The Fed is not a branch of the federal government.
The Federal Reserve, the central bank of the United States, is frequently in the news for its role in shaping the economy. Understanding the Fed and what is does is important knowledge for investors and can help with developing investment strategies. The Fed was created in 1913 under the Federal Reserve Act to provide the U.S. with a safe, flexible and stable monetary and financial system. The law, updated several times in subsequent years, outlines the purposes, structure, and functions of the Federal Reserve system. Here are seven facts investors should know about the Fed.
It uses several monetary policies.
The primary goal of the Federal Reserve System is to promote the goals of maximum employment and stable prices, or low inflation, says Robert Johnson, co-author of "Invest with the Fed: Maximizing Portfolio Performance by Following." The Fed executes its objectives through monetary supply activities as enacted by its open market operations. Four tools are used to accomplish its goals: the discount rate, reserve requirements, open market operations and interest on reserves. These activities influence the amount of funds in the banking system, according to the Federal Reserve Bank of St. Louis. "The most powerful monetary policy tool is through its open market operations -- that is, purchasing or selling U.S. government bonds," Johnson says.
It affects interest rates.
Federal Reserve interest rates refer to the discount rate. This is the interest rate charged to banks on short-term loans that are received from a regional Federal Reserve bank. The Fed doesn't set the interest rate, currently at 3 percent, but rather a target range for the rate, Johnson says.The discount rate indirectly influences other interest rates including the prime, credit card, vehicle and mortgage loan rates. "These market rates in turn influence businesses and consumers' decision to borrow, lend and spend," says Matthew Diczok, head of fixed income strategy and global wealth and investment management at Merrill Lynch Wealth Management. "Lower mortgage rates may encourage homebuying, and therefore support the housing market."
It influences the economy.
Interest rate policy is an enormous driver of the economy. Higher interest rates will slow borrowing by businesses and consumers, due to greater borrowing costs. Stock market investors find that higher interest rates generally correspond with lower returns. While lower rates encourage home building, business expansion and consumer borrowing. Lower interest rates tend to heat up economic growth, while higher rates tend to slow it down. "Raising interest rates is a double-edged sword. When the Fed raises the rate, it typically indicates the economy is doing well, but a higher rate makes it more challenging for real estate investors as they pay more for loans," says Elizabeth Norton, managing director of research services at Transwestern.
It makes adjustments to control inflation.
Inflation goals are like Goldilock's preferences: The Fed wants inflation to be just right, not too high or too low. The federal funds rate attempts to control inflation. "When the economy or inflation looks like they're going to overheat, the Fed raises the federal funds rate, its main tool to control inflation. A higher federal funds rate cools business lending, and cools the economy and inflation," says Robert Frick, corporate economist at Navy Federal Credit Union in Vienna, Virginia. The current inflation rate target is 2 percent. Investors should attend to the fed funds rate and its ripple effect on loans and stock market prices. If rates creep up too much, business and stock prices may falter.
It influences financial markets.
Some say that the Fed chair is the most important person in the world: When the Fed chair speaks, financial markets move up or down. In discussing the FOMC decision to leave interest rates unchanged for the near future, Chairman Jerome Powell's recent news conference preceded a run up in financial markets. Shortly after the recent announcement of stable interest rates, the S&P 500 advanced as well as the yield on the 10-year Treasury bond. Near full employment and constant interest rates means more certain borrowing costs, which is good for business, stock prices and investors.
It issues U.S. Treasurys.
The Fed's open market operations buys and sells Treasurys in the open market to help reach its goals. When the Fed buys bonds in the open market or from the pubic, it grows the money supply in the economy by putting more cash in the hands of consumers. Bond buying also affects interest rates. As the Fed buys bonds, the prices rise and interest rates fall. Conversely, by selling bonds, the Fed reduces the money supply by removing cash from the economy. This lowers bond prices and raises interest rates, consequently slowing down a quickly growing economy. Typically, investors benefit when interest rates decline as stock market prices rise.
It plays a nonpartisan role.
Although Fed decisions impact the economy, "the Federal Reserve is nonpartisan. With the current political turmoil, it's important for investors to keep that in perspective," Norton says. Despite its political independence, the Federal Reserve is ultimately accountable to the public and Congress. The Federal Reserve isn't funded through the congressional budgetary process, but largely from the interest on government securities, acquired through its open market operations. Investors can purchase government securities at TreasuryDirect.gov for a steady cash flow.
Important facts about the Federal Reserve.
To recap, here are a few facts about the Federal Reserve:
-- Uses several monetary policies.
-- Affects interest rates.
-- Influences the economy.
-- Makes adjustments to control inflation.
-- Influences financial markets.
-- Issues U.S. Treasurys.
-- Plays a nonpartisan role.
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