The Federal Reserve (Fed) can impact the economy by its open market purchases and sales of treasury and mortgage securities. By the laws of supply and demand, when the Fed buys securities in the open market it has the result of increasing the value of those securities and decreasing the percentage yield.
Open market purchases also have the effect of increasing the supply of money in the banking system as the Fed pays for the purchase of the securities. This is the Fed’s process for managing interest rates and the money supply. (Of course when the Fed sells securities it has the exact opposite affect).
So what has the Fed being doing lately? The Fed is actively involved in open market purchases of treasury securities and mortgage securities in order to reduce interest rates and increase the money supply. The objective is to make borrowing more attractive (via lower interest rates) so that businesses will borrow more, hire more people, and grow their operations. Also, the Fed wants home loan interest rates to be low so you will buy a home or refinance your home. All these things are targeted at stimulating the economy so we can get growing again, and reduce the unemployment rate.
The Fed is currently spending $85 billion a month to buy treasury and mortgage securities the open market. The Fed refers to this process as Quantitative Easing (QE). It is no coincidence that the $85 billion is about the same amount as the US government is losing each month because of its over-spending. The chart below shows how the US money supply has increased significantly to almost $2.6 trillion from $1.1 trillion in 2000.
The good news is that interest rates are very low. The bad news is that these lower rates have not yet resulted in the robust economic growth the Fed was looking for. The other bad news is that this kind of growth in the money supply normally threatens to create an inflationary spiral. We haven’t seen an inflationary spiral yet because our economy is so weak that producers of goods and services are not able to increase sales prices.
Longer term, as the economy recovers, the Fed will have to shut off the Quantitative Easing which will result in higher interest rates. Hopefully, the economy will be so strong that it can absorb these higher rates without going back into a recession. Keep an eye on the Fed’s open market activities.