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The central bank's monetary policy

Lesson in Course: Market movements (advanced, 12min )

What is the Federal Reserve and how do the actions of the Federal Reserve impact me as an investor?

The US central bank, or the Federal Reserve, dictates our country's monetary policy. However, monetary policy is not very well understood because the effects do not directly impact us like a tax rebate. Instead, the monetary policy creates or reduces the money supply between financial institutions. 

We have likely heard of quantitative easing or have seen interest rates reported in the news. These are all outcomes of changes in monetary policy and are essential in maintaining a healthy economy.

How does monetary policy work?

The Federal Reserve can increase or decrease the money supply via two methods. First, the Fed can change interest rates, or the Fed can print physical dollar bills. Although it's easy for us to connect printing with more money supply, interest rates are a little less straightforward.

To help us understand, we need to know what creates our money supply. Cash, or physical money, is one-half of the money supply, while credit makes up the other half. In addition, credit is affected directly by interest rates—higher interest rates reduce the amount of credit. In comparison, lower interest rates (quantitative easing) increases the amount of credit and money supply.

Creation of Debit + Credit

Debit, or debt, is created when credit is created. 

For example, we applied for a credit card with a limit of $500. That $500 is available for us to spend without needing to have any cash. The moment we swipe our card and spend the $500, we now owe the credit company (our debt) $500 at the end of the month. The creation of credit and debt has increased the supply of money we have and transactions going into the economy, raising GDP.

Let's review what credit is and the importance of credit in the short clip below.

 

Changing interest rates

The central bank uses interest rates as the main lever to create or reduce credit. The interest rate altered by the central bank is called the Fed Funds Rate and is the cost that banks can lend to each other overnight. The central bank increases Fed Funds Rate when inflation is high and decreases when credit creation is needed to stimulate the economy. 

The Federal Open Market Committee (FOMC) 

The FOMC is the monetary policymaking body of the central bank and the body meets eight times a year to determine if adjustments to the Fed Funds Rate are needed. Depending on their decision, the financial markets can change quickly.

Changes in the Stock market

Typically stock prices rise when Fed Fund Rates are lowered and fall when Fed Fund rates are increased.

When the Fed Funds Rate is low or lowered, the abundance in credit allows consumers to spend more, and companies earn more. Another reason supporting this observation is that when interest rates are low, savings accounts and bonds pay less and provide lower returns to the investor. Therefore, with the increased money supply, investors will prefer higher-earning stocks, and the increased purchasing continues to push the stock prices up.

Conversely, when interest rates are increased, stock prices decrease. Changes in Fed Funds Rates will trickle down to the costs banks charge companies to borrow money. Investors in the stock market consider the increased cost of borrowing or reduced cost of borrowing. Stocks of companies or business sectors that rely heavily on borrowing are adversely affected when the cost of borrowing increases. With less credit available and a higher cost of borrowing, companies will generate less revenue from sales and cannot borrow as much to invest for future growth.

An exception to above

The stock prices of financial companies rise when interest rates are increased because banks can earn more money by lending.

 

Changes in the Bond markets

When Fed Fund Rates are lowered, bond prices increase. When Fed Fund Rates are raised, bond prices decrease.

Bond prices have an inverse relationship with interest rates because every investor wants the highest interest-paying bonds. After the Fed drops interest rates, the new bonds that are issued pay less interest compared the old bonds. Investors rush to buy up all the existing old bonds with higher interest payments. The increased buying pushes bond prices higher. Likewise, when the Fed raises interest rates, all the existing lower interest-paying bonds are sold or dumped by investors to buy the new bonds paying higher interest. The selling drops the price of the bonds.

We can see in the chart above that the Fed Fund Rate changes affect borrowing rates in the 1-Year and 10-Year US Treasury bonds. 

Change in Mortgages

Interest rates charged on mortgages also change with the Fed Funds Rate.

Mortgages are loans and work like bonds between banks and consumers like us. As we would expect, mortgage rates also follow the change in Treasury and Fed Funds Rate.

When the Fed lowers interest rates, it's a good time to refinance or to take out a mortgage.

Printing of money

While rare, the central bank can choose to print physical money. The printed money is inflationary and more printed money results in a lower value of existing dollars. Since it's in our best interest that the Fed keeps tight control on inflation, the printing of money is used only in desperate times when the economy is in a recession and the interest rates are already at 0 with no further room to be lowered. We'll review an example of this in the next lesson.

Both stock prices and bond prices follow the same trend when it comes to reacting to interest rate changes. When rates go down, prices go up. When rates go up, prices go down. By understanding and following the actions of the central bank, we can stay on top of and take advantage of changes in market prices.

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