As bond market volatility increases, analysts are heightening their watch on Federal Reserve commentary. Turn on any financial channel and see how long it takes to hear the word Fed or Federal Reserve. While many of the organizations provide insight (with no lack of opinion,) it would be a good idea to explain a few basic principles of the Federal Reserve and then review the tools it can use.
First, let’s start with the dual mandate which Congress amended in 1977. The Federal Reserve Act. The stated objectives follow:
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” (1)
So what tools does the Fed have in the toolbox to help manage the economy? Traditional tools which typically help fight off high inflation are listed below:
Open-Market Operations- the Fed can buy and sell U.S. government bonds to increase or decrease the money supply, thus helping keep inflation in check.
Discount Rate- This is the rate banks pay on short-term loans from the Federal Reserve. This is closely linked to the federal funds target rate, a rate banks charge each other for overnight lending. The Federal Open Market Committee, FOMC, publicly announces their preference for the rate. The FOMC does not directly control the fed funds rate.
Reserve Requirements- The amount banks are mandated to keep against their deposits are known as reserve requirements. While the tool is not one normally used over the short run, it directly affects the aggregate dollar amount in loans.
What does this mean in light of the recent bond market volatility and media coverage?
Most analysts point to the raising of the fed funds discount as source of worry since an inverse relationship exists between the price of a bond and the yield. However, this blanket and often sighted relationship implies the entire yield curve moves equally up or down across all maturities. The investing environment does not really behave in a uniform fashion. For example, one can review the last interest rate hikes in 2004-2006 and see that shorter term rates were altered less than their longer brethren. After a self study, one will understand the Fed does control short-term rates; one additionally observes the intermediate and longer maturities will be moved by market forces, not the Federal Reserve.
What about the other tools mentioned? The discount rate and reserve requirements do not change very often. Recently, the FOMC exercised on a grand scale program to buy large amounts of bonds which reached $85 billion of bonds per month for a while.
The next time an analyst discusses the Fed raising interest rates, notice if the commentator illustrates how his view relates directly with the dual mandate or is he just sharing his opinion with a few numbers thrown in for good measure. As the global economy moves forward, conditions will warrant flexibility in changing the interest rate which will likely happen at a measured pace. However, no one can exactly predict when this will transpire. There are other various forces influencing conditions such as: other central banks, strength of the dollar, lack if inflation and lower expectations for growth, aka new market realities.