Wednesday, December 12, 2007

The Fed's Impact on the Economy

by Nancy Osborne, COO of ERATE

The Fed meets regularly every six weeks of the year to assess the state of the economy and after their two day Federal Open Market Committee (FOMC) meeting adjourns, the markets eagerly wait for any indication of their outlook on the economy or hints on the direction of interest rates. The irony is that the Fed, which is seemingly omnipotent in the eyes of the average American, really has no direct control over long term interest rates which determine what homeowners pay for a mortgage nor do they directly impact long term economic growth. What the Fed actually does is regulate monetary policy by setting short-term interest rates and controlling the supply of money in the short run. They do so through the use and control of the following tools:

  • The Discount Rate - this is the interest rate which the Fed charges to loan short-term funds from a Federal Reserve Bank directly to a member bank.

  • The Fed Funds Rate - this is the rate which banks charge one another for overnight loans. This is the key short term rate which directly influences changes in the prime lending rate which is charged to consumers and businesses.

  • Open Market Operations - this involves the buying and selling of government securities by the Fed whereby they can both inject (by buying) and drain (by selling) funds from the money supply.

Through the use and control of the above outlined tools, the Fed can wield a lot of influence in the areas of both consumer and business spending thereby guiding economic growth. However what the Fed cannot do is control the cyclical nature of the economy and prevent its pattern of highs and lows. When the Fed decides to cut short term interest rates the news is normally well received by the financial markets and the bond market will rally unless it is perceived as overly aggressive and may possibly lead to a higher rate of inflation. If a Fed move is seen as too conservative, or not aggressive enough, bond investors will likewise reveal their disapproval by summarily selling bonds and the yield will go up as yield and price move in opposite directions.

So if the Fed controls only short term interest rates, what influences rates in the long run? The answer is bond investors and they do so through the act of both buying and selling treasury bonds and notes. It is the bond investor's reading on the economy, influenced in part by the actions of the Fed and their resulting perception of Fed actions by bond investors which determines whether they will become either buyers or sellers of bonds. However other factors determine the behavior of the bond investor as well such as their future expectation of economic growth and the overall rate of inflation. Longer term economic growth is influenced by the government's control of fiscal policy which influences government spending as well as tax policies creating incentives for both consumers and businesses to save and invest.

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