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Left to their own devices, free market economies tend to be volatile as a result of individual fear and greed, which emerges during periods of instability. History is rife with examples of financial booms and busts but, through trial and error, economic systems have evolved along the way. But looking at the early part of the 21st century, governments not only regulate economies, but also use various tools to mitigate the natural ups and downs of economic cycles.

In the U.S., the Federal Reserve (Fed) exists to maintain a stable and growing economy through price stability and full employment - its two legislated mandates. Historically, the Fed has done this by manipulating short-term interest rates, engaging in open market operations (OMO) and adjusting reserve requirements. The Fed has also developed new tools to fight economic crisis, which emerged during the subprime crisis of 2007. What are these tools and how to they help mitigate recession? In this article, we'll take a look at the Fed's arsenal.

Manipulating Interest Rates

The first tool used by the Fed, as well as central banks around the world, is the manipulation of short-term interest rates. Put simply, this practice involves raising/lowering interest rates to slow/spur economic activity and control inflation.

The mechanics are relatively simple. By lowering interest rates, it becomes cheaper to borrow money and less lucrative to save, encouraging individuals and corporations to spend. So, as interest rates are lowered, savings decline, more money is borrowed, and more money is spent. Moreover, as borrowing increases, the total supply of money in the economy increases. So the end result of lowering interest rates is less savings, more money supply, more spending, and higher overall economic activity - a good side effect. (For related reading, see How Interest Rates Affect The Stock Market.)

On the other hand, lowering interest rates also tends to increase inflation. This is a negative side effect because the total supply of goods and services is essentially finite in the short term - and with more dollars chasing that finite set of products, prices go up. If inflation gets too high, then all sorts of unpleasant things happen to the economy. Therefore, the trick with interest rate manipulation is not to overdo it and inadvertently create spiraling inflation. This is easier said than done, but although this form of monetary policy is imperfect, it's still better than no action at all.

Open Market Operations

The other major tool available to the Fed is open market operations (OMO), which involves the Fed buying or selling Treasury bonds in the open market. This practice is akin to directly manipulating interest rates in that OMO can increase or decrease the total supply of money and also affect interest rates. Again, the logic of this process is rather simple.

If the Fed buys bonds in the open market, it increases the money supply in the economy by swapping out bonds in exchange for cash to the general public. Conversely, if the Fed sells bonds, it decreases the money supply by removing cash from the economy in exchange for bonds. Therefore, OMO has a direct effect on money supply. OMO also affects interest rates because if the Fed buys bonds, prices are pushed higher and interest rates decrease; if the Fed sells bonds, it pushes prices down and rates increase.

So, OMO has the same effect of lowering rates/increasing money supply or raising rates/decreasing money supply as direct manipulation of interest rates. The real difference, however, is that OMO is more of a fine-tuning tool because the size of the U.S. Treasury bond market is utterly vast and OMO can apply to bonds of all maturities to affect money supply.

Reserve Requirement

The Federal Reserve also has the ability to adjust banks' reserve requirements, which determines the level of reserves a bank must hold in comparison to specified deposit liabilities. Based on the required reserve ratio, the bank must hold a percentage of the specified deposits in vault cash or deposits with the Federal Reserve banks.

By adjusting the reserve ratios applied to depository institutions, the Fed can effectively increase or decrease the amount these facilities can lend. For example, if the reserve requirement is 5% and the bank receives a deposit of $500, it can lend out $475 of the deposit as it is only required to hold $25, or 5%. If the reserve ratio is increased, the bank is left with less money to lend out on each dollar deposited.

Influencing Market Perceptions

The final tool used by the Fed to affect markets an influence on market perceptions. This tool is a bit more complicated because it rests on the concept of influencing investors' perceptions, which is not an easy task given the transparency of our economy. Practically speaking, this encompasses any sort of public announcement from the Fed regarding the economy.

For example, the Fed may say the economy is growing too quickly and it is worried about inflation. Logically, if the Fed is being truthful, this would mean an interest rate increase is forthcoming to cool the economy. Assuming the market believes this statement from the Fed, bondholders will sell their bonds before rates increased and they experience losses. As investors sold bonds, prices would go down and interest rates would rise. This in effect would accomplish the Fed's goal of raising interest rates to cool the economy, but without actually having to do anything.

This sounds great on paper, but it's a bit more difficult in practice. If you watch bond markets, they do move in tandem with guidance from the Fed, so this practice does hold water in affecting the economy. (For more, see How Much Influence Does the Fed Have?)

Term Auction Facility/Term Securities Lending Facility

In 2007 and 2008, the Fed was faced with another factor that strongly influences the economy - the credit markets. With the recent interest rate increases and the subsequent meltdown in values of subprime-backed collateralized debt obligations (CDOs), investors were provided an unexpected and sharp reminder of the potential downside of taking credit risk. Although most credit-based investments did not see serious erosion of underlying cash flows, investors nonetheless began to require higher return premiums for holding these investments, leading not only to higher interest rates for borrowers but a tightening of the total dollars lent by financial institutions, which put a crunch on the credit markets. (For more on this issue, check out CDOs And The Mortgage Market.)

Due to the severity of the crisis, some innovation from the Fed was needed to minimize its impact on the broader economy. The Fed was tasked with bolstering credit markets and investors' perceptions thereof and encouraging institutions to lend in spite of worsening conditions in the economy and credit markets. To accomplish this, the Fed created the term auction facilities and term securities lending facilities. Let's take a closer look at these two items:

1. Term Auction Facility
The term auction facility was designed as a means to provide financial institutions with access to Fed dollars to alleviate short-term cash needs and provide capital for lending, but on an anonymous basis. The reason it was called an auction is that firms would bid on the interest rate they would pay to borrow cash. This differs from the discount window, which makes any institution's need for cash public information, potentially leading to solvency concerns on the part of depositors, which only exacerbate concerns about economic stability.

2. Term Securities Lending Facility
As an additional tool to combat balance sheet concerns, the Fed instituted the term securities lending facility, which allowed institutions to swap out mortgage-backed CDOs in exchange for U.S. Treasuries. Because these CDOs were falling in value, there were severe balance sheet considerations as firms' asset values fell due to heavy exposure to mortgage backed CDOs. If left unchecked, falling CDO values could have bankrupted financial institutions and lead to a collapse of confidence in the U.S. financial system. However, by swapping out falling CDOs with U.S. Treasuries, balance sheet concerns could be mitigated until liquidity and pricing conditions for these instruments improved. The Fed-orchestrated takeover of Bear Stearns in 2007 was made possible through this newly invented tool. (For related reading, see Dissecting The Bear Stearns Hedge Fund Collapse.)

Bottom Line

Overall, monetary policy is constantly in a state of flux, but still relies on the basic concept of manipulating interest rates and, therefore, money supply, economic activity and inflation. It is important to understand why the Fed institutes certain policies and how those policies could potentially play out in the economy. This is because the ebbs and flows of economic cycles offer opportunity by creating profitable times to either embrace or avoid investment risk. As such, having a sound understanding of monetary policy is key to identifying good opportunities in the markets. (For a comprehensive look at the Fed, check out our Federal Reserve Tutorial.)

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