How the Fed Affects the Economy
Alan Greenspan and the Federal Reserve

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Greenspan and the Fed
By Chris Rugaber (TMF Chris)

Every six weeks or so, traders on "The Street" eagerly anticipate the latest decision from Mount Olympus, otherwise known as the Federal Reserve. Will they cut interest rates, or raise them? By 50 basis points (0.5%), or 25 (0.25%)? Or will they do nothing?

While few individual investors will make trades based on such details, the process naturally raises questions: How does the Fed's change to a little-known interest rate, which is paid only by financial institutions, have such a large effect on the broader economy? We can only skim the surface of such a question here, so what follows is a basic explanation, largely drawn from publications at the Fed's website.

The big decision
Well begin with the federal funds rate decisions made by the Federal Open Market Committee (FOMC), a component of the Federal Reserve System.

As discussed in our previous article, the FOMC decides to raise, lower, or leave unchanged its target for the federal funds rate during its eight meetings each year, with occasional inter-meeting changes also taking place. Remember that there are other factors that can also affect the federal funds rate, such as the increased demand for cash that occurs during the winter holiday season. Banks will draw down their reserves in order to provide cash to consumers, placing additional demands on the reserves markets and increasing the federal funds rate. That's why the FOMC's decisions actually set a target for the fed funds rate, though the media generally refers to the decision as a cut or increase in the rate itself.

Regardless, if the FOMC wants to slow the growth of the economy, usually to tame inflation, then it will increase the target federal funds rate. Conversely, if it wants to spur economic growth, it will reduce the target rate.

How does the FOMC accomplish this? And what effects does this have?

Open market operations
The Fed has a very elegant tool at its disposal, referred to as "open market operations." In open market operations, the Fed buys and sells government securities -- usually Treasury notes of varying maturities -- in the same markets for those securities as other buyers and sellers. If the FOMC reduces the target federal funds rate, then the Fed buys securities on the open market; if the target has been increased, the Fed sells securities.

When buying government securities, the Fed creates reserves -- essentially, new money -- to pay for them, thereby increasing the supply of reserves in the market, and increasing money in the economy. The transaction works like this: The Fed -- specifically, the Federal Reserve Bank of New York -- buys a government security, and issues the seller a check. The seller deposits the check in a bank, and when the bank remits the check to the Fed for payment, the Fed credits the bank's required reserves. This increases the overall supply of reserves, and reduces the need for banks to engage in overnight borrowing on the reserves market, and therefore reduces the federal funds rate.

On the other hand, when the Fed sells securities, it reduces reserves held by the banks of the purchasers. This makes it more likely that banks will engage in overnight borrowing, which then increases the federal funds rate.

Technically, the Fed could accomplish the same goals purchasing a wide variety of securities, but the market for federal government issues is large and liquid enough that the Fed can make the high-volume purchases and sales it needs without overly disrupting the market. According to the Fed, the U.S. government securities market averages more than $100 billion in trading every day.

Ripple effects
Not only do open market operations affect the federal funds rate, but they also impact the amount of money circulating in the economy. If the Fed creates reserves to buy securities, this increases the amount of money available to banks to loan to consumers. For example, if a bank's reserves are increased by $100 million, it may loan $90 million of that to businesses and individuals, who will then deposit much of those loans in other banks, who will then be able to loan the funds again. This is another way that the Fed's open market operations can help boost economic growth. Of course, there is a reverse effect when the Fed sells securities and reduces the money supply as a result.

More importantly, interest rates influence each other, particularly for similar time periods. In other words, short-term rates are generally similar and affect each other, and the same is true for longer-term rates. Otherwise, market forces generally correct any outlying rate.

As a result, if the Fed increases the amount banks pay for their overnight reserve loans, then banks will follow suit by increasing rates on their short-term loans, essentially passing on the price of higher rates to the consumer. This also works its way into longer-term rates such as mortgage loans and corporate bonds, particularly if higher short-term rates are expected to continue.

It all takes time, of course, which is why most observers believe that any monetary policy changes by the Fed take at least six months to work their way through the economy.

The Fed's monetary policy tools are blunt instruments, and there are many other factors that affect the U. S. economy, such as the fiscal policies of the federal government. Investors may want to keep an eye on the Fed because of its influence on the economy, but the Fed is just one of many actors on the economic scene. As Warren Buffett stated in our intro, the quality of individual businesses should be foremost in the mind of individual investors.

Chris Rugaber is the Special Features Producer at The Motley Fool, and occasionally writes news on telecom and wireless companies. His stock holdings can be viewed online, as can the Fool's disclosure policy.

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