Three Policy Tools of The Fed

three policy tools of fed

Learn the three policy tools The Fed uses to influence markets and the economy…

Three Policy Tools of the Fed are used to shape monetary policy. And given the Fed’s active hand in markets these days, it makes sense to revisit the different policy tools the Fed can use. So what are the three policy tools of The Federal Reserve Board and The Federal Open Market Committee?

In this blog post we’ll walk through the three policy tools of The Fed. We’ll look at the goal of each policy tool, how it works and what some of the weakness or criticisms are. So by the end of the blog post you should have a good understanding of the three policy tools of the Fed, and how they apply to stock markets.

Three Policy Tools of The Fed:

The Fed is the American central bank responsible for the USD. It is not an arm of government but a private bank responsible for overseeing the monetary supply on behalf of the US Treasury department. It’s a bit of a weird arrangement, but the main thing to know is The Fed is responsible for monetary policy, while the government is responsible for fiscal policy.

So here are the three policy tools the Fed uses to control monetary policy…

Open Market Operations: This is the active hand of The Fed. Open Market Operations, conducted by the Federal Open Market Committee have been in the news a lot lately, as The Fed uses quantitative easy to buy bonds and mortgage backed securities from the primary dealers. It sounds kind of crazy, but basically The Fed increases the money supply by buying up securities and crediting the amount to the banks it buys them from. The Fed actually publishes it’s calendar for open market operations so you can see for yourself what kind of securities they are buying and when. Make sense?

While open market operations are controlled by the FOMC, the following two policy tools are determined by The Federal Reserve Board of Governors…

Discount Rate Policy: The federal funds rate is like the foundation of all interest rates because it’s what banks loan each other overnight when they have reserves, or need liquidity. The Fed usually announces a target federal funds rate (such as 0-0.25). The prime interest rate (which banks loan to consumers and business above) is usually 300 basis points above the Federal Funds rate. That’s how your ability to borrow and loan money is influenced by The Fed.

Reserve Requirements: These are the final policy tool of The Fed. And they basically dictate how much the bank must keep in reserve. Reserve requirements must be kept in the banks vault, or at the nearest federal reserve bank. By changing the percentage of deposits a bank must hold in reserve, The Fed is able to encourage or discourage lending. Make sense?

So there you have it: An overview of the three policy tools of The Fed.  While The Fed is a confusing (and far from transparent) entity, it’s important to have a basic understanding of the policy tools The Fed can use, and what their impact on stock markets is.

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