Today, I’m breaking down the Federal Reserve, how it works, and what the Fed is faced with as it looks to decide on rates! How does the Fed impact us? Why does it matter if it’s independent? And what the heck is the bond market, and why is that important? Find out what it is on this week’s episode of People Over Numbers!
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Also, as promised in the episode, here is some more information on the Fed:
The Federal Reserve sets the interest rate at which banks hold on to excess reserves; essentially, the Fed pays banks to hold money instead of lending it out. The reason that banks hold money in reserve is to ensure they have enough money to prevent their own failure and to prevent runs on the banks. So, the Fed pays them to hold that money. How does this influence interest rates, though? It has to do with the cost of holding money vs lending money. If the Fed raises interest rates using this method, it starts a chain reaction. Now, banks basically get free money from the Fed to hold more money in reserve, which means they then lend less money to peopleand businesses. This is used to slow down inflation.
The opposite happens when trying to boost employment and investment. The Fed lowers interest rates on reserves, so banks now have an incentive to lend money to more people and businesses.
Open Market Operations means that the Fed will either buy or sell bonds and other similar securities from banks toinfluence the money supply. If they need to lower interest rates, they buy from the banks, meaning the banks have more money, which they then lend topeople and businesses. If they need to raise interest rates, the Fed sells to the banks, which means banks have less money, so they lend less.
Discount Window Lending is something that is used to try and save banks and other depository institutions if they hit a crisis. Basically, banks can borrow money from theFederal Reserve so that they have enough cash, and they don’t crash.
Specifying Reserve Requirements means that the Fed would tell banks how much money they have to have in reserve, but after the financial crisis in 2008, the Fed stopped doing this
Non-traditional tools are used by the Fed when they don’t have room to move the fed funds rate, meaning the rate is at 0. This happened from around 2008-2016, and again during COVID, from 2020 to 2022. So, if the Fed can’t move the interest rate, what do they do? They use forward policy guidance. They tell markets what to expect in the near future, and if it’s good news, that will help stimulate the economy. The challenge with this is that people and businesses have to believe what the Fed is saying, or else their forward policy announcement won’t stimulate the way it should. For example, if the fed funds rate was at 0, and the Federal Reserve said it would stay that way for 2 years due to xyz economic conditions, people, and businesses would need to believe that, because if we all think that interest rates will rise before those 2 years are up due to inflation or something, then that might not stimulate the economy as much as it could’ve.
The other unconventional tool they use isQuantitative Easing, which means that the Federal Reservewould buy large amounts of long-term securities, like long-term government bonds, and things like that, which would increase their prices, because of the lower supply, and also flood the market with cash. This cash would then be used to stimulate the economy. This is kinda what people think of when they hear about the government printing money
The Fed Explained: https://www.federalreserve.gov/aboutthefed/files/the-fed-explained.pdf#p23
Atlanta Fed Taylor Rule Tool: https://www.atlantafed.org/cqer/research/taylor-rule
