The Federal Reserve (aka the Fed) is the central banking system in the US and it's tasked with deciding our country's monetary policy. Even though the Fed is part of the US government, it operates independently. It can make monetary policy decisions without the approval of the President or any other branches of government and it doesn't receive funding from Congress.
We can think of the Fed as the bank for other banks. Its job is to keep the economy healthy and reduce financial crises through its 3 main objectives:
- Maximizing employment
- Stabilizing prices
- Moderating long-term interest rates
We might have heard about quantitative easing or seen interest rate changes reported in the news. These are all outcomes of changes in monetary policy and are essential in maintaining a healthy economy.
How does monetary policy work?
The overall money supply in the economy is made up of 2 parts: cash (physical money) and credit.
There are two primary ways (though there are others) the Fed can increase or decrease the money supply:
- Printing physical dollar bills
- Changing interest rates
It's easy to connect printing more bills with adding to the money supply, but changing interest rates is a little less straightforward. For that, let's look at how credit is created.
Creation of debt + credit
We create both debt and credit when we borrow money. Let's say we have a credit card with a limit of $500. That $500 is available for us to spend without needing to have any cash. The moment we swipe our card and spend the $500, we now owe the credit company (our debt) $500 at the end of the month. By creating credit and debt, we've increased the supply of money because we're spending money that wasn't there before. We were able to spend an additional $500 and those additional transactions add to the economy, raising GDP.
Creating debt and credit isn't free. Remember, interest rates are the cost of borrowing since we have to pay back what we borrowed plus interest. We'll borrow less if interest rates are high, which means we'll create less credit and add less to the money supply. So, interest rates directly affect credit which impacts the money supply.
- Higher interest rates reduce the amount of credit — lower money supply
- Lower interest rates increase the amount of credit — higher money supply
How the Fed changes interest rates
The central bank uses interest rates as the main lever to create or reduce credit. Since the Fed is like a bank for other banks, it lends money to other banks for very short periods of time (literally overnight). It charges them an interest rate called the Fed Funds Rate and it's also the cost that banks charge to lend to each other. The central bank increases the Fed Funds Rate when inflation is high and decreases it when more credit is needed to stimulate the economy.
The Federal Open Market Committee (FOMC)
The FOMC is the monetary policymaking body of the central bank and the body meets eight times a year to determine if adjustments to the Fed Funds Rate are needed.
Depending on their decision, the financial markets can change quickly.
Changes in the Stock market
Typically stock prices rise when Fed Fund Rates are lowered and fall when Fed Fund rates are increased. When the Fed Funds Rate is low or lowered, the abundance in credit allows consumers to spend more, and companies earn more. Another reason is that savings accounts and bonds pay less and provide lower returns when interest rates are low, making higher-earning stocks look more attractive. Investors will start buying more stocks and the extra demand starts to push stock prices up.
On the other hand, when interest rates increase, stock prices decrease. Changes in Fed Funds Rates trickle down to the costs banks charge companies to borrow money. Stocks of companies or business sectors that rely heavily on borrowing are adversely affected when the cost of borrowing increases. With less credit available and a higher cost of borrowing, companies will generate less revenue from sales and cannot borrow as much to invest for future growth.
Changes in the Bond markets
When Fed Fund Rates are lowered, bond prices increase. When Fed Fund Rates are raised, bond prices decrease.
Bond prices have an inverse relationship with interest rates because every investor wants the highest interest-paying bonds. After the Fed drops interest rates, the new bonds that are issued pay less interest compared to the old bonds. Investors rush to buy up all the existing old bonds with higher interest payments. The increased buying pushes bond prices higher.
Likewise, when the Fed raises interest rates, all the existing lower interest-paying bonds are sold or dumped by investors to buy the new bonds paying higher interest. The selling drops the price of the bonds.
The chart above shows how changing the Fed Fund Rate affects borrowing rates in the 1-Year and 10-Year US Treasury bonds.
Change in Mortgages
Interest rates charged on mortgages also change with the Fed Funds Rate. Mortgages are loans and work like bonds between banks and consumers like us. As we would expect, mortgage rates also follow the change in Treasury and Fed Funds Rate.
When the Fed lowers interest rates, it's a good time to refinance or to take out a mortgage.
Printing of money
While rare, the central bank can choose to print physical money.
The printed money is inflationary and more printed money results in a lower value of existing dollars. Since the Fed keeps tight control on inflation, the printing of money is used only in desperate times when the economy is in a recession and the interest rates are already at 0 with no further room to be lowered.
Both stock prices and bond prices follow the same trend when it comes to reacting to interest rate changes. When rates go down, prices go up. When rates go up, prices go down. By understanding and following the actions of the central bank, you can stay on top of and take advantage of changes in market prices.