Therefore, unless they resign for various reasons, each Board member will serve under multiple presidents.

In practice, newly inaugurated presidents usually appoint 1-2 members to the Board of Governors. Of course, there are exceptions; one is Franklin Roosevelt, who appointed 9 Fed governors during his four terms in office during the Great Depression and World War II. Another well-known example is Donald Trump, who appointed 5 Fed governors in one term. The intricacies of this will be discussed later.

🔸2/ Twelve Regional Federal Reserve Banks

The U.S. has 12 different regional Federal Reserve Banks, each representing a different geographical area (for example, the New York Fed, Chicago Fed, San Francisco Fed, etc.). Why are there 12 and not one Federal Reserve Bank per state? This relates to the historical context and economic distribution when the Federal Reserve System was established in the early 20th century; the regions where the 12 Federal Reserve Banks are located are the most significant economic centers in the U.S., reflecting the concentration of major financial and economic activities at that time.

These 12 banks not only provide services to their respective regions but also collect economic data and participate in the execution of monetary policy. For example, earlier this year, the Philadelphia Federal Reserve Bank publicly accused the U.S. Bureau of Labor Statistics (BLS) of fabricating employment figures in its own report on early benchmark revisions of state payroll employment.

As a side note, since 2023, the U.S. Department of Labor has repeatedly revised down the non-farm employment figures, and the downward revisions have been significant. This inevitably leads many to believe that the accusations by the Philadelphia Federal Reserve Bank are correct; otherwise, why would the U.S. maintain strong economic growth and employment despite continuous rate hikes?

First, the U.S. Department of Labor first announces strong non-farm employment data to support the Fed's decision to maintain high interest rates, with the aim of continuing to harvest globally; later, the non-farm employment numbers are revised downward to support the Fed's decision to cut rates, ensuring a soft landing for the U.S. economy, thus forming a closed loop.

🔸3/ The Federal Open Market Committee (hereinafter referred to as FOMC).

The FOMC is the Fed's monetary policy-making and decision-making body, responsible for determining the federal benchmark interest rate and the money supply.

2️⃣ How does the Fed perform its functions?

🔸 The Fed primarily issues currency and formulates monetary policy.

Issuing currency essentially means printing money, which is relatively straightforward to understand.

So what is monetary policy?

Monetary policy sounds quite sophisticated, but essentially, what the Fed does can be summarized into three main tasks, which are achieved through three policy tools.

The first tool is the discount lending window. For example, in the event of an economic crisis or other urgent situations, if banks find themselves short on funds, the Fed opens this window to 'inject blood' into the banks, providing them with essential funds. Note that this is only used in times of banking crises, and generally remains inactive; moreover, this emergency funding is not free; banks must pay interest, known as the discount rate. Therefore, the terms discount rate and discount lending window refer to the same policy tool.

The second tool is the reserve requirement ratio. Commercial banks receive a lot of deposits and also need to lend to earn interest spreads. However, if banks lend out all the deposits, the risk becomes significant; if depositors rush to withdraw their funds, the banks would be left unable to meet demand. Thus, the Fed mandates a proportion, known as the reserve requirement ratio, that banks must hold a portion of their deposits with the Fed. This way, banks keep a safety net with the Fed, reassuring the public that their deposits are safe, thus stabilizing the financial order. Moreover, once set, this reserve requirement ratio does not change frequently.

The third tool—open market operations. To make it easier to understand, let's expand its name to regulating the federal funds rate through open market operations. The process is not important for now; just remember it does one thing: regulate the federal funds rate. What is the federal funds rate? It is the interest rate at which banks lend money to each other; in simple terms, it is the cost of borrowing money between banks. If this cost is high, the interest on loans will be high; if the cost is low, loan interest will be low.

Simply put, the Fed intervenes in the federal funds rate, creating a chain reaction leading to changes in bank rates. In straightforward terms, when the Fed raises rates, it generally means that the interest on money in American banks increases, leading to higher loan repayment interest; conversely, when rates are cut, the opposite occurs.

🔸 At the same time, the Fed's core tasks are:

According to the Federal Reserve Act, the specific goals of the Fed are to seek 'maximum employment, stable prices, and moderate long-term interest rates,' where moderate long-term interest rates and stable prices have an inherent causal relationship, generally referred to as curbing inflation.

Thus, it can be said that the Fed's two main tasks are to expand employment and curb inflation.

There is an inherent contradiction between these two objectives.

Expanding employment often requires stimulating the economy and increasing the money supply, which can lead to inflationary pressures.

Curbing inflation often requires tightening monetary policy and raising rates, thus limiting economic development and putting downward pressure on employment.

Thus, the Fed makes difficult balances amid constraints. Hence, there is regulation of rate hikes and cuts.

3️⃣ What determines whether to raise or cut interest rates?

So when does the Fed raise or cut interest rates?

🔸 First, let's talk about rate hikes:

If everyone is overly optimistic about the economy, spending and borrowing without restraint, money in the market becomes 'flooded,' but there are only so many goods to buy. When money exceeds the supply of goods, it leads to inflation, causing money to lose value. If inflation rises too quickly, it results in an overheated economy. For example, in Zimbabwe, at its peak of inflation, a plate of fish-flavored shredded pork could sell for 1.5 billion Zimbabwean dollars—how exaggerated!

At this point, the Fed must intervene. The method is to raise rates. Once rates are raised, the public thinks, with such high bank interest, it's worthwhile to deposit money. Those looking to take out loans for cars or houses hesitate, thinking the repayment interest is too high and decide to wait. As a result, trading in the market decreases, the flow of money slows down, and money gradually becomes more valuable, cooling the economy. Therefore, raising rates is a powerful 'weapon' for the Fed to control inflation.

🔸 Let’s also discuss rate cuts:

As mentioned earlier, interest rates must be raised in the case of an overheated economy, whereas rates should be cut when the economy cools. If interest rates are high, people will flock to deposit their money in banks, leading to reduced consumption, investment, and factory openings, resulting in increased unemployment. Additionally, raising rates means banks must pay higher interest to depositors, which puts significant pressure on banks.

So how to resolve this? The most direct method is to cut rates. When people see that the interest on bank deposits is low, they think it is not worth it to keep money in the bank and prefer to spend, start businesses, or build factories. This creates a renewed heat in the economy, gradually warming it up.

In simple terms, if we liken the U.S. economy to a balance scale, then the Fed's rate hikes and cuts are like the weights on either side of the scale; whichever side is unbalanced, it adjusts in that direction—reducing if too high, increasing if too low, and so on in a repeating cycle. In recent years, news has often reported Fed rate hikes or cuts, which essentially reflect efforts to maintain the balance of the U.S. economy.

🟨FOMC Voting Mechanism

Since there are rate hikes and cuts, we must first talk about the FOMC voting mechanism, which contains hidden intricacies and is not as simple as most people understand.

🔸 Voting Decision Mechanism: One person, one vote, majority principle, but tends to reach consensus.

First, it is important to clarify that the FOMC operates on a simple majority vote decision mechanism, rather than a 'veto' system. Specifically, a decision made during the Fed's monetary policy meetings requires at least 7 votes in favor, with no abstentions (except in rare cases of absence due to health reasons). Members who vote against may express their 'dissent' in the official statement of the monetary policy meeting, publicly stating their different views. For instance, during Jerome Powell's first term as Fed Chair, the presidents of the Boston and Kansas City Federal Reserves often voted against rate cuts, arguing that such cuts would fuel inflation and increase financial system risks.

The above are the obvious rules, but there are actually two aspects that the market often overlooks when anticipating the Fed's monetary policy:

First, the principle of one person, one vote means that the opinions of regular members cannot be overlooked. During the tenure of former Fed Chair Alan Greenspan, the market became accustomed to focusing on the Chair's views due to his personal influence, even judging whether the Fed would change monetary policy by observing the thickness of the documents in Greenspan's briefcase (the legendary stories of Greenspan and other Fed Chairs will be discussed in the third article). However, during Jerome Powell's tenure, the market initially focused solely on Powell's remarks to judge changes in interest rate policy, overlooking the perspectives of other FOMC members. In particular, Powell should strictly be classified as a dove, and in several rate hike decisions, he easily led the market to misjudge the Fed's determination to continue raising rates.

Second, although the majority vote principle is in place, the FOMC generally tends to reach a consensus to avoid confusion about the Fed's monetary policy in the eyes of the public. This means that we cannot simply count how many doves or hawks are among the FOMC members to judge whether the next monetary policy meeting will result in a rate hike or cut; rather, we must pay attention to the views of the extremely small minority and their changes. For instance, during a rate hike cycle, if the most 'hawkish' member's view shifts to 'dovish'; or during a rate cut cycle, if the most 'dovish' member suddenly makes 'hawkish' remarks, it often indicates an impending turning point in the Fed's monetary policy.

Note: The 7 members of the Fed Board of Governors are all assumed to be FOMC members, and they have permanent voting rights during their terms. Among the 12 regional Federal Reserve Bank presidents, the New York president has permanent voting rights (the New York Fed is particularly important as it manages market operations and implements FOMC decisions), while the remaining 11 presidents elect 4 each year to obtain voting rights. The 7 who are not selected can attend the Fed's monetary policy meetings and participate in the discussions. Although they do not have voting rights, their views will also be reflected in the dot plot.

🟨 A tool for observing dot plot perspectives.

The dot plot is part of the Fed's economic forecasting. Observers refer to this chart showing rate predictions as the 'dot plot.' The committee also began releasing a bar chart summarizing participants' forecasts for the year in which the federal funds rate would be increased for the first time. The dot plot appears in the Fed's Economic Projections Summary, which also includes the Fed's expectations for economic growth, inflation, and unemployment rates.

Next, let's discuss how the dot plot is a useful tool for observing the views of FOMC members. For instance, taking the dot plot released in June last year, the vertical axis represents interest rate values, and the horizontal axis represents time, with each point representing each FOMC member's forecast at the corresponding time point, i.e., their expressed views on future rate hikes or cuts. From the diagram below, we can see several key pieces of information:

🔸 Except for one member, all other FOMC members believe that the Fed will cut rates from the current level in 2025, although the extent varies.

🔸 This year, whether there will be a rate cut (4 members), a 25 basis point cut (7 members), or a 50 basis point cut (8 members), there is also a certain divergence among FOMC members. The degree of dispersion in the dot plot represents the divergence of members' views.

🔸 Compared to the dot plot from March, it reflects changes in the Fed's attitude toward rate cuts. In fact, compared to March, the number of people who think rates should not be cut increased from 2 to 4, the number who believe in a 25 basis point cut increased from 2 to 7, while the number who believe in a cut of 50 basis points or more decreased from 15 to 8.

The dot plot is generated by the collective predictions of the 19 committee members. The 19 members forecast future interest rates, represented in the dot plot as solid small dots. Each small dot represents one member making a forecast. Since the 7 members of the Fed Board of Governors may sometimes be incomplete, the dot plot typically does not contain 19 dots but could have 17 or 18. The positions of these dots help determine future interest rate trends.

The Fed releases the dot plot and also publishes the median interest rate, representing the Fed's future projected interest rate. First, all numbers are arranged from low to high. If the number of participating forecasters is odd, the middle number is the median; if it is even, the average of the two middle numbers is the median.

4️⃣ The monetary policy decision-making process (the FOMC is responsible, held 8 times a year).

🔸1/ Monetary policy decisions are based on the Green Book, Blue Book, and Beige Book.

The federal funds rate is usually determined at FOMC meetings (held every 7-8 weeks, each lasting 2 days, typically on Tuesdays and Wednesdays), and the decisions made are based on three documents, namely the Green Book, Blue Book, and Beige Book.

First, the Green Book mainly provides detailed assessment materials on the main economic sectors and trends in the financial market to the Fed Board members, looking ahead to economic growth, prices, and international sector conditions.

Secondly, the Blue Book mainly provides the Board members with the latest situation and outlook on money, bank reserves, and interest rates.

Third, the Beige Book mainly provides regional economic conditions of the 12 Reserve Districts (published before the meeting begins).

🔸2/ The FOMC expresses opinions based on the three documents and votes on key policy variables.

FOMC members first express opinions on the economy and its key variables, as well as the Fed's short-term and long-term dynamic goals based on the three documents mentioned above, and vote on key policy variables, forming a detailed directive for the open market account manager at the New York Federal Reserve Bank, which is announced the next day (detailed policies are published 45 days later).

🔸3/ Open market account managers specifically implement interest rate decisions.

The open market account manager needs to read a report on the previous day's bank system reserve numbers every morning before the market opens, reviewing changes in the federal funds rate; at 9 a.m., they contact several government bond traders to understand their predictions for the day's situation; at 10 a.m., they check with the Treasury about changes in fiscal deposits to adjust the Fed's advisory body's forecast (Treasury officials provide information on government bond trading volume through the Fed account and financing plans for the next few days); after completing these preparations, the open market account manager analyzes the specific instructions from the FOMC and, based on defensive operations, develops a practical plan for that day's open market operations; at 11 a.m., they seek approval from other FOMC members for the day's action plan, and after receiving approval, they take action, notifying about 40 government bond traders during the operation.

5️⃣ Periodic study of the U.S. federal funds rate (since 1982).

(1) A total of 164 adjustments, with median and average values around 6%

Since 1982, the Fed has adjusted the federal funds rate a total of 164 times (54 adjustments since 2007, 18 adjustments since 2008), with the minimum and maximum values being 0.25% (December 16, 2008) and 11.5% (August 9, 1984), respectively, and the median and average values being 6% and 5.9661%. Overall, the level of the U.S. federal funds rate has remained relatively high.

(2) 1991 is a historical watershed for the federal funds rate.

Before 1991, the U.S. federal funds rate was almost always above the historical average level (6 - 6.5%), primarily because after experiencing a prolonged period of low inflation and high growth, the inflation rate in the U.S. began to rise sharply from the 1980s, forcing the federal funds rate to remain high. However, despite this, from 1982 to 1990, the federal funds rate still showed significant fluctuations, both increases and decreases, but generally trended downward.

Since 1991, the federal funds rate has generally been below the historical average (6 - 6.5%), around 3%. During the period from 2001 to 2004, it was adjusted to below 2%, and during and after the 2008 financial crisis, it was even as low as 0.25%, nearly reaching the 0% interest rate level.

3) The Fed's Repetitions in the Post-Crisis Era: The Low-Interest Rate Period from 2008 to 2015, the Rate Hike Cycle from 2015 to 2018, and the Rate Cut Cycle Since 2019

After the U.S. federal funds rate reached a historical low in 2008, it remained at a low level of 0 - 0.25% for about 7 years and subsequently entered a strong rate hike cycle for three years. However, due to changes in internal and external factors, the Fed again entered a rate cut cycle in 2019, during which the Fed's entanglement and fluctuations in monetary policy were fully displayed.

On December 16, 2008, the Fed continued to lower the federal funds rate from 1% to 0.25%, with an adjustment magnitude reaching 75 basis points (the usual adjustment magnitude is 25 basis points, with a time span of less than 2 months), resulting in the federal funds rate reaching a historical low.

During the period from 2015 to 2018, the Fed resumed its rate hike path, and this rate hike cycle lasted for 3 years, with a total of 9 rate hikes (once in both 2015 and 2016, and three times in 2017, and four times in 2018). During this period, the federal funds rate level also rose to 2.50%, essentially returning to the average level since 2000.

After 2019, the Fed entered a new rate cut cycle, lowering the benchmark rate by 25 basis points to the range of 1.75 - 2% on August 1 and September 19.

(4) Since 1982, the U.S. has experienced six rate hike cycles and seven rate cut cycles.

Since 1982, the U.S. has experienced a total of 6 rate hike cycles and 7 rate cut cycles, and is currently in a phase between the end of the 6th rate hike cycle and the beginning of the 7th rate cut cycle. Among these rate hike cycles, the federal funds rate also experienced brief periods of decline.

From a historical comparison, the duration of each rate hike cycle in the U.S. has generally lasted about 1 to 2 years, with the 6th rate hike cycle lasting 3 years (2015 - 2018).

Each rate hike cycle by the Fed tends to trigger some global crises, such as the first and second rounds of hikes that caused and exacerbated the Latin American debt crisis in the 1980s, the third round worsening the Asian financial crisis, the fourth round corresponding to the internet bubble, and the fifth round triggering the 2008 global financial crisis.

Since the initiation of a rate cut cycle is usually a response to crises, its characteristics tend to be 'rapid and frequent,' meaning that the adjustments to the benchmark rate are significant and happen frequently, thus causing the target federal funds rate to trend downward.

At this point, we have basically analyzed the Fed. What I want to convey is that the Fed's policies have a strong predictive nature, and we can at least make predictions from the following three dimensions:

One is the level of economic growth and the inflation rate (core);

Secondly, the U.S. federal funds rate 30-day futures can predict future interest rate levels daily (via two paths);

Third, the neutral interest rate can serve as a predictive benchmark for the long-term level of the federal funds rate and the frequency of rate hikes.

The Fed's monetary policy often follows the following logic:

(1) During the rate hike cycle, there is a context of reducing the magnitude of quantitative easing—raising rates—reducing the balance sheet.

(2) During the rate cut cycle, there is a context of rate cuts - expanding the balance sheet (implementing quantitative easing).

Of course, as the anchor of the world's major central banks, the Fed is not static; it continuously innovates its own monetary policy tools (the introduction of 10 new monetary policy tools during the 2007-2008 financial crisis is an example), and other central banks often set their monetary policy tools with the Fed as a target or guide. It can be said that the most predictable and measurable Fed is also the global central bank with the richest monetary policy tools, the quickest response, and the fastest reaction.

This article comprehensively introduces the operational mechanism of the Fed; however, to thoroughly grasp how the Fed's policy decisions profoundly impact the global economy and markets, it is necessary to trace and deeply analyze the historical context of the Fed. Every move directly influences the cryptocurrency or US stock market, making it essential to understand the Fed's framework and operational mechanism.

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