The Federal Reserve is making moves to aid markets affected by the coronavirus, NPR reported. It will extensively buy several bonds and securities as well as ensure a supply of credit. Historically, central banks trigger major market effects.
According to the NPR article, the Federal Reserve will “buy bonds and mortgage-backed securities” in order to ensure the smooth operation of markets. “The open-ended plans escalate an earlier emergency move that called for the Federal Open Market Committee to buy at least $500 billion in Treasury securities and at least $200 billion in mortgage-backed securities,” the article said. “The move by the central banking system lifted Dow Jones Industrial Average futures, but the index still stumbled by roughly 3 percent in early trading, sinking below the 19,000 mark within the first 10 minutes.”
With central banking in the spotlight, it’s worth noting how central banks affect financial markets both directly and indirectly.
Understanding Central Banks
Central banks have two purposes, according to Dr. Connel Fullenkamp, Professor of the Practice and Director of Undergraduate Studies in the Department of Economics at Duke University. The first is to regulate the supply of money in an economy.
“In the U.S. Constitution, Congress is given the power to coin money and regulate its value,” he said. “In most economies, mints and government printers create the coins and notes, but it’s the central bank that issues all the currency.”
The second main purpose of a central bank, Dr. Fullenkamp said, is to make sure that the payment system works and doesn’t fall apart during financial crises. “The payment system is the system that links banks together and enables money to move from buyers to sellers, so that everyone can make and receive the payments they need. One way to think about what a central bank is, is that it’s a government bank that serves the private banks.”
Due to this, it’s easy to see how central banks affect financial markets.
“First, monetary policy affects several variables that are important to financial markets: inflation, interest rates, even economic growth and unemployment,” Dr. Fullenkamp said. “Second, central banks are an important player in the financial markets in their own right. Finally, central banks regulate and supervise banks, and in many countries they regulate other financial institutions, as well.”
How the Fed Makes an Impact through Interest Rates
One clear way that central banks affect the financial markets is through interest rates. Central banks don’t control most interest rates, but the ones it does control have a ripple effect throughout the economy.
The rate that the central bank charges on loans made to banks in need of short-term cash is called the discount rate. Dr. Fullenkamp said the discount rate signals the financial markets because as the central bank lowers the discount rate, that means it’s planning to increase the money supply at a faster rate than previously. When it raises the discount rate, it’s an indication that the growth rate of supply money will slow.
The interbank lending market is related to this. “As its name suggests, the interbank lending market is the market in which banks lend money back and forth to each other,” Dr. Fullenkamp said. “They lend each other the reserve deposits they hold at the bank.”
Banks are required to hold these reserves, which Dr. Fullenkamp said come in the form of vault cash in proportion to their deposits. “Since banks take deposits in order to make loans, the reserve requirement on deposits is effectively a reserve requirement on loans as well.”
In a case where the volume of customers who want loans exceeds what the bank has in its reserves, the bank can borrow reserves through the interbank lending market from a bank that’s not using that on-hand money at the moment. Excess reserves are kept at the central bank, which in the United States is called the fed funds market since banks are borrowing from each other’s accounts at the Fed.
“The rate of interest on a loan in the fed funds market is called the fed funds rate,” Dr. Fullenkamp said. “The central bank can control the fed funds rate very closely; most of the time, this is exactly what the Fed and other central banks do—they set, or peg, the fed funds or similar interbank lending rate where they want it to be. This interest rate is one of the anchors or key benchmarks for all other interest rates in the economy.”
When the central bank speaks, markets listen. The big moves currently being put in place by the Fed will have notable repercussions throughout the 2020 U.S. economy.
Dr. Connel Fullenkamp contributed to this article. Dr. Fullenkamp is Professor of the Practice and Director of Undergraduate Studies in the Department of Economics at Duke University. He earned his undergraduate degree in Economics from Michigan State University and his master’s and doctorate degrees in Economics from Harvard University.