federal reserve

The Fed's monetary policy toolbox

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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