How the Fed Impacts Markets

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The stock market is a sensitive and fickle thing. The quietest whisper of a merger rumor can impact dozens of companies, while central bank policies on the other side of the globe can affect entire industries. Every new bit of information that comes up is analyzed by investors where predictions are made and stock prognosticators attempt to beat others to potential profit-making changes. And, while this happens almost constantly everyday on Wall Street, there’s nothing that can make investors stop and reassess their beliefs quite like the Federal Reserve.

The Fed has the ability to control the money supply, interest rates and influence inflation – three critical pieces of data that impacts every corner of every industry in the stock market. As such, when the Fed makes an announcement or lets investors in on what it’s thinking, investors take it seriously.

But despite the Fed’s influence and apparent impact on market movements, one of the biggest questions investors have is exactly how powerful the Fed really is. How does the Fed actually influence markets?

The Fed’s Power Tools

The Federal Reserve’s stated purpose is to maximize employment, manage inflation and create a stable financial system. To this end, it utilizes three powers – it sets banking reserve requirements, buys and sells treasuries in order to control the money supply, and sets the federal funds rate, which in turn impacts interest rates.

The most commonly used ability by the Fed is its open market operations, which buy and sell treasury securities. Purchasing these treasuries injects more money into the banking systems, thus increasing the money supply, while selling them removes money from the banking system and reduces the money supply.

Setting the federal funds rate is the Fed’s way of influencing interest rates. The federal funds rate is the rate charged to banks to borrow money from the Fed. This method is the one the Fed uses to manage inflation. Lowering the fed funds rate stimulates investment activity and attempts to increase growth and inflation, while increasing the fed funds rate curbs investment activity and attempts to lower inflation.

Finally, the tool least used by the Fed is setting margin requirements for banking institutions. This tells banks how much they must hold in reserves relative to how much they loan out in order to control the money supply. A low reserve ratio increases the money supply, while a higher one lowers the money supply.

The Fed uses all three tools in combination in order to manage inflation and economic growth, while keeping the financial system stable.

While the Fed does have the ability to influence economic activity and the stock market, much of the Fed’s power simply lies in the belief of the investor. For example, despite inflation levels under 2 percent in 2015, the Fed still increased interest rates, which led to investors believing that the Fed had faith that the economy was strong enough to require a rate hike.

Whether that was a way to convey belief to investors, which in turn caused inflation to go higher, or whether the fed really thought the economy was strong enough is a hotly debated subject. Recent failings by the Fed to properly convey future economic policy changes and actions has led some investors to doubt the ability of the Fed to properly manage the economy. As time goes on, the Fed’s ability to influence markets may become weaker.