The Fed and Monetary Policy

The Fed moves interest rates, and interest rates move every security you will ever sell. This lesson covers who runs monetary policy, the tools they use, and which way markets go when they act.

Monetary policy vs fiscal policy: who does which

Monetary policy is the Federal Reserve's job: changing the money supply and credit conditions to steer the economy. Fiscal policy is the government's job: taxing and spending, decided by Congress and the President.

Keep the split clean. The Fed cannot raise your taxes. Congress cannot set the discount rate.

Congress gave the Fed a dual mandate, two goals it has to balance:

• Maximum employment.
• Stable prices, which the Fed defines as 2 percent inflation over the longer run.

The Federal Open Market Committee (FOMC) is the group inside the Fed that decides monetary policy. It has twelve voting members:

• The seven members of the Board of Governors.
• The president of the Federal Reserve Bank of New York.
• Four of the other eleven Reserve Bank presidents, who rotate on one-year terms.

Open market operations: the main lever

Open market operations are the Fed's purchases and sales of government securities in the open market. The FOMC directs them, and they are the Fed's primary tool.

The direction is what the exam wants:

• The Fed buys securities. It pays the sellers, so banks hold more money. The money supply grows, rates fall, and borrowing gets cheaper. This is easing, also called expansionary policy.
• The Fed sells securities. Buyers hand over cash, so banks hold less money. The money supply shrinks, rates rise, and borrowing gets more expensive. This is tightening, also called contractionary policy.

Buy means boost. Sell means slow.

The Fed has two other classic tools. It lends to banks directly through the discount window, its short-term loan program for banks. It also sets reserve requirements, the share of deposits a bank must hold back rather than lend. The Fed cut those requirements to zero in March 2020.

The rate family

Four rates show up on the exam. The trap is always who sets which one.

• The federal funds rate is what banks charge each other for overnight loans of reserves. Banks set it between themselves. The FOMC only sets a target range and steers the market rate into it.
• The discount rate is what a Federal Reserve Bank charges a bank that borrows from it directly. The Fed sets this one outright.
• The prime rate is what banks charge their strongest corporate customers.
• The broker call rate is what banks charge broker-dealers on loans backed by securities.

Bank to bank means the federal funds rate. Fed to bank means the discount rate. The exam runs this trap. Learn the two directions and the swap stops working on you.

How Fed moves reach the markets

Start with bonds. Bond prices and interest rates move in opposite directions. When rates fall, an old bond paying a 6 percent coupon looks generous beside new bonds paying 4 percent, so buyers bid its price up. When rates rise, that same old bond looks stingy and its price drops.

Now stocks. Cheap money helps companies borrow and expand, so easing usually lifts stock prices. Tightening does the reverse. Borrowing costs rise, growth slows, and stocks come under pressure.

Work one example. The FOMC buys $50 billion of Treasuries. Bank reserves rise, and the federal funds rate drifts down inside its target range. Mortgage and business loan rates follow it down. Existing bond prices rise, and stocks usually rally.

How this gets tested

Most questions hand you an action and ask for the effect, or hand you an effect and ask for the action. Train one chain and run it both ways: buy, easing, rates down, bond prices up.

The other question type sorts out responsibilities. Who cut taxes? Congress, so that is fiscal policy. Who sets the discount rate? The Fed. Who lends at the federal funds rate? One bank to another.

One note for real life, not for the exam. Today's Fed keeps bank reserves plentiful and steers rates mainly with the rates it pays and charges banks directly. The exam still tests the classic version above, so learn that version.