a bank maintains at the Federal Reserve to satisfy reserve requirements
and facilitate check clearing.
If the Federal Reserve wants to reduce the money supply, it sells gov-
ernment bonds from its portfolio. The buyer of these bonds instructs his or
her bank to pay the seller (the Fed) from his or her account. The bank then
instructs the Fed to debit the bank’s reserve account bank, and that money
disappears from circulation. This is called an open market sale. The buying
and selling of government bonds are called open market operations.
HOW THE FED’S ACTIONS AFFECT INTEREST RATES
We have seen that when the Federal Reserve buys and sells government
securities, it influences the amount of reserves in the banking system.
There is an active market for these reserves among banks, where billions
of dollars are bought and sold each day. This market is called the federal
funds market,and the interest rate at which these funds are borrowed and
lent is called the federal funds rate.
Although this market is called the “federal funds market,” the mar-
ket is not run by the government, nor does it trade government securi-
ties. The fed funds market is a private lending market among banks
where rates are dictated by supply and demand. However, the Federal
Reserve has powerful influence over the federal funds market. If the Fed
buys securities, then the supply of reserves is increased and the interest
rate on federal funds goes down because banks then have ample re-
serves to lend. Conversely, if the Fed sells securities, the supply of re-
serves is reduced and the federal funds rate goes up because banks
scramble for the remaining supply.
Although federal funds are lent overnight so the funds rate is an
overnight rate, the interest rate on federal funds forms the anchor to all
other short-term interest rates. These include the prime rate, which is the
benchmark for most consumer and much commercial lending, as well as
short-term Treasury securities. The federal funds rate is the basis of lit-
erally trillions of dollars of loans and securities.
Interest rates are an extremely important influence on stock prices
because interest rates discount the future cash flows from stocks. There-
fore, bonds compete with stocks in investment portfolios. Bonds become
more attractive when interest rates rise, so investors sell stocks until the
returns on stocks again become attractive relative to the returns on
bonds. The opposite occurs when interest rates fall.
Over most of the past 50 years, changes in the fed funds rates have been
a very good predictor of future stock prices. This is shown in Table 11-1,
196 PART 3 How the Economic Environment Impacts Stocks