Lesson 59 – How the Federal Reserve Moves Interest Rates

Topic Progress:

Monetary Policy very simply is anything which relates to action by the Federal Reserve to influence the amount of money and credit available in the economy. To understand exactly what this means, one first must understand the concept of fiat monetary systems.

Fiat Monetary Systems: The United States, like most major economies, has what is known as a fiat monetary system. A Fiat Monetary system very simply is any system which uses a monetary unit (in this case the US Dollar) which is not convertible to some commodity, in general a precious metal such as gold.

Fiat money, is money that is backed by the credit of some entity, normally a government, and the value for which is derived from its relative scarcity and the faith placed in it by the population which uses it.

This is important to us as traders because the fact that the Dollar is not convertible to a commodity such as gold gives the Federal Reserve the ability to increase or decrease the money supply as it sees fit, or in other words to enact Monetary Policy.

With this in mind the 3 tools available to the Fed for enacting monetary policy are:

• Open Market Operations
• The Discount Rate
• Reserve Requirements

The most common tool that the Fed uses, and therefore the one that we will cover, is Open Market Operations. Once we have an understanding of this and how increases or decreases in the supply of money affect demand and prices, the other two less commonly used tools will be more easily understood.

Through something which is known as the Open Market Committee, the Fed increases and decreases the supply of money by buying and selling US Government securities.

When The Fed wishes to reduce interest rates they will increase the supply of money by buying government securities using money that was not available in circulation before they made their purchase. As with anything, when additional supply is added and everything else remains constant, price normally falls. In this case the price that we are referring to is the cost of borrowing money or interest rates.

Conversely, when the fed wishes to increase interest rates they will instruct the open market committee to sell government securities thereby taking the money they earn on the proceeds of those sales out of circulation and reducing the money supply. When supply is taken away and everything else remains constant, price (or in this case interest rates which represent price) will normally rise.

When the fed increases or decreases the supply of money they are doing so to try and directly influence something which is known as the Fed Funds Rate, or the interest rate in which charge to each other for overnight loans. With this in mind we now when we hear the fed has lowered or raised the Fed Funds rate by a quarter of a percentage point, for example, what has actually happened is they have increased or decreased the supply of money in the economy.

As you can hopefully now begin to see if you’ve watched our lesson on fiscal policy, monetary policy is a strong tool which can affect the business cycle and therefore the markets in much the same way as fiscal policy. In the next lesson we will look at exactly how this is done so we hope to see you in that lesson.