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Federal Reserve System And Monetary Policy – Remember the unprecedented rate hikes in 2022? The Fed raised interest rates seven times by 425 basis points that year, a historically fast move.
Why did the Fed raise interest rates? How does monetary policy affect the economy and your investment? In today’s lesson, we’ll explore the Federal Reserve’s monetary policy and help you gain a deeper understanding of its composition, function, and impact on major assets. Let’s begin!
Federal Reserve System And Monetary Policy
The Federal Reserve System is the central bank of the United States. There are three key entities in the Federal Reserve System: the Board of Governors, the 12 Federal Reserve Banks, and the Federal Open Market Committee (FOMC).
Monetary Policy Transmission Through Online Banks
The Board of Governors, an agency of the federal government that reports to and is directly responsible to Congress, provides general guidance for the System and oversees the 12 reserve banks. The officers of the Council are all appointed by the President and confirmed by the Senate. The Chairman of the Board of Governors is the head of the Federal Reserve and the active executive officer of the Board of Governors of the Federal Reserve System.
The 12 regional reserve banks are located throughout the country. You may have seen news headlines like “Atlanta Fed Chair on Debt Ceiling and Inflation.” These spokespersons are from the Regional Reserve Banks, which help monitor regional economies and report to the Council.
The members of these two entities make up the Federal Open Market Committee (FOMC). The FOMC holds eight regular meetings a year, but sometimes more in an emergency. For example, during COVID-19, there were five meetings in March 2020 alone.
At these meetings, the Committee sets the direction of monetary policy by managing open market operations. It also assesses the risks to its long-term goals of price stability and sustainable economic growth.
Federal Reserve Board
Therefore, interest rate hikes are decided during FOMC meetings. This is why the FOMC is considered the most influential part of the Fed.
The first function is probably the most crucial for the market and investors. The Fed has two primary mandates when conducting monetary policy: achieving a maximum level of employment and price stability.
For example, why did the Fed start the new rate hike cycle in 2022? To try to reduce inflation and stabilize prices. But this action plan also tends to affect the labor market, as it is difficult to achieve a balance between full employment and price stability. There are inevitably trade-offs between different objectives.
Generally, the Fed puts the brakes on the economy before it overheats and provides stimulus when it slows, which helps reduce market volatility and make the economy run more stably. This is the primary objective of the Fed.
Dot Plot Signals Hawkish Monetary Policy
Viewed from a “quantity” and “price” perspective, the Fed attempts to stabilize the economy by controlling the money supply and interest rates. How is this achieved? The Fed normally uses three tools to conduct monetary policy:
The Fed buys or sells government securities in the open market to increase or decrease the total money supply, which can also affect the federal funds rate.
Here is an example. Suppose the Fed buys securities from a commercial bank. The transaction involves the Fed obtaining the securities from the bank and the bank receiving payment from the Fed. The bank then circulates the money by lending it to consumers, creating a transmission from the Fed to the bank and finally to the real economy, which achieves the goal of increasing the global money supply.
Conversely, if the Fed sells securities in the open market, it means that liquidity is withdrawn to reduce the overall money supply of the economy.
Money, Banking, And Monetary Policy: Objectives
How does buying or selling securities affect interest rates? First, it is important to understand the relationship between prices and interest rates: when prices rise, interest rates usually fall, and vice versa. Therefore, if the Fed buys a lot of securities, their prices will generally rise, causing interest rates to fall. On the other hand, if the Fed sells bonds, it will likely lower bond prices and raise interest rates.
Here is a classic case for better understanding. From late 2008 to October 2014, the Federal Reserve significantly expanded its holdings of long-term securities through open market purchases to put downward pressure on long-term interest rates, thereby supporting economic activity and job creation. work, making financial conditions more accommodating.
The discount rate is the interest rate at which the Fed lends money to banks. As a lender, the Fed can influence a bank’s decision to lend money by changing the discount rate.
What are the potential effects on the economy? The lower the interest rate, the cheaper the loan and the lower the returns on savings, stimulating consumption and encouraging individuals and corporations to borrow money. The increase in credit will stimulate the overall money supply in the economy, leading to a more active economy.
What Are Central Banks And Why Are They So Important?
One piece of evidence is the record US consumer price index numbers in 2022. At that time, the Fed engaged in balance sheet expansion, popularly known as quantitative easing (QE), to respond to COVID-19.
Reserves are the amount of cash that banks must hold to protect themselves against deposits. The Fed has the power to adjust a bank’s reserves and influence the value of bank loans by changing reserve requirements. For example, if a bank’s deposit reserve ratio is relatively low, it does not need to hold as much cash. The bank can lend more money to consumers, adding to the total money supply in the economy.
During COVID-19, the Fed cut the reserve requirement ratio to 0% as part of its massive stimulus program.
QE is a large-scale asset purchase program implemented by the Fed that directly affects the size and composition of the Fed’s balance sheet. Its purpose is to provide additional stimulus by lowering long-term interest rates and increasing financial market liquidity.
Speech By Governor Jefferson On The Implementation And Transmission Of Monetary Policy
In terms of specific implementation, the Fed first lowers its target interest rate to near-zero levels. They then inject reserves into the banking system to buy large amounts of US Treasuries and mortgage-backed securities (MBS) on the open market. As a result of these purchases, the Fed’s balance sheet has doubled from about $4 trillion before the pandemic to nearly $9 trillion in early 2022.
When the economy expands, we must prepare for the possibility of it overheating. To try to prevent an overheated economy and inflation, the Fed raised interest rates and reduced its holdings, leading to unprecedented increases in interest rates.
As mentioned, the Fed aims to achieve a maximum level of employment and price stability. There are standards for deciding whether the objective has been achieved.
The Fed sets its target of reducing inflation to 2% to stabilize prices. In terms of full employment, the Fed pays attention to various indicators such as non-farm payrolls, unemployment rates, job openings, etc.
Monetary Policy In A New Era
If the Fed hits 2% inflation or sees signs of a sluggish labor market, it will likely stop raising interest rates.
It is difficult for investors to predict rate increases or decreases from the Federal Reserve. However, some useful tools can help us gauge the Fed’s intentions.
Let’s start with some background information. At the last FOMC meeting each quarter, the Fed issues its economic projections (SEPs), including a dot chart showing the expectations of the 12 members of the Federal Open Market Committee for future changes in the federal funds rate. Voting is done anonymously, and each point represents the expectations of a Fed official.
Taking 2023 as an example, the median on the dot chart is between 5.5%-5.75%, indicating that the federal funds rate target is likely to fluctuate within this range over the course of the year.
Complete Guide To The Federal Reserve System: Monetary Policy And The American Economy, Central Bank Role, Interest Rates, Panics, Recessions, Depression, Stimulus And Tapering Ebook By Progressive Management
The dot chart can be an effective tool to help forecast interest rate changes, but it’s not as reliable as you might think. Why?
This is because it is primarily used to indicate the Fed’s attitudes toward current monetary policy, rather than potential changes in the federal funds rate.
With the help of CME FedWatch, we can observe the fluctuations of the target rate in real time. It forecasts potential changes in the Fed’s interest rate and monetary policy as implied by Fed Funds futures price data.
Therefore, it is not an indicator that can forecast increases or decreases in rates with 100% accuracy. We use it primarily to gauge market attitudes.
The Federal Reserve: How It Works, What It Does, Why It Matters
To summarize this section, investors can use two tools to monitor potential interest rate changes. However, we must always remember that monetary policy changes frequently, so we should be flexible and adapt our strategy to the current situation.
The Fed’s monetary policy impacts major asset classes such as stocks, bonds, cash, real estate, commodities and currencies.
The Fed can influence how much money banks lend by changing the discount rate. When tight monetary policy is implemented, high interest rates will limit corporate risk appetite and increase the cost of borrowing for publicly traded companies, which is likely to affect stock returns.
Conversely, low interest rates will make savings less attractive when the Fed loosens monetary policy. Investors are more willing to allocate funds to high-yield investments, such as buying stocks. This is why we usually see strong returns in the stock market when there is a loss
