Inside The Temple: Lifting The Curtain on The Fed

Federal Reserve monetary policy has been a major financial story for the past few years.

And yesterday, the Fed made headlines again by announcing that it is again keeping its benchmark interest rate at the same place it’s been since July of last year.

Surprise, surprise.

The Fed also indicated that investors should expect only one rate cut by the end of 2024. That’s a far cry from the beginning of the year, when the markets were pricing in the likelihood of six cuts in 2024.

“Inflation has eased over the past year but remains elevated,” the Fed’s post-meeting statement said. “In recent months, there has been modest further progress toward the [Federal Open Market Committee’s] 2% inflation objective.”

Whoever happens to be in charge of the Fed dominates our lives, like a demi-god. During his press conference today, Fed Chair Jerome Powell will likely once again prove that he has the power to move markets.

Of course, many investors remain afraid that the Fed’s policies will tip the economy into a recession.

Recent data indicates that the Fed’s policies are finally starting to work, and that inflation is beginning to cool.

As the following chart shows, the fed funds rate currently stands at 5.33%.

The new targeted rate range is between 5.25% and 5.5%.

These Fed-related events are transparent and public, garnering plenty of coverage in mainstream news outlets. But let’s lift the curtain on the more arcane aspects of the Fed. There’s more to the Fed’s policy moves than many investors realize.

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Average investors are familiar with the Federal Reserve System, our nation’s central bank, so it requires little in the way of explanation. But few people can actually tell you much about the Federal Open Market Committee (FOMC), the Fed’s monetary policy arm, aside from the fact that it sets the federal funds rate.

But the FOMC has four more subtle tools in its bag of tricks that it can use to change the direction of the U.S. economy.

Those behind-the-scenes machinations may not be apparent to the naked eye, but they’re every bit as important as the overall federal funds to the day-to-day operations of our monetary system.

To understand how these tools work, it’s necessary to understand the very basics of monetary policy theory.

Historically speaking, when there’s a large money supply, borrowing costs remain low, encouraging businesses to invest in inventory and expansion and consumers to buy. That leads to fairly rapid growth in gross domestic product.

But when inflation becomes a concern (as it is now), or the economy is growing at an unsustainable pace, money supply can be reduced, thereby increasing borrowing costs and slowing the pace of lending.

Open market operations are the FOMC’s primary tool in influencing money supply. When there are references in the media to the Fed adding liquidity to the system, there’s no federal employee going bank-to-bank passing out checks.

The market operations desk of the FOMC is actually buying U.S. Treasuries and federal agency securities from a group of 20 banks or bond dealers, known as primary dealers, using what are known as repurchase agreements.

Under the repo agreement, the FOMC purchases the securities on the understanding that the institution selling them will repurchase them on a set date. That frees up cash for the seller to meet other short-term obligations without forcing an outright sale of the securities.

If the FOMC wants to reduce the amount of liquidity in the system, the same transaction can be executed in reverse, with the operations desk selling rather than buying the securities. Not only does this change the amount of cash available to the system, it can also make subtle changes in the yield curve if the operation only transacts in securities of a specific maturity.

Another tool the FOMC has to add liquidity to the system is the discount window, through which financial institutions essentially take a short-term loan directly from their regional Federal Reserve Bank. The discount window system is meant to help banks meet short-term liquidity needs; loans must be backed up by prime collateral.

But there’s hesitancy among financial institutions to use this tool. That’s because loans through the window typically carry higher interest rates than if the money had been borrowed elsewhere, so it’s viewed as the lender of last resort. If you have to go to the window for a loan, folks wonder why a loan couldn’t be obtained from another source, calling a bank’s solvency into question.

This dynamic spawned the creation of the FOMC’s “auction facility,” which is intended to address the concerns that can be created by a credit crisis.

The auction facility is set up in similar fashion to the discount window in that it amounts to a financial institution taking a loan from the Fed. But there are three key differences.

The first is that, as the name implies, the program is set up on an auction system in which institutions bid the interest rate they’re willing to pay, with the loans going to those most willing to pay for them.

Second, the loans are longer term, ranging between 28 and 35 days versus the discount window’s typical overnight duration.

The third and most significant difference is that the Fed will accept less than prime collateral for loans received through the auction facility, which means assets such as collateralized debt obligations (CDOs) can be posted.

Finally, the FOMC can also use reserve requirements, which determine how much cash a financial institution has to keep on hand to affect the overall money supply.

For example, when borrowing has become too cheap and inflation is an issue, the FOMC can increase reserve requirements and force banks to keep more cash in their vaults. That, in turn, reduces the amount of money that can be lent and pushes up the cost of credit. Inversely, if the FOMC wants to increase money supply, it can reduce reserve requirements.

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This article previously appeared on Investing Daily.