Investors love to watch the Federal Reserve. When monetary policy is up for a change, traders can bank on all kinds of assets responding to the central bank's decision. Since the financial crisis, though, the role of the Federal Reserve in moving markets has greatly expanded.
It's all about the QE
The quantitative easing programs -- the asset-purchase stimulus plans introduced by the Fed -- have been game-changers. The third round of quantitative easing, known as QE3, began in September. The central bank has been purchasing $40 billion worth of mortgage-backed securities per month and began purchasing $45 billion worth of Treasury securities every month beginning in January, after the end of Operation Twist.
QE3 has had a salutary impact on the stock market. For instance, the Standard and Poor's 500 index has increased 8.83 percent since the beginning of the year.
The goal of lower interest rates
A fundamental goal of the quantitative easing program was to push interest rates as low as possible. Low interest rates stimulate the economy in traditional ways -- lower costs of borrowing encourage businesses and individuals to loosen the purse strings and buy more. Very low interest rates have had a secondary impact on businesses and individuals. The low returns on safe investments are no longer tenable, which pushes investors into riskier assets.
"There's no doubt the main driving force behind the stock market has been the Federal Reserve. By keeping rates low it does provide an incentive for investors to move out further on the risk spectrum to take on more risk," says Bernard Baumohl, chief economist for The Economic Outlook Group in Princeton, N.J.
The fact that companies can borrow money for a song helps their bottom lines, which improves their earnings. "So the outlook for earnings is good because of the low cost of credit. That is a second factor," Baumohl says.
Does more money mean more problems?
The asset purchases by the Fed have provided some extra fuel for the markets in another way -- by increasing the overall amount of money. When the central bank goes out to buy Treasuries or mortgage-backed securities, it goes through big banks known as primary dealers.
Much of the money created through quantitative easing has stayed in the financial system in the form of reserves, but the proceeds from asset purchases "are flowing into liquid balances," says Herbert Kaufman, professor emeritus at W.P. Carey School of Business at Arizona State University and a former economist with Fannie Mae.
"The central bank has been providing so much liquidity, that liquidity has to go somewhere," Kaufman says. "It is very logical to expect it to go into assets. You would think that it would go into equities. It would normally go into bonds, but there is an incentive to go into equities because of interest rates."
Draining the money supply
While it's great for everyone that the stock market has gone up, this is why the inflation hawks at the Fed are particularly wary of ongoing quantitative easing. All of the extra money sloshing around could be inflationary as the economy heats up.
In order to reverse this process, the Federal Reserve will reduce the monetary base, which will be an interesting process in itself.
"The Fed has never been in this situation before, and no one knows how they are going to successfully tighten monetary policy. It's not like the old days when they could just raise or lower the federal funds rate," Baumohl says.
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Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.