We got a regular glimpse behind the curtain at the Federal Reserve on Wednesday when the central bank released minutes from its last meeting in March.
It was then that the Fed raised interest rates by a quarter of a percentage point in an effort to cool the economy. The minutes leave no doubt that there will be further rate increases this year; they report that “many” meeting participants thought half-percentage-point rate increases would be needed later this year.
But raising interest rates is only one tool in the Fed’s arsenal. It can also raise and lower the temperature of the economy by buying and selling bonds, some issued by the Treasury, others backed by mortgages.
The central bank has purchased more than $4.5 trillion of these assets since the pandemic tore through the economy in March 2020. According to the minutes, the Fed will begin dumping these bonds to the tune of $95 billion. dollars per month.
The Fed is not just an interest rate arbiter or banking regulator, it is also a kind of bank itself.
“One way to think about it is that it has a balance sheet, with assets on one side and liabilities on the other,” said Tim Duy, an economics professor at the University of Oregon.
Since the 2008 financial crisis, Duy said the Fed had filled its balance sheet with billions of dollars in government bonds and mortgage-backed securities “as a mechanism through which it hoped to further stimulate economic activity.” .
Indeed, when the Fed buys government bonds, it reduces the supply of them on the market.
“And so, by taking those assets out of the market, the financial markets have to find other assets, and thus drive up the value of those assets,” Duy said.
At the same time, when the Fed buys bonds, it also increases the demand for them by definition. It can also boost the economy, said Winnie Cisar, global head of strategy for CreditSights.
“So if you have more demand, that means prices are going to be higher, and yields are going to be lower, and that drives interest rates down.”
Lower interest rates and plenty of cash in the economy are great when the Fed is trying to spur a recovery. But now the economy is overheating.
Thus, last month, the Fed stopped buying bonds. Suddenly, “that means that there is one very big buyer less. Which means other investors are going to have to step in and absorb all the available supply,” Cisar said.
Reduced demand and increased supply means lower bond prices. And that, in turn, means higher interest rates, according to Guy LeBas, chief fixed income strategist at Janney Montgomery Scott.
“They are causing – intentionally – financial conditions to get worse, worse,” he said.
In other words, the Fed is making consumer and business spending a bit more difficult, lowering the temperature of the economy in hopes of bringing inflation under control and easing the tight labor market.
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