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What Tools Do the Federal Reserve Use to Influence the Economy

Economy

What Tools Do the Federal Reserve Use to Influence the Economy

by | Economy

Ben Constanty

CEO, Smartlink

Disrupting online payments with smart contracts.

Over the last year we have heard about the Fed more than we care to admit. The reason for their large presence is the Fed dictates money and interest rates.

With the pandemic, they were called upon to help support a slowed economy and ensure American’s were not left behind.

Through stimulus and direct payments, they stopped the bleeding.

You may be wondering what tools the Fed can use and how they use them. This article details what the Fed does and how it can impact the economy and overall market.

🔎 Key takeaways

  • The FED uses monetary policy to inject liquidity into the economy
  • Inflation is created by the FED when they lower interest rates
  • The FED also buys government and corporate bonds but might need other options with the current Covid crisis

Monetary Policy

Monetary Policy

The Fed has used monetary policy most recently. Monetary policy is when the Federal Reserve attempts to manage the money supply through interest rates and balance sheet purchases.

This methodology can be argued as a more impactful and quicker way to manage the money supply.

The other option is fiscal policy, which is adjusted through spending and can take time before results are seen.

Currently, the Fed has been purchasing Mortgage Backed Securities (MBS) and lowering interest rates to zero.

The asset purchases are likely to continue, but interest rates should remain at zero and not turn negative according to the Fed.

Inflation

Inflation

When the Fed decides to bring liquidity to the market, or print money, it can help accelerate inflation.

Inflation is a goal of the Central Bank going forward, but with the current pandemic it seems to be proving difficult.

Inflation will also be promoted through asset purchases. By doing this, the Federal Reserve is providing liquidity to large financial institutions.

Keep in mind though, inflation lowers purchasing power and results in higher prices for goods and services.

Government Debt

Government debt

A growing problem with monetary policy is the increasing debt. The United States continues to build debt with no end in sight.

It is interesting to think about because with great amounts of debt, there should be a looming issue.

However, the Fed continues to stage off problems via lower rates.

An argument can be made that interest rates will never go back to normal because of the large amounts of debt tied to rates.

Time will tell, but unless something improbable happens, the U.S. could be in trouble.

For reference, the current debt-to-GDP ratio is over 100.

Commercial Debt

Commercial debt

With low interest rates, it has promoted corporation to issue corporate debt for two reasons.

First, with rates low corporations can raise cash through cheap debt.

Secondly, the demand for higher yielding bonds can be met through issuing corporate debt, specifically investment grade debt.

Investors will gladly purchase corporate debt around 4% instead of Treasuries below 1%.

The Fed has plenty of tools, but the question of their effectiveness is front and center.

They can no longer turn to lower interest rates and with U.S. debt soaring, it begs the question of what happens next.

Should the pandemic persist, the Federal Reserve will need to get creative.

Unfortunately, it always seems at the end of the day, it is taxpayers that foot the bill and not the U.S. Government.

Ben Constanty

CEO, Smartlink

Disrupting online
payments with smart contracts.

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