The Fed and the Markets (Part 1)

Friday, July 28, 2017

By: Christopher P. Cline

The media, it seems, can’t get enough of stories about the Federal Reserve System. Alan Greenspan, Ben Bernanke and Janet Yellen are minor celebrities, and for good reason. The economic decisions that each has guided have had significant impacts on all of our lives for more than 25 years.

 But most people aren’t clear about the ways in which the Federal Reserve System operates. This three-part series of articles tries to explain that process, and what it might mean for the future. This article, the first in the series, explains the ways in which the Federal Reserve System impacts our lives. Part Two will discuss the ways in which stock and bond markets are affected by Federal Reserve System actions, and Part Three will talk about what’s happening now and perhaps in the future as a result.

 Overview

According to its website, the Federal Reserve System, often referred to as the Federal Reserve or simply "the Fed," is the central bank of the United States. It was created by Congress to provide the nation with a safer, more flexible, and more stable monetary and financial system. The Fed has four main responsibilities:

1. Conducting the nation's monetary policy to pursue full employment and stable prices;

2. Supervising and regulating banks and other important financial institutions to ensure the safety of the nation's banking and financial system and to protect consumers’ credit rights;

3. Maintaining the stability of the financial system and containing systemic risk in financial markets; and

4. Providing financial services to the U.S. government, U.S. financial institutions, and foreign official institutions, and operating and overseeing the nation's payments systems.

Congress determined that directing monetary policy should be free from political influence. As a result, the Fed is an independent agency of the federal government.

How Does the Fed Achieve its Goals?

In general, the federal government affects the economy through either monetary or fiscal policy.

• Monetary policy refers to the Fed’s actions to achieve large-scale policy objectives such as price stability, full employment, and stable economic growth.
• Fiscal policy refers to the federal government’s tax and spending policies.

Fiscal policy decisions are determined solely by the Administration and Congress. The Fed directs monetary policy only.

Technically, monetary policy is set by the Federal Open Market Committee (FOMC), a group within the Fed that meets eight times a year.  So when the papers talk about the Fed meeting, they’re really talking about the FOMC. The FOMC considers how the current and projected fiscal policy (taxes and spending) might affect gross domestic product growth, employment, and inflation when it makes its monetary policy decisions. In this way, government fiscal policy and the Fed’s monetary policy affect each other.

For example, if federal tax and spending programs are projected to boost economic growth, the Federal Reserve would assess how those programs would affect its key objectives of maximum employment and price stability and make appropriate adjustments to its monetary policy.

In recent years, attention has been turned to two main tools the Fed has used to try to improve employment and price stability: setting of the federal funds rate, and quantitative easing. 

Federal Funds Rate

The Fed’s first and most important tool is setting the target for the federal funds rate (the rate that banks charge each other for short-term loans). By adjusting this short-term rate, the Fed hopes to influence longer-term interest rates and key asset prices, and thereby the spending decisions of households and businesses.  When you read about the Fed “raising rates,” what it’s really only doing is raising the federal funds rate.

From December 2008 to December 2015, the Federal Reserve's target for that rate was between 0 and 1/4 percent (basically as low as it could have gone), an extraordinarily long period for keeping short term rates effectively at zero.  Since December 2015, the Fed has raised rates four times, bringing the target rate to between 1 and 1.25 percent (still historically very low).

In addition to setting the federal funds rate, the Fed also provides "forward guidance" (its forecast for the path of that rate in the future).

Through forward guidance, the FOMC indicates to households, businesses, and investors the direction of future monetary policy decisions. By indicating how long the FOMC expects to keep the federal funds rate low, the forward guidance puts downward pressure on longer-term interest rates.  The hope is that, by keeping those longer-term rates low, the cost of credit for households and businesses also will stay low, improving broader financial conditions.

It’s important to remember, though, that the change in the federal funds rate only directly affects the rate for very short-term loans between banks.  It does not automatically affect mortgage rates, business loans or any other rate decisions from lenders. 

In fact, lenders sometimes use the forward guidance to change interest rates they charge, so that when the Fed gets around to actually making a change to the federal funds rate, it might have very little impact.  In other words, changing the federal funds rate is an inexact tool for making significant economic change.

Quantitative Easing

In response to the financial crisis, the Fed engaged in “quantitative easing,” or “QE.” The best description of QE comes from The Economist (“What is Quantitative Easing?” www.Economist .com, from which the following discussion is taken).

Part of the Fed’s job in maintaining price stability is keeping inflation in check. Before the financial crisis, it mostly used federal funds rate changes to do so. If businesses were nervous about the future and scaled back on investment, the Fed would reduce that rate. That would reduce banks' funding costs and encourage them to make more loans, keeping the economy from falling into recession. By contrast, if credit and spending were getting out of hand and inflation was rising, the Fed would raise the rate.

As already discussed, when the crisis struck, the Fed cut the federal funds rate to almost zero. But even that didn’t spark recovery. So the Fed turned to QE.

To implement QE, the Fed “creates” money by buying securities, such as government bonds, from banks, using electronic cash that did not exist before. The new money swells the size of bank reserves in the economy by the quantity of assets purchased—hence "quantitative" easing. Like lowering interest rates, QE is supposed to stimulate the economy by encouraging banks to make more loans. Banks should take the new money and buy assets to replace the ones they sold to the Fed, thereby lowering interest rates and boosting investment.  It was also designed to show the markets that the Fed was serious about fighting deflation, which should have boosted confidence.

Today, interest rates on everything from government bonds to mortgages to corporate debt are probably lower than they would have been without QE. Several rounds of QE have increased the size of the Fed’s balance sheet—the value of the assets it holds—from less than $1 trillion in 2007 to more than $4 trillion now.

As The Economist notes, the jury is still out on QE. Studies suggest that it did raise economic activity a bit. But some worry that the flood of cash encouraged reckless financial behavior and directed a “firehose of money to emerging economies that cannot manage the cash.” Others fear that when the Fed sells its assets, interest rates will rise, causing disturbances. For instance, when the Fed first floated the idea of tapering its asset purchases, global interest rates jumped and markets wobbled. So QE probably helped the recovery, but no one really seems to know by how much.

* * * * *

In the next installment, we’ll look at how monetary and fiscal policy affect stock and bond prices. This will give some context to this basic discussion of Fed operations.