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Dictating markets: Understanding Fed’s policy instruments

IFM_ Fed’s policy instruments
The Fed and other central banks worldwide employ short-term interest rate manipulation as their primary instrument

When left to their own devices, free-market economies are volatile because of personal anxiety and greed that manifest during unstable times. Although there have been many financial booms and busts throughout history, economic systems have changed due to trial and error. But, in the early 21st century, governments control economies and employ several measures to lessen the ups and downs of regular economic cycles.

Price stability and full employment, the United States’ Federal Reserve’s two legally mandated goals, are necessary to ensure a healthy and expanding economy in the global powerhouse. The Fed has done this in the past by changing reserve requirements, doing open market operations (OMO), and changing short-term interest rates. The Fed has also developed new ways to fix the economy since the subprime crisis started in 2007. What are these instruments, and how do they lessen the effects of a recession? First, let’s examine the Fed’s toolbox.

Talking about Fed’s policy stance for 2023, it has already released the hypothetical scenarios for its annual stress test, which will help it to ensure that large banks are able to lend to households and businesses during a severe recession.

“This year, 23 banks will be tested against a severe global recession with heightened stress in both commercial and residential real estate markets, as well as in corporate debt markets,” the Fed communication remarked.

The Federal Reserve Board’s stress test generally evaluates the resilience of large banks by estimating losses, net revenue, and capital levels, which provide a cushion against losses, under hypothetical recession scenarios, that may extend two years into the future.

Critical Points

The Federal Reserve is the central bank of the United States. Its job is to set monetary policy and control the amount of money in circulation. The Fed’s two main instruments (OMO) are interest rate setting and open market operations.

Among other less common ways to help failing banks, the Fed can change the legal reserve requirements for commercial banks or act as a lender of last resort.

These measures allow the Fed to implement an expansionary monetary policy when the economy is struggling. It can resort to unconventional measures like quantitative easing if that doesn’t work.

Interfering with Interest Rates

The Fed and other central banks worldwide employ short-term interest rate manipulation as their primary instrument. Simply put, this strategy is increasing/decreasing interest rates to slow/boost economic growth and manage inflation.

The mechanics are pretty straightforward. By lowering interest rates, borrowing money becomes more affordable and saving money becomes less profitable, encouraging people and businesses to spend. As a result, savings drop as interest rates fall, more money is borrowed, and more money is spent. Also, the overall amount of money in the economy rises as borrowing levels do. So, lowering interest rates has the excellent side effect of making people save less and spend more, which is good for the economy as a whole.

Conversely, decreasing interest rates also tend to raise inflation. This has a negative side effect since, in the near term, the total supply of commodities and services is fundamentally finite. When more money competes for a limited number of items, prices rise. The economy experiences various undesirable side effects if inflation becomes too high. The key to manipulating interest rates is not to go too far and start inflation by accident. Although this approach to monetary policy is flawed, it is still preferable to taking no action.

System of Federal Reserve (FRS)

Public Market Transactions

Open market operations (OMO), in which the Fed purchases or sells Treasury bonds on the open market, are the Fed’s other primary weapon. Because OMO can change interest rates and the overall money supply, it is comparable to directly influencing interest rates. This process’ rationale is relatively straightforward.

When the Fed purchases bonds on the open market, it expands the money available to the general public by exchanging the bonds for cash. In contrast, if the Fed sells bonds, it reduces the money supply because it takes money out of circulation in return for bonds. OMO thus has a direct impact on the money supply. OMO also affects interest rates because when the Fed purchases bonds, prices are pushed up, and swiftness is lowered; conversely, when the Fed sells bonds, prices are pushed down, and rates are raised.

Hence, OMO has the same effect as direct manipulation of interest rates in terms of lowering rates/increasing money supply or raising rates/decreasing money supply. The essential distinction, however, is that OMO can apply to bonds of any maturity to alter the money supply since the size of the U.S. Treasury bond market is so enormous.

Prerequisites for Reserves

The amount of reserves a bank must retain about specific deposit liabilities is determined by the reserve requirements, which are subject to adjustment by the Federal Reserve. Therefore, based on the required reserve ratio, the bank must hold a portion of the specified deposits in vault cash or warranties with the Fed-backed banks.

The Fed can also effectively raise or lower the amount these facilities lend by altering the reserve ratios imposed on depository institutions. For instance, if the bank gets a USD 500 deposit and the reserve requirement is 5%, it can lend out USD 475 because it only needs to keep USD 25, or 5%, of the deposit. The bank has less money to lend out on each dollar deposited if the reserve ratio is raised.

Changing Consumer Attitudes

The Fed’s final instrument for influencing markets was its influence over market perceptions. Given the transparency of our economy, this strategy is more challenging because it relies on influencing investors’ opinions. Practically speaking, this includes any economic announcement made public by the Fed.

The Fed could say that the economy is growing too fast and that inflation is a concern. If the Fed is telling the truth, an increase in interest rates is logically on the horizon to slow the economy. If the market agrees with what the Fed says, people who own bonds will sell them before interest rates increase and they lose money. Bond prices would decline as investors dumped their holdings, and interest rates would rise. This would allow the Fed to raise interest rates to slow the economy without taking action.

On paper, this looks fantastic, but it’s a little more challenging in practice. This method holds water in terms of impacting the economy because, if you observe the bond markets, they move in unison with the Fed’s instructions.

Term Securities Lending Facility and Term Auction Facility

The credit markets, which significantly impacted the economy, presented challenges to the Fed in 2007 and 2008. Investors have now received an unexpected and acute reminder of the possible risks associated with taking on credit risk due to the recent hikes in interest rates and the subsequent collapse in the value of subprime-backed collateralized debt obligations (CDOs).

Although the underlying cash flows of the majority of credit-based investments did not significantly erode, investors started to demand higher return premiums for holding these investments, which not only increased interest rates for borrowers but also restricted the total amount of money that financial institutions were willing to lend, which in turn put pressure on the credit markets.

Given how bad the crisis was, the Fed had to devise new ways to lessen its effects on the economy as a whole. The Fed supported credit markets, investors’ perceptions of them, and institutions’ willingness to lend despite deteriorating economic and credit market conditions. The Fed established the term “auction” and “securities lending facilities” to achieve this. Let’s examine these two things in detail.

Term Auction Center

The term auction facility was created to give financial organisations anonymous access to Federal Reserve funds to help with short-term liquidity needs and generate capital for lending.

Because businesses would bid on the interest rate they would pay to borrow money, it was given the name auction. This contrasts with the concession window, which makes an institution’s need for funds known to the public, causing depositors to worry about the institution’s viability, which only serves to heighten worries about the stability of the economy.

Lending Facility for Term Securities

The Fed established the term securities lending facility as an additional option to address balance sheet concerns, enabling banks to exchange mortgage-backed CDOs for U.S. Treasury securities. Because of the high exposure that the firms had to mortgage-backed CDOs, the value of their assets was declining. This had profound implications for their balance sheets. If uncontrolled, falling CDO prices might have caused financial institutions to go bankrupt and contributed to losing faith in the American financial system.

Balance sheet worries, however, may be lessened until liquidity and pricing circumstances for these securities improve by replacing falling CDOs with U.S. Treasuries. This recently developed technique allowed for the 2007 Fed-planned seizure of Bear Stearns.

Monetary Easing

The Fed’s arsenal of tools may occasionally need to be improved to boost economic activity during a severe crisis. For example, quantitative easing (QE) is an unconventional monetary policy where a central bank buys longer-term government securities or other kinds of protection on the open market to expand the money supply and promote lending and investment. By driving up the price of fixed-income assets, purchasing these securities boosts the economy’s money supply and lowers interest rates. As a result, the central bank’s balance sheet also significantly increased.

Normal open market operations, which target interest rates, are ineffective when short-term interest rates are at or near zero. Thus, a central bank can instead target specific asset purchases. In addition, quantitative easing expands the money supply by acquiring assets with freshly issued bank reserves to give banks more liquidity.

Some central banks have turned to even more severe measures like hostile interest rate policy if QE fails (NIRP). Although it was adjusted to 0%-0.25% after the 2008 financial crisis and once more in March 2020 in the wake of the COVID-19 pandemic, the Fed has never before placed target interest rates below zero.

Even though monetary policy is generally in flux, it relies on the fundamental idea of changing interest rates, which affects the money supply, the economy, and inflation—understanding the Fed’s motivations for implementing particular policies and how those policies might affect the economy. This is so that opportunities presented by the ups and downs of economic cycles can be taken advantage of to accept or shun investment risk. As a result, finding attractive chances in the markets requires a solid understanding of monetary policy.

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