What does the Federal Reserve (Fed) do, and how does it influence the markets?
The Fed operates under what is called a dual mandate, meaning that it has two primary tasks that it works to accomplish: maximum sustainable employment (unemployment around 4%) and stable prices (inflation around 2%). There are four "conventional" monetary policy tools that the Fed utilizes: 1) open market operations (OMO), 2) reserve requirement ratio 3) discount window/rate and 4) interest on reserve. We will only discuss the conventional methods here, but if interested here are some of the "unconventional" methods which you can research if interested: 1) open mouth operations, 2) forward guidance, and 3) quantitative easing.
When the economy is slowing down, the Fed lowers interest rates in order to boost consumer spending and business investment (in areas such as production plants and products) in order to get the economy churning again. On the other hand, when the economy is on the brink of overheating, the Fed raises interest rates in order to slow spending and investment. This works as such because high interest rates means that it is expensive for consumers to spend because the opportunity cost is high - a consumer can instead put this money in a savings account and earn good interest. For businesses, high interest rates means that it is costly to borrow money to fund production expansion. The size of consumer spending and business investment affect U.S. G.D.P. - which is widely used to estimate the size and growth rate of the economy. Currently, interest rates are near 0% because the Fed wants to expand the economy after it began to contract under the COVID-19 pandemic.
So how exactly does the Fed accomplish this?
The Fed does this by influencing what is called the federal funds rate (F.F.R.). The F.F.R. is the rate at which banks lend money overnight (short term loan) to one another because they have capital requirements that they must meet and need to make sure they have enough reserves / money in the vault to meet this requirement. Banks make money by charging consumers interest on loans they take out from the bank. When the bank's borrowing cost (the F.F.R.) is lower, so is the interest they charge consumers. As explained above, as the borrowing cost falls, consumer spending and business investment booms and the economy speeds up.
The Fed has a target F.F.R. that it can adjust every six weeks during open market committee meetings. The committee meets every six weeks in order to set/adjust its monetary policy based on how the economy and markets are doing. The Fed; however, does not directly adjust the F.F.R., but it alter it through indirect means through what is called the transmission mechanism (this simply explains how Fed's actions transmit through the economy all the way down to the individual consumer and investor). The Fed adjusts F.F.R. through open market operations, which we mentioned above is a conventional monetary policy tool. The Fed buys/sells Treasury bonds and this decreases/increases the money supply in the economy.
Here is an example of an expansionary monetary policy: what the Fed is currently doing. When the Fed sells T-bonds (called an "open market sale"), this increases supply of bonds in the bond market, driving down the price of said bonds (because there are so many bonds available for purchase). Bond prices and yields are inversely related and thus because prices rose, yields fell. When yields fall so does the F.F.R. because it is the cost of borrowing for banks. This also drives down the saving interest rate because all interest rates generally move in the same direction. Consumers spend more because the interest they would earn by putting money in a savings account is just too low (low opportunity cost) and businesses invest because operating costs have decreased (cheaper to borrow). This all drives up the G.D.P.
In order to get the F.F.R. to the desired range, the Fed also has to set a "floor" rate and "ceiling rate" below which / above which the F.F.R. will not go and this will help ensure that it is moving in the desired direction. The "floor rate" is called interest on excess reserve. This is the interest that banks earn from the central bank (Fed) when they keep some money in the vault instead of loaning it all out. It is the floor because if a bank is looking to make money and its options are to either lend to another bank at the F.F.R. and reap interest in this way or get interest from the Fed by simply keeping excess reserves in the vault instead of lending them out. There is no point to led to another bank if the F.F.R. is below the interest on excess reserves because lending money always comes with risk. Thus, the bank would simply keep money in its vault and earn interest in that way (no risk associated with that option).
"Ceiling" rate is the discount rate. This is the interest banks pay when borrowing directly from the Fed. This is because banks cannot charge each other more than what the Fed would charge them (remember that banks charge each other the F.F.R. which is what the Fed is targeting) because then a bank would simply go directly to the Fed. However, banks want to earn interest by lending to another bank so it is in their benefit to lower the rate below the discount rate so that another bank will borrow from them.
These are, in simpler terms, the steps that the Federal Reserve has been taking in recent months to prevent a recession and get the economy moving again.
