What is the Federal Open Market Committee (FOMC) and its role in financial markets?

In the complex world of finance, the U.S. Federal Open Market Committee (FOMC) plays a crucial role in influencing the country's economic stability. Made up of key figures from the Federal Reserve (Fed), the committee shapes monetary policy, impacting financial markets and the lives of everyday people, including you and me. 

In this two-part series, we're lifting the curtain on the Fed and how it controls interest rates. This article demystifies what the Fed is all about, the FOMC's composition, and how it uses interest rates to maintain a smoothly functioning economic engine. The next article in the series explores how the FOMC’s interest rate decisions affect your investments. 

The roles of the Federal Reserve and FOMC in setting interest rates

Established by Congress in 1913, the Fed serves as the central bank of the United States. Its core objective is to provide the nation with a robust and effective monetary and financial system.

In particular, the Fed is in charge of five key functions to promote the health of the U.S. economy and ensure the stability of the U.S. financial system. One of those functions is to conduct the country’s monetary policy to promote stable prices in its economy. 

Source: US Federal Reserve 

Three main Federal Reserve entities are responsible for the decision making to maintain the system. Those entities are:

1. the Federal Reserve Board of Governors (Board of Governors); 
2. the 12 Federal Reserve Banks (Reserve Banks); and 
3. the Federal Open Market Committee (FOMC).
   

The FOMC is the body that sets the country’s monetary policy, including the federal funds rate (the target interest rate at which financial institutions borrow and lend their extra reserves to one another overnight). 

The group is made up of 12 individuals who have the power to vote. This includes:

• 7 members from the Board of Governors;
• the president of the Federal Reserve Bank of New York; and 
• 4 out of the 11 other Reserve Bank presidents.

The Board is headed by the Chair, Jerome H. Powell. He first took office on 5 February 2018 and was reappointed for a second four-year term on 23 May 2022. He also serves as the Chairman of the FOMC. 

In the following section, we will discuss the intricacies of the FOMC’s mechanism and schedule. 

Monetary policy and federal funds rate: A dual mandate

The FOMC assumes the responsibility of determining the course of monetary policy. A guardrail to that is its “dual mandate” prescribed by Congress. The missions are to: 1) maximize employment, and 2) maintain price stability. 

While there’s no target level for maximum employment, the FOMC targets an annual average inflation rate of 2% over the longer run. To achieve those two goals, the committee raises or lowers its target range for the policy rate, which is the federal funds rate. This is the interest rate at which depository institutions, such as banks and credit unions, borrow from and lend to each other overnight from their reserve balances. 

The FOMC sets the target interest rates at its eight yearly meetings. During the meetings, the committee considers how the US economy has been performing and how it’s likely to evolve going forward, together with risks to the economic outlook. Using this assessment, the FOMC determines the right monetary policy setting. 

When the FOMC changes the target range for the federal funds rate, other interest rates and financial conditions generally adjust in response. As a result, this has an impact on the choices made by households and businesses regarding their spending. This then would tend to move the economy toward the “dual mandate.”

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Source: US Federal Reserve 

How has the US Fed interest rate changed over the years?

Over the years, the Fed has made numerous adjustments to interest rates to effectively manage the economy and achieve its dual mandate of promoting maximum employment and stable prices. The interest rate set by the FOMC has fluctuated in response to economic conditions and policy objectives.

While the current interest rate may seem high, we have had even higher periods of interest rates in the 1980s. 

Source: Fed Board of Governors via FRED

We will illustrate the mechanism and rates’ relationship with the economy and the interest rate increases and decreases in recent history. 

‍Post GFC: Dating back to 2007-2008, during the Global Financial Crisis (GFC), the Fed lowered the interest rate to near-zero levels to stimulate economic growth and prevent a deep recession. This accommodative monetary policy aimed to encourage borrowing and investment, thereby boosting consumer and business spending.

‍Improvements in the economy: As the economy gradually recovered, the Fed began to raise the interest rate in 2015. This tightening of monetary policy was driven by improving economic indicators, such as low unemployment rates and steady inflation. By increasing the interest rate, the Fed aimed to prevent the economy from overheating and to maintain price stability.

‍COVID-19 pandemic: In response to the economic impact of the COVID-19 pandemic, the Fed once again lowered the interest rate to near-zero levels in 2020. The unprecedented nature of the pandemic required aggressive monetary policy actions to support the economy and ensure financial stability. However, that brought about another problem – and that is inflation. 

‍Controlling soaring inflation: In a move designed to help control inflation, the Fed began raising the federal funds target rate in March 2022. From that point through July 2023, the Fed increased rates eleven times. 

At the January 2024 FOMC meeting, the Federal Funds rate was maintained at between 5.25% and 5.5%. The Fed has left rates unchanged since July 2023.

Source: US Federal Reserve 

Fed rate cut predictions in 2024 and beyond

The Fed’s projections are communicated through the “dot plot,” which comprises interest rate forecasts by the voting members of the FOMC. 

In the latest communication made on 13 December 2023, the dot plot reveals a median rate of 4.6% for 2024 and a median of 3.6% the following year. 

This is far from static as views expressed by the FOMC members change meeting over meeting through votes. 

The latest one shows that 16 out of the 19 dots were below 5%. Compared with the September edition, despite the actual interest rates being maintained, the FOMC members indicate a consensus of putting rates lower in 2024.  We can see from here that predictions are just that – predictions – and they are revised over time against the real-world environment. 

How should we use such information?  Stay tuned for part two, where we break down the US Fed interest rates and what they mean for your investments.

[Editor’s note: Part two on "How does the US Fed interest rate affect investors?" has since been published.]