Free-market economies tend to be volatile as a result of individual fear and greed that emerge during periods of instability. History is rife with examples of financial booms and busts but economic systems have evolved along the way through trial and error. Governments not only regulate economies in the early part of the 21st century but they also use various tools to mitigate the natural ups and downs of economic cycles.
The Federal Reserve (The Fed) exists to maintain a stable and growing economy in the U.S. through price stability and full employment. The Fed has historically done this by manipulating short-term interest rates, engaging in open market operations (OMO), and adjusting reserve requirements. The Fed has also developed tools to fight economic crises that emerged during the subprime crisis of 2007.
Key Takeaways
- The Federal Reserve is America's central bank. It's responsible for conducting monetary policy and controlling the money supply.
- The primary tools used by the Fed include interest rate setting and open market operations (OMO).
- The Fed can also change the mandated reserves requirements for commercial banks or rescue failing banks as lender of last resort, among other less common tools.
- The Fed can use these tools to enact expansionary monetary policy when the economy is faltering.
- The Fed can use unconventional policy such as quantitative easing if expansionary monetary policy fails.
Manipulating Interest Rates
The first tool used by the Fed, as well as by central banks around the world, is the manipulation of short-term interest rates. This practice involves raising and lowering interest rates to slow or spur economic activity and control inflation.
It becomes cheaper to borrow money and less lucrative to save when interest rates are lowered and this encourages individuals and corporations to spend. Savings decline, more money is borrowed, and more money is spent as interest rates go down. The total supply of money in the economy increases as borrowing increases. The result is a good side effect: fewer savings, more money supply, more spending, and higher overall economic activity.
But lowering interest rates also tends to increase inflation. This is a negative side effect because the total supply of goods and services is essentially finite in the short term. Prices go up when more dollars are chasing that finite set of products. All sorts of unpleasant things happen to the economy if inflation gets too high.
The trick with interest rate manipulation is not to overdo it and inadvertently create spiraling inflation. This is easier said than done but it's still better than no action at all.
Open Market Operations
Another major tool available to the Fed is open market operations (OMO). This involves the Fed buying or selling Treasury bonds in the open market. OMO can increase or decrease the total supply of money and also affect interest rates.
The Fed increases the money supply in the economy by swapping out bonds in exchange for cash to the general public when it buys bonds in the open market. It decreases the money supply by removing cash from the economy in exchange for bonds when it sells bonds. OMO therefore has a direct effect on money supply.
OMO also affects interest rates because prices are pushed higher and interest rates decrease when the Fed buys bonds. It pushes prices down and rates increase when the Fed sells bonds.
OMO has the same effect of lowering rates/increasing money supply or raising rates/decreasing money supply as direct manipulation of interest rates. The real difference is that OMO is more of a finetuning tool because the size of the U.S. Treasury bond market is vast and OMO can apply to bonds of all maturities to affect money supply.
Reserve Requirements
The Federal Reserve can also adjust banks' reserve requirements. This determines the level of reserves a bank must hold in comparison to specified deposit liabilities. Based on the required reserve ratio, the bank must hold a percentage of the specified deposits in vault cash or deposits with the Federal Reserve banks.
The Fed can effectively increase or decrease the amount these facilities can lend by adjusting the reserve ratios applied to depository institutions. It can lend out $475 of the deposit if the reserve requirement is 5% and the bank receives a deposit of $500. It's only required to hold $25, or 5%. The bank is left with less money to lend out on each dollar deposited if the reserve ratio is increased.
Influencing Market Perceptions
The final tool used by the Fed to affect markets is an influence on market perceptions. This is a bit more complicated because it rests on the concept of influencing investors' perceptions and that's not an easy task given the transparency of our economy. It encompasses any sort of public announcement from the Fed regarding the economy.
The Fed might say that the economy is growing too quickly and that it's worried about inflation. This would logically mean that an interest rate increase is forthcoming to cool the economy. Bondholders who sell their bonds before rates increase would experience losses. Prices would go down and interest rates would rise. This would effectively accomplish the Fed's goal of raising interest rates to cool the economy but without actually having to do anything.
You'll notice that bonds do move in tandem with guidance from the Fed if you watch the markets so this practice does hold water in affecting the economy.
Term Auction Facility/Term Securities Lending Facility
The Fed was faced with another factor that strongly influenced the economy in 2007 and 2008: the credit markets.
Investors were provided with an unexpected and sharp reminder of the potential downside of taking credit risk with the interest rate increases and the subsequent meltdown in values of subprime-backed collateralized debt obligations (CDOs). Most credit-based investments didn't see serious erosion of underlying cash flows but investors nonetheless began to require higher return premiums for holding these investments.
This not only led to higher interest rates for borrowers but to a tightening of the total dollars lent by financial institutions. This put a crunch on the credit markets.
Some innovation from the Fed was needed to minimize its impact on the broader economy due to the severity of the crisis. The Fed was tasked with bolstering credit markets and investors' perceptions thereof and encouraging institutions to lend despite worsening conditions in the economy and credit markets. The Fed created the term auction facilities and term securities lending facilities to accomplish this.
1. Term Auction Facility
The term auction facility was designed as a means to provide financial institutions with access to Fed dollars to alleviate short-term cash needs and provide capital for lending but on an anonymous basis.
It was called an auction because firms would bid on the interest rate they would pay to borrow cash. This differs from the discount window that makes an institution's need for cash public information, potentially leading to solvency concerns on the part of depositors which only exacerbate concerns about economic stability.
2. Term Securities Lending Facility
The Fed instituted the term securities lending facility as an additional tool to combat balance sheet concerns. This allowed institutions to swap out mortgage-backed CDOs in exchange for U.S. Treasuries.
There were severe balance sheet considerations because these CDOs were falling in value as firms' asset values fell due to heavy exposure to mortgage-backed CDOs. Falling CDO values could have bankrupted financial institutions if left unchecked, leading to a collapse of confidence in the U.S. financial system. But balance sheet concerns could be mitigated until liquidity and pricing conditions for these instruments improved by swapping out falling CDOs with U.S. Treasuries.
The Fed-orchestrated takeover of Bear Stearns in 2007 was made possible through this tool.
Quantitative Easing
Sometimes the Fed's toolkit is simply not enough to spur economic activity in a severe crisis. Quantitative easing (QE) is a form of unconventionalmonetary policyin which a central bank purchaseslonger-termgovernment securitiesor other types of securities from the open market to increase the money supply and encourage lending and investment.
Buying these securities adds new money to the economy and also serves to lower interest rates by bidding up fixed-income securities. It greatly expands the central bank's balance sheet at the same time.
Normalopen market operations, which target interest rates, are no longer effective when short-term interest rates are at or approaching zero. A central bank can therefore target specified amounts of assets to purchase instead. Quantitative easing increases themoney supplyby purchasing assets with newly created bank reserves to provide banks with moreliquidity.
Some central banks have resorted to even more extreme measures such as a negative interest rate policy (NIRP) if QE fails. The Fed has never set effective interest rates below zero although they were set to 0% to 0.25% following the 2008 financial crisis (12% in October 2009) and again in April and May 2020 (.05%) during the COVID-19 pandemic.
What Is a Central Bank?
A central bank is a public entity that controls a country's monetary policy, currency, and money supply. It can monitor a whole group of countries in some cases. The Federal Reserve is the central bank of the U.S. and it's often touted as the most powerful in the world.
What Was the Worst Financial Crisis in the U.S.?
The Great Depression is indisputably the worst financial crisis ever faced by the U.S. It began with the stock market crash in 1929 followed by banking panics and collapses and it's been referred to as the "worst economic disaster in American history." It's been asserted that errors and missteps made by the Fed led to and sustained the disaster.
How Do Treasury Bonds Normally Work?
Treasury bonds or "T bonds" are issued by the U.S. Treasury Department. They're securities that pay interest twice a year at a fixed rate that's set at the time of purchase. Buyers are also repaid the bond's face value at maturity which ranges from 20 to 30 years after purchase. T bonds are virtually risk-free because they're backed by the U.S. government.
The Bottom Line
Monetary policy is constantly in a state of flux but it still relies on the basic concept of manipulating interest rates, money supply, economic activity, and inflation. It's important to understand why the Fed institutes certain policies and how they could potentially play out in the economy. The ebbs and flows of economic cycles offer opportunities by creating profitable times to either embrace or avoid investment risk.
Having a sound understanding of monetary policy is key to identifying good opportunities in the markets.
