Sometimes I forget when reading articles about the Fed and monetary policy that I spent years figuring out Fedspeak. Lately the news has been about reports that the Fed will soon raise interest rates. I imagined the Fed telling each bank to raise its rate on savings accounts. But that's not really how it goes. So I decided I would put on my teacher hat and explain what I think all this means.
What is the Fed? Why do we expect them to raise interest rates? What are they doing? How are they doing it? Why are they doing it? How will it work out? How does all this affect the stock market? Whew. Lots of questions.
The Fed is short for Federal Reserve. The Fed is an organization that is part of the government's national policy making institutions. These policy decisions come out of the Fed's Open Market Committee. That policy making committee consists of the Governors of the Fed and the Presidents of the Fed district banks. Those folks meet regularly to decide on Fed policy.
Fed policy in the real world has two basic goals. The first is to keep the economy humming or at least keep it out of recessions. The second is to create a stable inflationary environment with the inflation rate of goods and services rising at around 2% per year. It has a hard time with these two goals because sometimes making progress on one automatically causes problems with the other. So they have to walk a fine path so as to make economic growth strong enough and inflation low and stable.
Often the Fed's decisions and its goals are framed using words like money growth and interest rates. Notice I used the word "goals". On a day to day basis, the Fed does not set interest rates. It is more proper to say that they try to influence interest rates. There is much confusion when people imagine the Fed moving a dial for interest rates. Or telling bankers what interest rate to charge.
This might sound crazy, but the Fed influences interest rates because they buy and sell government bonds. They do not write down an interest rate on a bond. The US Treasury does that. What the Fed really does is to trade government bonds in bond markets as a way to change the market value of these bonds..
When the Fed decides to buy a lot of government bonds, they buy the bonds with newly created money. Boring. Create money. Really? Yes they create it at will. Wowee -- makes me think of Scrooge McDuck playing in his vault.
Anyway, back at the vault. The Fed creates money and then uses it to buy bonds. If they create enough demand for bonds, this causes the price of the bonds to rise and the interest rate on those bonds to fall. Aha. The interest rate on the bonds is written in ink -- but if the market prices the bonds higher, then the rate expressed as a percent of the market price of bonds falls. Suppose the bond says 4% on it. The more you pay for that bond and for the stated 4%, the lower return you get.
Don't moan. The Fed does not tell banks what interest rate to charge. But the Fed does influence a broad swatch of interest rates as it buys and sells government bonds.
This gets us back to the Fed's goal. If they want a stronger economy they will buy bonds as a means to reduce interest rates and to persuade people to buy more goods and services at those lower rates. If the Fed wants to reduce the inflation rate, then it does the opposite. It will sell bonds as a means to raise interest rates and persuade people to purchase less goods and services.
I see you are starting to nod off. I did my best to write about a tough topic. I hope it helped you understand the Fed and monetary policy a little better. If not, there is always a sweet walk by the lake with your honey.
Excellent explanation. Lima charlie. I first learned about the Fed when taking courses circa 1972-75. Actually, I should have learned about it when taking Macro 101 as an UG in college, but I dumped whatever I learned 0.5 nanoseconds after walking out of the final exam figuring knuckle-dragging Marine officers with small brains needed all available mental storage space for stuff like how to actually cut throats, not cutthroat financial gobbledygook. It worked. I still remember stuff like a K-Bar in the eye socket ends the fight. But alas, in becoming a banker somebody thought I needed to know about the Fed, so I took courses in financial gobbledygook. Buy bonds, bonds get fewer, bonds worth more, rates go down. Sell bonds, bonds get morer, bonds worth less, rates go up. Think I got it. What always puzzled me, however, were important questions such as, "Where does the Fed store all those bonds it buys?" It must have a huge safety deposit box somewhere. And, "When the Fed writes a check to buy bonds, what bank's name is on the check?"
ReplyDeleteThanks John. I thought my post was a little too pedantic but I enjoyed writing it. To a lot of people monetary policy is like magic. I have no idea where they store the bonds...nice question. I suspect the Fed is its own bank and FED is on those checks. If course, much is done electronically and avoids the use of paper checks. The Fed slides some money over to your IUCU checking account.
DeleteDear LSD. Talk’n hedz on the boob tube are yak’n ‘bout the Fed rais’n rates 4 to 8 times this year, speculat’n in .25 to .5 basis points each. This soundz a little different than your ‘splanation that de Fed buyz/sellz bonds to affect rates. Huh? Also, my finny frendz down here in Tuna Econ Skool say The Federal Open Market Committee (FOMC) uses several tools to influence interest rates and the economy. Two tools used currently to keep the FFR (Federal Funds Rate) in the target rate range are:
ReplyDelete•Interest on reserve balances (IORB): The Fed pays interest on the reserves banks keep with it.
•Overnight reverse repurchases (ON RRP): The Fed sells securities to banks not eligible for interest on reserve balances, and then buys them back at a higher price the next day—essentially paying the bank interest.
Without gitt’n wrapp’d round my tail fin can you ‘splain the difference betwixt rais’n rates a few basis pointz, sell’n/buy’n bondz, the IORB, and the ON RRP to affect interest rates? This tuna’s mindless inquir’n mind wantz to know. Or is this gitt'n too far into the seaweedz? Bottom line, seemz the Fed is experiencing an irritable Powell syndrome.
Yes, too far into the seaweeds for most folks. My quick and dirty answer is that the Fed has a lot of tools by which they can influence interest rates. For example, changing the discount rate is a lot like turning an interest rate dial. But the goal is not to affect the discount rate -- it is to affect market rates via changes in the discount rate. Depending on the present circumstance they might prefer one tool over another. But my recollection of money and banking is that it all pretty much amounts to the same thing. As for open market sales and purchases -- it was always my understanding that this was the main way the Fed influences interest rates. They use this method more than the other ways....in fact they seem to be in those bond markets continuously.
DeleteDon't have an IUCU account any longer, but if the Fed is putting money in them I'm going to open one.
ReplyDeleteAnd I'm pretty sure the Fed don't write checks to pay for bonds...it credits the accounts of banks from
which it buys bonds. And I also suspect the bonds purchased are transferred electronically to the Fed. At least that's my recollection...which grows dimmer by the moment. I even have trouble recalling Yogi Berra played for the Packers.
As for magic, much is magic about the federal govt to me. For example, why were masks effective in preventing transmission of COVID a month ago...but then ineffective 3 weeks ago...but once again effective 2 weeks ago? How is the sudden Afghanistan withdrawal suddenly a success? How is reducing the number of cops reducing crime? How well would gun control work if we had open borders for immigration? I wish I had some of the federal govt's fairy dust to sprinkle on my mistakes and make them disappear. And ex post her current assignment, will Fairy-Duster-in-Chief whatshername Psaki do washing machine commercials because she's an expert on spin cycles?
Magic is for magicians. The government mostly just lies or at best they are incompetent for the things they try to do. Would have been better for us if we had artistic skills and spent our time focused on the best way to paint a petunia.
DeleteI like John’s last comment.
ReplyDeleteDear LSD. Otay, tankz fer the Cliff’s Notes of how de Fed affectz rates but it’s still as clear a Mathesom Hammock mud as to how de Fed dealz with its irritable Powell syndrome.
ReplyDeleteKudos to John ‘n James re: the spin cycle’s Psaki. Unfortunately, John misspelled the name. It be “Suckie.”
You are welcome? Maybe he needs a suppository?
Delete