Here’s everything crucial for Australian investors to know about the Federal Reserve (or ‘The Fed’)!

The first central bank Australian investors will watch is our own RBA, but watching the US Federal Reserve should be second on their list – maybe even first. Actions it takes, from the setting of US interest rates to emergency money in times of crises, have implications not just for the US but the entire world. And so here is what you need to know about the Federal Reserve.

Who is the Federal Reserve?

The Federal Reserve (Fed) is the central bank of the United States. Its primary roles include regulating the U.S. money supply, managing inflation, ensuring financial stability, and overseeing the banking system. The Fed makes monetary policy decisions, such as setting interest rates (the federal funds rate), buying or selling government securities (quantitative easing), and providing emergency loans to financial institutions during times of crisis.

The Fed is cutting rates too

Just like our own RBA, the Fed influences economic activity by adjusting interest rates. Lowering rates typically stimulates spending and investment, while raising rates can cool down an overheated economy. It reduced rates to near zero during the pandemic and kept them on hold for two years. It began the hiking cycle 2 months before Australia did, making the first hike in March 2022, and making 11 increases to 5.25-5.5% by July 2023. It has delivered 3 cuts in the last 4 months of 2024, to 4.25-4.5% now. Even in spite of cutting rates in December, this news was not received well because Jerome Powell indicated that there could be less cuts in the new year.

‘As long as the economy and the labour market are solid, we can be cautious about as we consider further cuts,’ Powell said.

Beyond interest rate setting, the bank does other thing too including supervising banks and other financial institutions to maintain the stability of the financial system; acting as a bank for the U.S. government and other financial institutions, including clearing and settling payments; managing the issuance of the U.S. dollar and ensures it is a trusted currency for global transactions.

How the Fed differs

The key is that the Federal Reserve has a dual mandate: to promote maximum employment and stable prices (inflation control). Our RBA has a single mandate focused primarily on price stability (inflation targeting), aiming to keep inflation between 2-3%. That is not to say it directly disregards employment rate, inflation is key.

Also consider that in general terms the decision-making processes and the timings of rate changes might differ due to differing economic conditions and policy frameworks in the U.S. and Australia.

How Fed decisions impact Australia

When the Federal Reserve raises or lowers its interest rates, it affects global financial markets, including Australia. Higher rates in the U.S. typically lead to a stronger U.S. dollar and a flow of capital away from emerging and developed markets like Australia in search of better returns in U.S. assets. Conversely, if the Fed cuts rates, it could push investors to look for higher returns in Australia, boosting the Australian dollar and local stocks.

The Fed’s decisions also influence global currency markets. A rate hike in the U.S. tends to strengthen the U.S. dollar, which could make the Australian dollar weaker (AUD/USD), impacting Australian exports. A stronger U.S. dollar can make Australian exports more expensive for overseas buyers, possibly reducing demand.

U.S. monetary policy can cause ripple effects in global stock markets, including Australia. For example, if the Fed increases interest rates aggressively – or maybe just indicate rate cutting may not be as much as the market wants (as Powell indicated last week), global risk sentiment could sour, causing stock markets, including the Australian stock market, to fall.

On the other hand, if the Fed signals a dovish stance or cuts rates, this can create optimism, causing global markets (including Australian stocks) to rally. Just wait and see if Powell makes more dovish comments at the next meeting.

If the Federal Reserve raises interest rates to combat inflation, this could signal a tightening global economic environment. This could lead to reduced demand for Australian exports, which would affect Australian companies, especially those in resource sectors (like mining) that are sensitive to global economic conditions.
Capital Flows:

Decisions by the Federal Reserve often influence global capital flows. For instance, higher U.S. interest rates may attract investment into U.S. bonds or stocks, leading to outflows from Australia’s markets, which could negatively impact the Australian stock market. On the flip side, if the Fed lowers rates, investors might seek higher returns in Australian equities or bonds, which could lead to an inflow of capital and benefit Australian stocks.

Conclusion

In summary, the Federal Reserve influences global financial conditions, including Australia, through its policies, which can affect the Australian dollar, capital flows, inflation expectations, and overall investor sentiment. Consequently, Australian stocks and the Australian economy can experience both direct and indirect impacts from the Fed’s decisions. So you could argue that the Fed is even more important to watch than our own RBA.

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