For years, commentators have endlessly talked about the accommodative monetary policy that the Federal Reserve has provided to try to boost the U.S. economy. But for most investors, it's hard to figure out exactly what monetary policy is, let alone how it affects them and their money.
In order to understand monetary policy, the natural first place to get information is from the Federal Reserve itself. Using its resources, let's take a look at how the Fed uses various tools to implement and manage the role that money pays in the economy.
The Fed and you
For 100 years, the Federal Reserve has had the power to implement monetary policy. As it describes its role, the Fed traditionally uses three different tools to "influence the availability and cost of money and credit to help promote national economic goals." The discount rate that the Fed sets establishes terms under which banks can borrow funds on an overnight or in some cases seasonal basis, but because the rate is typically above prevailing market rates, banks tend to take advantage of the Fed's discount window only as a last resort. In addition, the Fed's reserve requirements force banks to keep a certain percentage of deposits and other liabilities on reserve at the Fed.
The Fed's most important monetary tool lately, however, has been its open market operations. Before the financial crisis, the Fed tended to buy and sell primarily short-term securities in an effort to maintain the supply and-demand dynamics that affect the federal funds rate. After setting a fed-funds target, the Fed typically used what's known as repurchase and reverse repurchase agreements to influence trading in the federal funds market to keep market conditions from disrupting its monetary policy and keep the actual fed funds rate near its target. These temporary open market operations fine-tuned rate levels effectively.
More recently, though, the Fed's open market operations have included massive asset purchases that have targeted longer-term rates. By spending hundreds of billions of dollars on purchasing long-term Treasury bonds and mortgage-backed securities, the Fed has tried to keep long-term rates low in order to spur businesses to make investments that boost economic activity and create jobs.
Does monetary policy help you or hurt you?
The impact of the Fed's rate policies largely depends on whether you're a net saver or a net borrower. Savers have seen the rates of safe investments like bank CDs and Treasury bonds plunge as a result of the Fed's actions, leading many of them to make more aggressive investments in riskier assets to generate income. But borrowers have been able to take advantage of favorable rates to lock in cheaper financing costs that increase profits.
For corporate borrowers, the impact of monetary policy has been huge. Last November, top-rated corporate issuer Microsoft (NASDAQ: MSFT ) was able to borrow money for five years at less than 1%. More recently, Disney (NYSE: DIS ) and Coca-Cola (NYSE: KO ) were able to issue floating-rate debt at rates below those that financial institutions charge each other for overnight loans.
The biggest beneficiaries of low rates, though, have been big banks. As the two largest banks in the country, Bank of America (NYSE: BAC ) and JPMorgan Chase (NYSE: JPM ) have been aided by low rates. Not only have low rates directly affected the spreads between what those banks pay on deposits and what they get from loan income, they've also spurred greater mortgage refinancing activity that has increased banks' transaction-based income.
Watch the Fed
The Federal Reserve is often misunderstood, but its monetary policy is a vital part of the way the U.S. economy works. Understanding monetary policy is a critical element in assessing not just your own exposure to interest rates but also the effect those rates have on the other investments you make.
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