The Federal Reserve of the US, or simply “Fed,” can seem a bit nebulous at times because they are always being mentioned on the news yet few fully understand what exactly they do. It’s worth understanding the Fed because their decisions and economic clout can make or break decisions that most Americans make on a day-to-day basis.
Most of the news centers around the Federal Reserve’s interest rate, but they actually have many ways to affect the economy. Lately, there has been discussion that the Fed will either decrease buying or stop buying bonds. We’ll get into a bit of background on this topic and then explain what it means when the Fed starts to decrease bond buying.
The Fed’s purpose is to maintain the stability of the financial system in the US. They do this by making changes to monetary policy and using tools to effect those changes. The one many already know about is the interest rate.
The one we’ll focus on, though, is that the Fed will buy bonds on the open market. The open market is where you and I operate to invest our money, and the Fed goes to the open market to buy bonds.
The Fed goes to the open market to buy US Treasury bonds. When the US Treasury “prints money,” as we’ve seen all over the news lately, they are issuing US Treasury bonds on the open market. These bonds are typically bought by investment firms because it is a large-scale, relatively safe investment for them to place investable money.
When the Fed buys bonds, they are essentially giving the US government (the Treasury) cash for the bonds. Once the bonds are bought, the Treasury can then print physical cash, which is then filtered out to people via the regional Federal Reserve banks.
In fewer words, when the Fed buys bonds, they increase the money supply in the US. This has an effect on the interest rate as well, though bond buying affects the economy slower than changing the interest rate.
As mentioned, bond buying is a fine-tuning tool the Fed uses because the market for bonds is so big. When they begin to decrease bond buying, this effectively slows the increase in the money supply, but doesn’t necessarily decrease it.
This does, however, send a signal to the banks and the rest of the market that the Fed may feel the economy is beginning to overheat, meaning they want to reign in the rise of inflation.
When the Fed reduces bond buying, the banks have less money to loan out to customers. Since the supply of money gets slightly tighter, banks may actually increase the interest rates they charge customers in response to the lower amount they have in reserve.
Speaking of bank reserves, the Fed can change the reserve requirement that banks must adhere to. During 2020, the Fed drastically cut the reserve requirement, which meant that banks didn’t have to keep as much of its money in cash reserves and could lend it out to customers. This helped increase the money supply in the system by allowing banks to write more loans.
The reserve requirement recently went back to pre-pandemic levels, so this already had an effect on the money supply and may have affected interest rates.
As mentioned previously, the Fed can also change the Federal Reserve interest rate, which is the broadsword the Fed wields to manipulate the money supply. This rate, if increased, would almost over night have an effect on the interest rates people pay for things like mortgages and business loans.
Final Thoughts
The Fed wields enormous power over the money supply of the US economy, and the one that has been discussed recently is the buying of bonds in the open market. When the Fed decreases their purchase of US treasury bonds, this begins to decrease the inflow of cash to the economy. It also sends signals to the market that they may be preparing to limit economic growth to keep inflation from getting out of hand.
