Learn About the Fed and What It Does

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The Federal Reserve Board's Open Market Committee (FOMC) is perhaps the single most important group of individuals for the stock market. Its action or inaction on interest rates has immediate consequences for investors. The stock market anticipates the Fed will take a certain action. If that doesn't happen it can cause chaos. The Fed controls key interest rates and its actions can have a direct impact on the stock market. We hear a lot about the Fed, but what does it really do?

The Fed

The Federal Reserve ("Fed") is America's central bank. The Fed is technically an independently run entity charged with maintaining a stable economy and strong financial system. Its decisions do not have to be ratified by the President or anyone else in the executive branch of government, although the entire System is subject to oversight by the U.S. Congress. The Fed operates 12 Federal Reserve Bank branches around the country that serve as banks to commercial banks, providing a variety of services and ensuring a stable financial system. The activity that has the most direct bearing on the stock market occurs eight times a year when the Federal Open Market Committee meets.

Target Rate

It is at these meetings that the target for key fed funds rate is set. This interest rate is the basis for all other interest rates and when it moves, other interest rates move. Banks are required to keep a certain level of cash reserves on hand, depending on the level of their deposits. During the daily course of business, it is not unusual for a bank to drop below its reserve level. When that happens, the bank borrows overnight funds from another bank until its own reserves are replenished. The interest rate the lending bank charges for that often-overnight loan is the fed funds rate. The actual rate is set by market conditions, so the Fed only suggests a target.

Prime Concern

The Fed's primary concern is to prevent inflation from wrecking the economy, which can occur if the economy grows too fast. On the other hand, if the economy slows down too much, it will stall into a recession. The way the Fed adjusts the speed of the economy is with interest rates. If the economy is growing too fast or inflation appears to be growing, the Fed will raise interest rates. Higher interest rates tend to slow business growth and consumer spending. If the economy is slowing too much, the Fed can lower interest rates, which makes it cheaper to borrow and that encourages businesses to expand and consumers to spend.

The Bottom Line

The Fed is the single most influential body in the U.S., when it comes to moving the markets. You should watch for its meeting announcements and pay attention to which way interest rates are headed.

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