The function of The Federal Reserve and how their actions are affecting the financial markets.
The Federal Reserve “The Fed” gets a lot of press and has certain responsibilities and duties that affect the financial markets. The Federal Reserve has 4 general mandates in regards to its purpose and responsibilities:
- Influence money and credit conditions to pursue full employment and stable prices.
- Regulate and supervise banks and financial institutions.
- Maintain stability of financial systems and minimize systematic risk.
- Provide financial services to the US Government and financial institutions.
The Fed is basically the bank of the United States.
So why are we talking about the Fed? Well, interest rates have dropped to historically low levels and the Fed has some influence on long-term rates, and certainly affects short-term rates, which we will examine.
The Fed has tremendous influence.
The influence of the Fed on the global economy cannot be understated. They are the US bank, but in many regards, they are the world bank as well. The US dollar and economy are still the apex of the world economy. This is evidenced by the careful and nuanced communications from the Feds. By way of example, these are some quotes from The Wall Street Journal recently on the Fed’s actions:
At Wednesday’s news conference, Mr. Powell used the word “powerful” 10 times to describe the Fed’s new guidance.’
“Under its new framework, the Fed says that following periods when inflation has run persistently below its 2% target, officials will want inflation to run “moderately” above 2% for “some time.” The Fed’s policy statement adopted similar language Wednesday.’
Mr. Powell, when pressed, declined to define those modifiers.
Three things that The Fed really does
Three things that the Fed really does are: 1) set short-term interest rates, 2) affect long-term interest rates, and 3 disseminate pertinent information.
- The Fed is able to set short-term rates. These short-term rates are the rates that banks are charged to lend and borrow money from each other.
- The Fed can affect long-term rates. This is done by buying long-term bonds. The supply and demand of selling long-term bonds affects rates. Lately, the Fed has been all buying. This is known as expanding or shrinking their balance sheet.
- The Fed disseminates pertinent information. The Fed publishes The Beige Book. The Beige Book is published just prior to the eight meetings of The Fed. The Beige Book has information gathered internally and externally on items such as gross domestic product, inflation, cost of goods, et cetera.
More than Interest Rates
The Fed affects financials markets not just interest rates. Changes to interest rates will certainly affect the financial markets. This is done by making bonds more or less attractive. If interest rates are lowered, then bonds particularly compared to equities or stocks become less attractive, because a better yield can be derived through income producing stocks and equities. That is what has happened more recently, since interest rates are at historic lows, there has been a tail wind for the equity or stock markets due to the low interest rates that can be earned on fixed income. Lower interest rates have also made real estate a more attractive and affordable investment. And, vice versa, there are certainly times when interest rates are high, which would be a headwind for stocks or equities, because the safety or relative assurance of interest on bonds is certainly a beneficial thing.
In conclusion, the actions of the Federal Reserve affect all financial markets. These effects can be subtle, but are very important and worth noting.
For more on Making Sense of the Federal Reserve click HERE.
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