Fed’s Toolkit

The Central Bank has the ability to, directly, impact the economy of the United States. It is the through this ability that the Fed uses the tools that it has available to induce change to the economy. In short, the Central Bank (Fed) recognizes trends in the economy and then makes policy changes that attempt to curb whatever segment of the economy in which the negative trend has occurred.

The Tools

Increasing Assets is one tool that the Fed has and uses. In poor economic times, the Fed can increase its assets as a means of impacting supply and demand. We might see this as buying up money. When there is less money in the marketplace the value of the dollar rises and consumers are able to buy more products by spending less money. When the Fed sells money, then the opposite is true. There is more money available, and the value of the dollar falls, or the cost to borrow money drops because there is so much money floating around in the market. The amount of asset that the Fed holds has a direct impact on the economy.

Holding Bonds Until Maturity is another tool that the fed has to use in its battle with the Economy. The risk to holding bonds is that eventually they lose money or value. When the Fed has assets that lose money it causes economic impacts that cause the price of bonds to fall. The Fed receives a great portion of its income from the sale of bonds.

Adjusting the Unemployment Level as a Key to Raising Interest Rates is yet another tool the the Fed can use to help stimulate economic growth. Typically when the unemployment rate is high interest rates are reduced to encourage small business development and large business growth, thus stimulating the creation of new jobs. Those policies of when to raise or lower interest rate come directly from the Fed. To impact the percentage rate for money borrowed the Fed can adjust the percentage level of unemployment so that the interest rate rises. This is pretty much equal to taking money out of the marketplace, and creating demand for money by limiting its volume.

Considering what is happening now, the Fed is buying back bonds in large volume. That can be seen as increasing their assets. Are they planning to hold these bonds until they mature? That is a million or rather a 3 trillion dollar question. Fed Chairman Ben Bernanke seems to think that there is no cause for concern. Bernanke feels that the loss of holding bonds until maturity, can be managed by careful moderation of the bond assets. Despite the poor improvement of the job market, there are still doubts over how the Fed will handle what could equate to a half trillion dollars in loss from holding bonds until they mature. Even diehards are issuing caution over the policies that are currently in favor by the Fed.