There’s a certain mystique surrounding the Federal Reserve (Fed) and how its decisions affect the economy and the interests of investors. Let’s imagine that the U.S. economy is an engine. It’s comprised of components such as market forces, government policy, and the spark of entrepreneurism—but it’s fueled by money. And the amount of fuel entering the engine determines its speed.
Adjusting the Throttle
When it comes down to it, the Fed determines how much fuel to add based on two main gauges: the labor market and inflation. Congress has given the Fed a mandate to promote maximum employment, stable prices, and moderate long-term interest rates. With that in mind, the central banking system uses a number of tools to adjust the amount of money in the economy, but most of them relate to interest rates, and by extension, credit availability. Ultimately, the more credit (fuel) that is available, the faster the economy (engine) runs.
The fed funds target rate, which represents what banks charge each other for overnight loans of reserve balances, is probably the most widely known tool used by the Fed. When the Fed raises or lowers interest rates, this is the rate that is being referenced. Interestingly, the Fed doesn’t directly control this rate—it only sets a preferred range. Because the Fed isn’t directly lending the money, the rate on the loan is actually set by the lending bank.
Using open market operations tools, the Fed purchases or sells Treasury securities in the open market to help keep the fed funds rate in the preferred range. The Fed can also loan money directly to banks if needed, through its discount window. The rate for these loans (known as the discount rate), however, is higher than the fed funds rate. When the interest costs for banks rise (or the amount they could receive from lending to other banks rises), rates for end-borrowers will generally rise as well. This means that over time, interest rates for end-borrowers are likely to increase as the fed funds rate rises.
The Fed’s Goal
The Fed’s ultimate objective is to keep the economic engine running smoothly, which essentially means jobs are available and inflation is controlled. If the Fed hits the gas and injects money into the system, interest rates fall, and businesses and consumers become more willing to borrow. However, if too much money is added, inflation can result from too many dollars chasing the same amount of goods and services (the engine overheats).
Alternatively, if the Fed lets off the gas, money becomes less plentiful, and borrowing becomes less attractive as interest rates rise. With the spike in fuel costs, fewer businesses and consumers borrow, spending drops, and the economy slows (the engine stalls). By affecting the interest rates that businesses and consumers pay or receive for borrowing or lending, Fed policy affects the broader economy. And this is why Fed policy matters for individuals and businesses.
Take a closer look at today’s job market with our Chart of the Day, which looks at the current state of unemployment and underemployment.
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