The central bank and your investments: Tools of monetary policy

The Fed obviously cannot directly control inflation, or the growth of the economy, or employment, or trends in the stock market. What they can do is directly affect it by changing the growth of the money supply or by changing the levels of real short-term interest rates. The Fed affects these two important variables mainly through open market operations consisting of buying and selling of government securities by the Federal Reserve, and the discount rate. Both of these methods work through the market of bank reserves known as the Federal Funds Market.

The third tool of monetary policy is changes in reserve requirement of the banks. Banks and other depository institutions are legally required to hold a specific amount of fund reserves. These funds, which can be used to meet unexpected out-flows, are called reserves and banks keep them as cash in their vaults or as deposits with the Fed. There has to be a fixed ratio between the funds loaned by the banks and reserves held by the banks. The Fed has an impact on interest rates and money supply by changing the reserves required to be held by the banks. By increasing the reserve requirements, the Federal Reserve is telling the banks to lend less, and of course as the banks lend less, the money supply slows down and interest rates rise in the near term. If instead the Federal Reserve tells banks that they can decrease the reserve requirements, the banks can lend more money, therefore there is more liquidity in the system, and the money supply accelerates as people borrow more money. Because of the increased amount of money, interest rates tend to decline in the near term. At reporting time, banks need to show to the Federal Reserve that they have the appropriate level of reserves. In order to meet this need, banks will have to borrow for very short periods of time, sometimes just a few hours, from banks that have plenty of reserves. The rate that is charged when banks lend reserves to each other is called the Fed funds rate. This is an important rate because corporations have to borrow for very short periods of time to maintain the required balance in their bank accounts and the interest rate charged is closely related to the Fed funds rate.

A way of controlling the money supply and interest rates is through open market operations. This is the major tool the Fed uses to affect the supply of reserves in the banking system. The Fed achieves its objective by buying and selling government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York. Suppose the Fed wants the funds rate to fall in the near term. To do this it buys government securities from a bank. Government obligations are called bills if their maturity is less than a year; they are called notes if their maturity is less than ten years; and they are called bonds if their maturity is greater than ten years. The Fed then pays the bank for the securities it purchased thus increasing bank's reserves. As a result the bank has more reserves than it is required to hold. The bank can now increase its lending activity to consumers, investors and businessmen. This increase in liquidity is what makes the federal funds rate and other short-term interest rates fall in the near term and the money supply accelerates. The federal funds rate is the interest rate charged on reserves traded among commercial banks for overnight use in amounts of $1 million or more.

When the Fed wants the Fed funds rate to rise, it reverses the process - that is, it sells government securities. The Fed receives payment in reserves from banks and this payment lowers the supply of reserves in the banking system. Since there is now less money to lend, interest rates rise and the money supply starts slowing down.

A third way of controlling interest rates and money supply is through the discount rate. Banks can borrow reserves between themselves, and can also borrow reserves from the Federal Reserve banks at their discount windows. The interest rate they must pay on this borrowing is called the discount rate. Discount window borrowing tends to be small because the Fed discourages such borrowing except to meet occasional short-term reserve deficiencies. The discount rate plays a role in monetary policy because traditionally, changes in this rate have an announcement effect, that is they sometimes signal to markets a significant change in monetary policy. A higher discount rate can be used to indicate a more restrictive policy to the banks, while a lower rate may signal a more expansionary policy. This is a signal to the banks that the Federal Reserve is discouraging borrowing and lending through the discount window. Therefore, banks have to become more cautious and careful on how they manage their reserves.

The times characterized by rising short-term interest rates and discount rates are very critical for the banking system and the stock market. A very negative configuration of interest rates for the stock market is rising Treasury bills rate and rising discount rate. During these times, it is not unusual to see the Treasury Bills rate well above the discount rate. This is a clear indication of an aggressive tightening of monetary policy of the Federal Reserve, attempting to slow down the economy and keep inflationary forces under control. An example of such periods can be seen from 1987 to the end of 1988, throughout 1994, and beginning in 1999. All these periods have signaled a high-risk area for the stock market and they have determined conditions that dictated extreme caution for investors. Sector and stock selectivity is very crucial during these times because the bond market tends to perform very poorly during such times, and therefore, does not offer a safe alternative to stocks.

Because the discount rate establishes the cost to members of reserves borrowed from Reserve banks, it plays a significant role in the decision a bank makes about whether to borrow at the Federal Reserve discount window. For example, if the rate on short-term Treasury bills is high in relation to the discount rate, the member bank may prefer to borrow from the Federal Reserve rather than sell Treasury bills in its portfolios. Similarly, if the rate charged for reserves obtained through the federal reserve funds market is high, a bank has an incentive to use the discount window.

If monetary policy is tightening it is understood that the Federal Reserve is using open market operations, reserve requirements, or the discount rate to slow down the growth of the money supply by letting short-term interest rates rise by following market forces. When instead the Federal Reserve eases it is understood that the Fed is using open market operations, reserve requirements or the discount rate in order to favor an acceleration of the money supply and lower short-term interest rates.

(From Chapter 6 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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