If you know anybody who works in the finance industry, you likely have heard them mention a nebulous entity called “The Fed.” Likely, the Fed has done something they don’t approve of, or is failing to take some necessary action. It’s very important to understand what the Fed is and the role it plays in the American economy. The Fed is the Federal Reserve System of the United States. Its most important role is to set monetary policy, which it does by controlling interest rates.
Eight times a year, the Fed meets to decide what the federal funds rate should be. The federal funds rate is the interest rate banks can charge when loaning other banks money. To make sure that this target rate is met, the Fed conducts what are known as open market operations to increase or decrease the amount of reserves banks have. By changing the amount of money in circulation (known in the financial world as the money supply), the Fed influences interest rates. If the money supply increases, banks have more money to loan out, and so interest rates fall. If the money supply decreases, banks will be able to issue fewer loans, and interest rates will rise.
The federal funds rate has a significant impact on short term interest rates, but much less over the long term. Long term loans have more risks for the lender than short term loans, so lenders charge what’s known as a risk premium. Inflationary expectations also impact long term interest rates. If you expect 10% inflation in the next ten years, you’re not going to loan someone money for a decade at an 8% rate- you’d be losing money! Because of these factors, long term interest rates tend to be higher than short term interest rates.
In the last few months, the Fed has announced several increases in the federal funds rate, which has not happened since the beginning of the pandemic. This is known as a tightening of monetary policy, and indicates that the Fed is trying to reduce inflation. However, targeting inflation with interest rates is a tricky process, and the goal of the Fed is to slow inflation while also keeping interest rates low enough that they do not stifle economic growth. Investors should be paying attention to what the Fed is doing. When the Fed sets rates low, it is generally trying to boost the economy, which promises economic growth and is encouraging for investors. When it sets rates high, investors should be wary of potential economic slowdowns, and adjust their investments accordingly.
