The Federal Reserve (the “Fed”) is the central bank of the United States. Whether it be directly or indirectly, the Fed has an enormous impact on US interest rates. Interest rates on everything from a savings account to a 30 Year corporate bond are affected by the decisions of the Fed. While the Fed has the authority and responsibility to regulate the solvency of banks, most people (particularly bond holders) focus on the Fed’s influence on interest rates and the economy.
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How does the Fed influence the economy? Primarily they do this by increasing or decreasing the supply of money in the economy, which in turn affects interest rates.
Interest rates can be seen as the intersection of the supply and demand for money. All else being equal if the supply of money available in the economy rises then interest rates should fall. Conversely if the supply of money available in the economy decreases then, all else being equal, interest rates should rise.
Key Concept: An increase in the money supply generally equates to lower interest rates. A decrease in the money supply generally equates to higher interest rates.
When interest rates rise the cost of borrowing money increases. All else being equal, if the cost of borrowing rises then individuals and businesses borrow less, and economic growth should slow. When interest rates fall the cost of borrowing money also falls. All else being equal, if the cost of borrowing falls then individuals and businesses should borrow more, and economic growth should quicken.
Key Concept: Higher interest rates tend to slow economic growth. Lower rates tend to accelerate growth.
While the federal reserve has a number of tools to affect the economy by far the most used and most important is their ability to increase and decrease the supply of money in the economy. If the Fed thinks the economy is growing too quickly and inflation is a concern, they will sell government securities. This lowers the supply of money available in the economy and causes interest rates to rise. If they think the economy is growing too slowly and high unemployment is the primary concern, they will buy government securities. This increases the money supply and causes interest rates to fall.
Key Concept: Through the buying or selling of Treasury Bonds, the FED has the ability to increase or decrease the money supply.