The Fed

Fed meeting this coming Tuesday. Looks to be a fairly important one. Let's talk a bit about what the Fed does and why they're so important to our economy.

The Fed is the United State's central bank. They control monetary policy, which is to say they try to control the money supply. There are three main ways in which they control monetary policy: The Fed Funds Rate, the Discount Rate, and reserve requirements.

The Fed Funds Rate is the interest rate banks charge each other for overnight loans. The market determines this rate, so the Fed can not use regulations to enforce this (well, maybe they could but that would screw with market dynamics). Instead of regulation the Fed conducts open market transactions to buy/sell treasuries from the open market to increase/decrease the amount of money available to the public. When there is less money circulating, the interest rate for borrowing it must increase. The Fed Funds Rate is what the market watches the most closely because it is the Fed's primary means of affecting the market.

The Discount Rate is the interest rate that the Fed charges for overnight loans. Most banks go to other banks to borrow at the Fed Funds Rate before going to the Fed for their loans. Clearly the Fed can choose its Discount Rate at will.

The reserve requirement refers to the amount of reserves banks have to keep as a percentage of their deposits. If banks have to keep more money in reserve (as opposed to lending it out or buying illiquid assets), then the demand for money is higher and interest rates go up. The Fed hasn't actually messed with the reserve requirement for along time, but if they did it'd be a really big deal. The reserve requirement is the Fed's sledgehammer when it comes to monetary policy.

Alright, so now we know what the Fed does. Now how does this effect the economy? Well all of the above change the supply and demand for money and thus interest rates. The Fed's mandate, however, involves inflation (go wikipedia inflation if you don't know what it is) and economic growth. This is slightly different from most central banks who are only mandated to control inflation. Too much money floating about invokes high inflation, which is disastrous on an economy (well, some theory says it doesn't matter, but in practice inflation has been the devil). So the Fed has to maintain a delicate balance between wanting to raise interest rates to control inflation and wanting to lower rates for growth. Most people think if the rates are high that's bad for the economy, if rates are low that helps stimulate the economy.

A "hawkish" Fed means they are primarily focused on the inflation rate (e.g. watching inflation like a hawk). A "dovish" Fed means they are kind on the economy and worry as much about economic growth as inflation. Most people agree that the primary target of the Fed should be inflation. A hawkish Fed tends to demand more respect and can more easily control inflation and the markets without having to mess with the interest rates.

When the Fed Funds Rate is high, banks have to fund at a somewhat higher interest rate, so they have to charge others a higher rate as well (for those of you familiar with LIBOR funding, LIBOR tends to trade at a spread to Fed Funds, we'll talk about this more later). When interest rates are high, however, companies can not borrow as much money, so domestic companies tend to suffer a bit and aren't able to invest in as many capital intensive projects. New bonds tend to come out at a higher interest rate. When interest rates are high foreigners are more likely to buy US dollar denominated assets, so the dollar would appreciate.

When the Fed Funds Rate is low, borrowing is cheap so liquidity is plentiful. Thus companies can invest a lot in projects with the thought that funding these projects is nice and cheap. Another way people talk about this is to say credit is plentiful, which seems to be a problem with the economy right now.

Alright, so now you know the basics of the Fed. Why does this seem like a timely post? Markets are really moving these days, and the markets just priced in a Fed "ease" (lowering of the interest rate) via the Eurodollar futures. Eurodollar futures basically point to LIBOR. Future LIBOR being lower basically means the Fed has cut rates. In fact a lot of what I saw on the ticker on Friday was a lot of banks buying Eurodollar future calls, which means people were buying protection against a Fed cut (if the fed cuts rates, then the eurodollars go up in value a lot and the calls are in the money). A lot of the hype is around the policy statement that the Fed gives after the FOMC meeting on Tuesday. As much as policy effects the markets, the statement tends to have just a large an effect because it points to future policy. A lot of the move in markets seems to be pricing in what the Fed will "say" about the state of the economy (and whether a cut will be necessary in the future.