The Federal Reserve System, known as The Fed, is the U.S’s central banking system. At the root of all monetary transactions, The Fed makes sure it all goes smoothly. The main goals of The Fed are to manage the money supply and maintain stability of the financial system. Most of the time, The Fed does not have to utilize its toolkit to influence the financial system. However, in times of recession or sudden volatility, The tools will be used and indirectly, The Fed influences the markets. The main tools The Fed uses most often are: open market operations, the discount rate, and printing more currency. Let’s start with the most often used tool, open market operations…
Influence Tool #1 | Open Market Operations
Open Market Operations are used more frequently than the other tools at The Fed’s Disposal. This is because OMOs take effect more immediately. For The Fed to influence the money supply using this tool it just has to go to the open market. Market operations are generally when The Fed buys or sells government securities. When the Fed buys securities, it is increasing the inflow of money into the banking system. This action brings more cash into the money supply which tends to make markets go up in value as there is more excess cash. When the Fed sells securities, it creates an outflow of money from the banking system. As expected, this will decrease the money supply and tends to make markets go down in value.
Influence Tool #2 | Discount Rate
This tool is used much less often and really only changes significantly in times of economic crisis. In addition, the discount rate’s effectiveness occurs more slowly as The Fed is not directly increasing or decreasing the money supply. The Discount Rate is the interest rate the federal reserve charges on its loans. Who gets loans from the federal reserve? Banks.
So when the discount rate increases, banks get less loans which indirectly decreases the money supply, and decreases market values. The inverse happens when the discount rate decreases. When the discount rate decreases, more banks get loans from the Fed which creates an inflow of cash, and increases market values.
Let’s say a $1-million loan from the Fed has the Discount Rate of 3%. Let’s say Bank-A decides to get that loan and Bank-B decides not to. This means that $1-million dollars is given to Bank-A and thus there is a potential $1-million entering the money supply.
However, let’s say that same loan had a discount rate of 1% and both banks decide to get that loan. Now there would be a potential $2-million entering the money supply! In essence, the discount rate doesn’t stop money from flowing but restricts the flow itself.
Influence Tool #3 | Printing More Money
This tool is used the least frequently and is fairly self-explanatory. The dangers of this tool is that once the printed money is put into the money supply, it is possible for rapid inflation to occur depending on how the money is spent. Generally, when money is printed market valuations go up initially.
How “Printing More Money” actually works is a little less self explanatory. The Fed does not print physical money itself. Instead, it submits an order to the Treasury Department which can fulfill or deny the order. If fulfilled the money is printed and then promptly distributed. However, the Fed can circumvent the Treasury by buying assets and paying for those assets with electronic funds. The electronic funds were basically created out of thin air! Or by computer key strokes, whichever you prefer. This is how the Fed “prints money”. Once again, The Fed only does this in extreme economic and financial situations.
Click here to get a more in-depth explanation: HERE
The Fed is an independent institution in the United States. This means that it is technically not part of the government and is thus less influenced by politics. In fact, The Fed tries to stay out of politics as much as possible. Which is very important when your responsibility is managing the financial system! The Fed’s actions influence the markets through their direct influence on the money supply. The Fed understands the power of its influence on the financial system and takes the responsibility very seriously.
In regards to the influences Fed tools have, understanding what each tools does can allow you to make some generic market predictions. Simply, if a Fed action increases money supply then markets go up. If decrease, then markets go down. These predictions are not precise but they are accurate. Overall, The Federal Reserve is a powerful institution in the world of finance and everyone should always be listening to what the Fed has to say!
Check out some predictions for specific stocks! : https://the-common-trader.com/2021/07/12/earnings-season-is-here-what-to-look-out-for/