Why Do Investors Care What The Fed Does?

Economics Economics Questions
1

I am on a mission to fully understand what the FED does, what it purports to do, and why anyone cares. I am beginning to understand in theory what the FED’s mission is and the methods it uses to try to accomplish this mission, but I cannot fully follow the trail of effects the FED’s monetary policy has on each individual.

As an example, why do investors care about what the FED does? I work in commercial real estate investment brokerage and I know that investors and mortgage brokers all have an opinion on what the FED should do. What affect do these people think the FED’s actions have on them and their investments, and what are the long-term negative consequences of the FED’s actions that these people overlook? Is there a win/lose relationship with investors vs. other kinds of people, whereby investors are in a privileged class of people that benefit at the expense of others from the fed artificially lowering interest rates?

Thoughts?

-A Struggling Layman

2

Please correct me if I’m wrong, but I think the Fed’s mission is to inflate the money supply in order to set an interest rate below the value that the market would ordinarilly choose. The inflation has the effect of spurring malinvestment, devaluing the dollar, and transferring wealth from everyone into the hands of banks. The Fed also has duties including issuing new currency and retiring old currency.

Stockholders are usually pleased when the Fed lowers the interest rate - this makes it cheaper for companies to borrow the money for their capital investments. Unfortunately, the risks of the Fed’s behavior include an overall economic recession due to malinvestment, plus a loss of confidence in bonds and currency due to the theft of wealth from holders of dollar-denominated assets.

3

First, I will endeavor to answer “what the Fed does,” since this will help you understand why investors care what it does.

The Fed is the nation’s monetary authority. It is governed by a board of governors, appointed by presidents in staggered terms, as well as regional bank presidents, of which there are twelve. Virtually all banks in the United States are members of the Federal Reserve System and they all have to abide by decisions made by the Fed board of governors. When one speaks of “the Fed,” one is typically talking about the board of governors, which is currently led by chairman Ben Bernanke.

One of the things the Fed does is set the reserve ratio. Currently, it is set at 10%. This means that for every dollar a bank lends, it must keep $0.10 in cash reserves. The Fed could change that to 12% or 8%, etc., if it felt conditions warranted. Obviously, this would have a tremendous impact on how member banks (i.e. all banks) conduct their business, since a hike in the reserve ratio would constrict the amount of money they could lend and vice versa.

A second thing the Fed does is set the discount rate by fiat. The discount rate is an interest rate at which Fed member banks can borrow directly from the Fed as “the lender of last resort.” If the discount rate is 5.75% and the Fed then lowers it to 5.25%, well now the “cost of money” has been decreased for banks, who can then afford to make lower-interest loans to businesses and other borrowers. If the Fed raises the discount rate, the reverse is true.

Thirdly, the Fed sets the federal-funds target rate. The federal funds rate is set by the market, but the Fed sets a target, and tries to manipulate the market into compliance with that target. The federal funds rate (fed funds rate) is the rate that Fed member banks charge each other. It is typically a little lower than the discount rate, since the Fed itself is supposed to be the lender of last resort. The fed funds rate is the most volatile rate in the economy and changes minute by minute due to supply and demand.

How does the Fed manipulate the fed funds rate if it does not set it by fiat? Well, one way is to alter the discount rate. Clearly a change in the discount rate should cause a change in the fed funds rate, since member banks’ cost of borrowing is directly affected by the discount rate. This also spills over into other short-term rates, such as the prime rate, etc. – the rates that banks charge private borrowers.

But more frequently, the Fed manipulates rates by “open market activities” – the buying and selling of government bonds. The Fed does not issue those bonds, but it keeps a healthy inventory of them, and thus, can sell at any time. By buying government bonds, the Fed is increasing the money supply (it “prints” money to buy the bonds with). By selling, it is decreasing the money supply (it takes the cash that people pay for the bonds and holds it). Changes in the money supply affect interest rates. The greater the supply of money, the lower the intersection point of supply and demand, and vice versa.

So why do people care what the Fed does? Because it plays a manipulative role in interest rates and in causing inflation, as illustrated above.