Monetary policy can influence both employment and economic production. When demand in the economy weakens the Fed will lower interest rates to stimulate the economy, they do this by lowering the fed funds rate. In the world of banking, banks are required to have reserves (roughly 10%) and when a particular bank is low on reserves it must get them from another bank that has too much reserves.
The Fed funds rate is the rate of interest on overnight loans for excess reserves made between commercial banks. A declining fed funds rate usually indicates the Feds desire to stimulate the economy by releasing reserves into the banking system. This rate influences other short term rates, the prime rate and rates on Treasury bills. If the Fed provides too much stimulus then you have a rise in inflationary expectations and long term interest rates will usually go higher.
The Fed lowered the fed funds rate drastically in 2008 and they were running out of ways to stimulate the economy. But then along came quantitative easing, a way of reducing long term interest rates and really stimulating the economy, at least that was the theory.
The economic collapse that was caused by the bubble in the real estate market put a lot of people out of work: builders, carpenters, appraisers, loan officers, title companies, escrow companies…..the list goes on and on. So, the Fed determined that the way to get the economy and employment heading in the right direction was to resurrect the housing market.
The Feds only option was to pump money into the economy directly lowering interest rates and encouraging people to spend, not save. That is quantitative easing (QE).
The Fed does this by buying assets, Treasuries, Mortgages basically anything that they want. The money is simply created out of thin air. The institutions selling those bonds (either commercial banks or other financial institutions) will then have “new” money in their accounts, which then boosts the money supply.
Under QE the Fed’s increased demand for government bonds pushes up their value, thereby making them more expensive to buy, and so they become a less attractive investment. This means that the companies who sold the bonds could use the proceeds to invest in other companies or lend to individuals, rather than buying any more of the bonds.
Notice that big brown area emerging in 2008 that is the Fed creating money.
What happens when the economy recovers?
Theoretically, when the economy has recovered, the Fed sells the bonds it has bought and destroys the cash it receives. That means in the long term there has been no extra cash created. The problem is that all of this stimulation has created a lot of money in the system and that can cause inflation. So, if rates go higher the Fed would be forced to hold onto the bonds rather than to sell them at a loss.
So what has been happening to the markets. As you can see from the chart below; there has been a very positive effect on the stock market.
The market has moved from the low in 2009 at 666 to the mid 1600’s and this move has been going on through all of the quantitative easing. The Fed has said that they will continue to spend $85 Billion a month on government bond purchases to help stimulate the economy and until the unemployment rate is down to 6.5%.
So, investors have been crowded out of the government bond market and they have been investing more of their funds in the stock market. When this easing is taken off the table you can expect that to change. We appear to have a little bubble going on, one that is being fed by the Fed.
Usually, it is not wise to move contrary to the Fed!