The Fed’s tools to influence the economy

Left to their own equipment, free market economies are often volatile as a result of separate fear and greed, which appear during periods of instability. History is full of financial booms and depressions, but, through trial and error, the economic system has also evolved along the way. But looking at the beginning of the 21st century, governments of various countries not only regulate the economy, but also use various tools to alleviate the natural UPS and the ups and downs of the economic cycle.

In the United States, the US Federal Reserve (Federal Reserve) exists to maintain price stability and full employment stability and economic growth-its two statutory duties.Historically, the Fed has done this by manipulating short-term interest rates, participating in open market operations (OMO), and adjusting reserve requirements.The Fed also developed new tools to combat the economic crisis, which appeared during the subprime mortgage crisis in 2007.What are these tools and how can they help ease the economic downturn? Let’s take a look at the Fed’s arsenal.

Key points

  • The Federal Reserve is the central bank of the United States, responsible for implementing monetary policy and controlling the money supply.
  • The main tools used by the Fed are interest rate setting and open market operations (OMO).
  • The Fed can also change the statutory reserve requirements of commercial banks or rescue banks in trouble as the lender of last resort, as well as other unusual tools.
  • When the economy is faltering, the Fed can use these tools to formulate expansionary monetary policy. If it fails, it can use unconventional policies, such as quantitative easing.

Manipulate interest rates

The first tool used by the Federal Reserve and central banks around the world is to manipulate short-term interest rates. In short, this approach involves raising/lowering interest rates to slow/stimulate economic activity and control inflation.

The mechanism is relatively simple. By lowering interest rates, it becomes cheaper to borrow money, save less money, and encourage personal and corporate consumption. Therefore, when interest rates fall, savings fall, more money is borrowed, and more money is spent. In addition, due to the increase in borrowings, the total supply of currency to economic growth. So the end result of lower interest rates is reduced savings, more money supply, more consumption, and higher overall economic activity-a good side effect.

On the other hand, lowering interest rates also tends to increase inflation. This is a negative effect, because the total supply of goods and services in the short term is basically limited-as more and more dollars chase limited products, prices will rise. If inflation is too high, all kinds of unpleasant things will happen to the economy. Therefore, the trick to manipulating interest rates is not excessive, but inadvertently creating a spiral inflation. This is easier said than done, but although this form of monetary policy is imperfect, it is better than no action.

Federal Reserve System (FRS)

Open market operations

Another major tool available to the Fed is open market operations (OMO), which involves the open market in which the Fed buys or sells Treasury bonds. This approach is similar to directly operating the OMO interest rate, which can increase or decrease the total money supply and also affect interest rates. Again, the logic of the process is quite simple.

If the Fed buys bonds on the open market, it increases the money supply in the economy by exchanging bonds for the general public in exchange for cash. Conversely, if the Fed sells bonds, it removes the money supply from the economy in exchange for bonds in cash. Therefore, OMO has a direct impact on the money supply. OMO also affects interest rates because if the Fed buys bonds, prices are pushed up and interest rates fall; if the Fed sells Treasury bonds, this pushes prices down and interest rates rise.

Therefore, OMO has the same effect as lowering interest rates/increasing money supply or raising interest rates/reducing money supply directly manipulating interest rates. However, the real difference is that OMO is more like a fine-tuning tool, because the US Treasury bond market is very large, and OMO can be applied to bonds of all maturities to affect the money supply.

Reserve requirements

The U.S. Federal Reserve must also adjust bank reserve requirements, which determines the ability of the Reserve Bank to hold levels relative to the designated deposit debt. Based on the deposit reserve ratio, the bank must hold the cash on hand or the percentage of the deposit to the Federal Reserve Bank of the designated deposit.

By adjusting the reserve ratio applicable to depository institutions, the Federal Reserve can effectively increase or decrease the amount of loans that these facilities can lend. For example, if the reserve requirement is 5% and the bank receives a deposit of $500, it can lend a deposit of $475 because it only needs to hold $25 or 5%. If the reserve requirement ratio is increased, the amount of funds that can be loaned out for every dollar deposited by the bank will decrease.

Influence market perception

The tools used by the Fed ultimately affect the market’s perception of the market. This tool is a more complicated one because it is built on the concept of influencing investors’ perceptions, which is an easy thing that does not give us economic transparency. In fact, this includes any kind of Fed’s economic announcements.

For example, the Fed may say that the economy is growing too fast and worry about inflation. Logically speaking, if the Fed is real, it will mean that interest rates are about to be raised to cool the economy. Assuming that the market believes this Fed statement, bondholders will sell their bonds before interest rates rise and suffer losses. As investors sell bonds, prices will fall and interest rates will rise. This will actually achieve the Fed’s goal of raising interest rates to cool the economy, but in fact no action is required.

This sounds great on paper, but it is more difficult in practice. If you look at the bond market, they move back and forth with the guidance from the Federal Reserve, so this approach does not hold water to affect the economy.

Regular auction tools/regular securities lending tools

In 2007 and 2008, the Fed faced another factor that strongly affected the economy-the credit market. With the recent interest rate hikes and the collapse of the value of CDOs backed by subprime mortgages, investors have provided unexpected and sharp reminders of the potential downside of credit risks.Although most credit-based investments have not seen a serious erosion of potential cash flow, investors are still beginning to demand higher return premiums to hold these investments, which not only leads to higher interest rates for borrowers, but also US dollars lent by financial institutions Total tightening has caused a tightening of credit markets.

Due to the severity of the crisis, the Fed needs to make some innovations to minimize its impact on the overall economy. The Federal Reserve’s mission is to strengthen the credit market and investors’ perception of it, and encourage institutions to lend when economic and credit market conditions deteriorate. To this end, the Federal Reserve has created regular auction tools and regular securities lending tools. Let’s take a closer look at these two projects:

1. Regular auction tools

The purpose of the regular auction tool is to provide financial institutions with access to Fed dollars to ease short-term cash needs and provide loan funds in an anonymous manner.It is called an auction because companies will bid at the interest rate they pay for borrowed cash. This is different from the discount window, which makes institutions need cash to disclose information, which may cause depositors to worry about solvency, which will only exacerbate concerns about economic stability.

2. Convenience of regular securities borrowing and lending

As another tool to solve the balance sheet problem, the Federal Reserve established a regular securities lending facility, allowing institutions to exchange mortgage-backed CDOs in exchange for U.S. Treasury bonds.As these debt-collateralized bonds have undergone a decline in value, there has been a serious balance sheet consideration of the decline in the value of corporate assets due to the heavy exposure of CDOs in housing mortgage loans. If left unchecked, a decline in the value of the CDO may have bankrupted financial institutions and cause the confidence of the US financial system to collapse. However, with the declining CDO swapping out U.S. Treasuries, balance sheet concerns may be eased until the liquidity and pricing conditions of these instruments improve significantly. The acquisition planned by the Fed in 2007 by Bear Stearns was made possible through this newly invented tool.

Quantitative easing

Sometimes, the Fed’s toolkit is simply not enough to stimulate economic activity in a severe crisis. Quantitative easing (QE) is an unconventional monetary policy in which the central bank purchases longer-term government securities or other types of securities from the open market to increase the money supply and encourage borrowing and investment. The purchase of these securities adds new capital to the economy and can also lower interest rates by raising fixed income securities. At the same time, it greatly expanded the central bank’s balance sheet.

When short-term interest rates are zero or close to zero, normal open market operations that target interest rates are no longer effective, so the central bank can purchase a specific amount of assets. Quantitative easing increases the money supply by purchasing assets with newly created bank reserves in order to provide banks with more liquidity.

If quantitative easing fails, some central banks will take more extreme measures, such as a negative interest rate policy (NIRP). So far, the Fed has never set the target interest rate below zero, although it set the target interest rate at 0%-0.25% again in March 2020 after the 2008 financial crisis and after the 2020 crisis.

Bottom line

In general, monetary policy has been in a state of constant change, but it still relies on the basic concept of manipulating interest rates, therefore, money supply, economic activity, and inflation. It is important to understand why the Fed makes certain policies and how these policies may play a role in the economy. This is because the ebb and flow of the economic cycle provides opportunities by creating profitable time to embrace or avoid investment risks. Therefore, a full understanding of monetary policy is the key to identifying market opportunities.

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