Eight times a year, the august members of the Federal Reserve Board gather in a room to pore over economic data and debate where to set interest rates and how much credit to make available to the banking system.

The Fed’s decisions on these two questions affect practically every aspect of your financial life, from your job market opportunities to the rates you pay on mortgages and car and consumer loans. They also affect the investment returns you receive from certificates of deposit, savings accounts and even equity holdings.

“The Federal Reserve has its hand on the controls of the economy more directly than anybody else,” says Greg McBride, senior financial analyst for Bankrate.com. “In terms of pocketbook issues, the Federal Reserve is arguably more influential than the president. Unemployment, inflation, the pace of economic growth — these are really the measuring sticks.”

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Exactly how does the Fed carry out its two-pronged mission to spur economic growth while keeping inflation in check? A look inside the Fed’s monetary policy toolbox reveals four primary levers of influence: interest rate targets, the level of liquidity, the buying and selling of securities and its public statements. Each one impacts either interest rates or credit availability or both, and is closely watched by investors and economists.

Interest rate targets

The most traditional Fed role is to set the federal funds rate, which banks pay to one another for overnight loans and which many consumer interest rates follow as a benchmark. The Fed can reach the desired federal funds rate in three ways: open market operations, the discount window and reserve requirements.

The phrase “open market operations” refers to the Fed practice of buying and selling Treasury securities to influence the supply of government debt and the cost of money. When the Fed wants to stimulate the economy, it buys bonds, thereby increasing the price and bringing down the interest rate on the securities. When the Fed wants to put the brakes on the economy, it sells Treasuries into the market to increase the supply, lower the price and raise interest rates, McBride says.

The Fed makes these transactions with primary dealers, the handful of securities firms authorized to trade in U.S. government securities with the Federal Reserve Bank of New York. Those dealers in turn transact with other banks and financial institutions so the Fed’s actions ripple through the markets.

Open market operations

When the Fed eases When the Fed tightens
Fed buys government securities from a firm that deals in them. Fed sells government securities to a firm that deals in them.
It pays by crediting the account that the dealer’s bank has at the Fed. It takes payment by debiting the account that the dealer’s bank has at the Fed.
The bank in turn credits the dealer’s account. The bank in turn debits the dealer’s bank.
The banking system has more funds to lend. The banking system has fewer funds to lend.
Downward pressure on the federal funds rate — the interest rate banks charge each other for overnight loans. Upward pressure on the federal funds rate.
Influences other interest rates in the economy — which also go down. Other interest rates in the economy also rise as a result.
Gives the economy a boost. Slows the economy and curbs inflation.

Similarly, the Fed sets the discount rate, which moves up and down in tandem with the federal funds rate. Banks pay the discount rate when they borrow from the regional Federal Reserve banks. When the discount rate rises, banks pay more to borrow and tend to lend less, which boosts interest rates and reduces the available credit. When the discount rate falls, banks lend more freely, flooding the market with credit and causing consumer interest rates to fall, McBride says.

Discount window lending

Discount Rate Impact on Economic Activity Monetary Policy
Raising the discount rate Slows economic activity. The Fed is concerned about inflation. The Fed’s goal is to check inflation.
Lowering the discount rate Stimulates economic activity. The Fed is concerned about economic weakness. The Fed’s goal is to spur economic growth.

Finally, the Fed can influence interest rates through reserve requirements, which refer to the amount of capital that banks must hold as security for their deposits. If the Fed increases the amount required as reserves, banks will be discouraged from lending, which tightens credit availability and increases rates. If the Fed lowers reserve requirements, the reverse occurs. Typically, the Fed refrains from changing reserve requirements to influence monetary policy, unless it has no other option available, because of the uncertainty it can introduce for banks.

A prolonged period of near-zero interest rates, such as the time of the 2008 financial crisis through the present, severely limits the Fed’s ability to conduct monetary policy through interest rate targets, McBride says. As a result, the board turns to other tools in its arsenal.

Providing liquidity

The Fed is often referred to as the lender of last resort. During the 2008 financial crisis, that was certainly true. When the financial market climate seems so uncertain that no other institution will make loans, the Federal Reserve steps in to fill the gap. This is known as providing liquidity because the availability of credit is what keeps financial markets from creaking to a halt like a set of rusty gears.

The Fed can provide liquidity directly through loans to primary dealers, whether overnight or for a month or more. Other Fed loan programs are open to any U.S. bank or holding company, each aimed at a slightly different market segment. This allows the Fed to strategically inject liquidity to a specific market, whether it’s the market for commercial paper, money market funds or asset-backed securities.

“Those are things that you’d only roll out at a time when the financial market is headed for collapse,” says Mark Zandi, chief economist at Moody’s Analytics and author of “Paying the Price: Ending the Great Recession and Beginning a New American Century,” a book on the policy response to the financial crisis.

While the Fed doesn’t actually print money — that power is exclusive to the U.S. Treasury — people often refer to the Fed as “printing money” when it lends to banks because it essentially is pushing additional money into the economy. The Fed uses this tool sparingly because even though it gooses the economy, it also can lead to runaway inflation.

“Long term, the consequence is inflation,” McBride says. “It’s like eating too many cheeseburgers. Eventually it catches up with you.”

Buying and selling securities

Because of the financial crisis, the Federal Reserve developed some new tools for managing monetary policy. Prime among these is making direct purchases of bonds, known as quantitative easing. This technique helps in a number of ways. First, it calms markets because it provides a buyer when other investors are panicked or simply reluctant. Simply by announcing plans to purchase bonds, the Fed has an impact, Zandi says.

Second, buying bonds will increase the demand for these securities and increase their price, which brings down interest rates. So when investors were scared about the future of the financial markets in 2008, the Fed purchased long-term Treasury bonds and brought down long-term interest rates in a targeted way. Those long-term rates are important because they govern mortgages and the rates that impact the housing market, which were at the center of the financial crisis.

You can see the importance of the Fed’s ongoing bond purchase program by looking at how interest rates spiked when the Fed hinted this past summer that it might begin tapering its purchases. “Our experience over the last few months shows it has a lot of impact,” Zandi says.

The Fed used a variant of this tool in “Operation Twist,” announced in September 2011 and continued through December 2012, by simultaneously selling short-term securities while buying long-term ones. This just reduced long-term rates at a time when short-term rates couldn’t physically go any lower.

“Short-term interest rates were at near-zero, but the rate on your mortgage was a long-term rate over which the Fed had virtually no control,” McBride says. “Operation Twist was designed to influence longer-term rates in an effort to rehabilitate the economy, but to do so without flooding the system with money.”

Since the Fed debuted quantitative easing, there’s now the possibility of quantitative tightening. The Fed could either sell bonds into the market or simply let securities that it holds mature without replacing them, which reduces the money supply.

Public statements

When the Federal Reserve governors meet to discuss monetary policy, they convene the Federal Open Market Committee. McBride says that it’s sometimes called the “Federal Open Mouth Committee” because the pronouncements that come out of this meeting can influence both debt and equity markets. This is another tool in the Fed’s toolbox: jawboning.

A couple of decades ago, the Fed didn’t even announce when it changed the federal funds rate target. But then an interest rate change in 1994 took the financial markets by surprise, drove up the cost of borrowing and sent some big municipal governments into bankruptcy, McBride says. With trillions of dollars of investments swinging in value based on the Fed’s decisions and pronouncements, the Fed created ways to signal to the market any change in policy well in advance.

“Over time, they’ve developed a better strategy of communicating or foreshadowing what’s coming,” McBride says. “Because financial markets are so big and so much money hinges on every move that the Federal Reserve makes, the consequences of surprising financial markets can be pretty significant.”

While former Fed Chairman Alan Greenspan was sometimes called an oracle because of the convoluted and opaque statements he made about the economy, outgoing Chairman Ben Bernanke has been more direct. In 2011, Bernanke even introduced a press conference that followed some FOMC meetings, at which he answers questions from reporters and explains the Fed’s thinking about the economy and interest rates. The Fed also began announcing explicit “forward guidance,” saying how long it expects to hold short-term rates steady — another move toward greater transparency and fewer unpleasant surprises.

“If they tell investors it will be a long time before they’re going to increase short-term rates, that keeps long-term rates down,” Zandi says. “They’ve been using that tool for quite some time to great effect.”

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