AMERICA’S PLUMBING PROBLEM. The United States financial system is like the plumbing in your home. The water pressure needs to be just right to keep the system flowing smoothly. The Fed, which is the U.S. central bank, is the primary plumber responsible for maintaining the system. The Fed adjusts interest rates One tool the Fed uses to keep the financial system operating efficiently is the federal funds rate. When newscasters say the Fed raised or lowered rates, that’s often the rate they’re discussing. Many investors keep a close eye on Fed rate cuts and hikes because they can influence financial markets. For example: - When the economy is overheating (water pressure is too high), the Fed can release the pressure by raising the federal funds rate. Higher rates make it more expensive to borrow, reducing the flow of money. This action can also put pressure on stock prices because higher borrowing costs can lead to lower profits, according to Mary Hall of Investopedia.
- When the economy is slowing or in recession (water pressure gets too low), the Fed can increase the pressure by lowering rates, causing money to flow more freely through the system. Rate cuts can boost stock prices because lower borrowing costs can lead to higher profits.
The Fed also buys bonds Over the past few months, Wall Street’s attention has shifted from the federal funds rate to another tool the Fed relies on to keep money flowing through the system – the Fed’s balance sheet. That’s basically a list that includes everything the Fed owns, such as Treasury bonds and mortgage-backed securities. - When the pressure in the financial system is low, the Fed pumps more money into the system by purchasing government bonds and securities. This process is known as quantitative easing or QE.
During the financial crisis, and again during the COVID-19 pandemic, the Fed bought a lot of government bonds to stabilize U.S. financial markets. Over the last two decades, its “balance sheet grew from about $800 billion to roughly $6.5 trillion—an increase from around 6 percent to 21 percent of GDP,” reported Burcu Duygan-Bump and R. Jay Kahn, writing in FEDS Notes. - When pressure in the financial system is high, the Fed stops buying bonds and lets the ones it owns mature. As a result, the Fed’s balance sheet gets smaller. This process is called quantitative tightening or QT.
After the pandemic, as inflation rose well above the Fed’s target inflation rate, the central bank raised the federal funds rate to cool the economy. It also stopped buying bonds, shrinking its balance sheet from about $9 trillion to about $6.5 trillion. The size of the Fed’s balance sheet affects long-term interest rates. A bigger balance sheet can keep long-term rates lower, encourage borrowing, and support stock prices. In contrast, a smaller balance sheet can push long-term rates higher, make borrowing more expensive, and put pressure on stock prices. In other words, the Fed’s balance sheet can influence mortgage rates, bond prices, and even the stock market. A change of course in 2026 After years of shrinking its balance sheet, the Fed paused in December and began buying bonds again. Typically, it does this to stimulate economic growth, but the economy isn’t slowing. The Fed paused because of a different stress that was building in the financial system — falling bank reserves, according to Michael S. Derby of Reuters. Over the next couple of weeks, we’ll explain the role of bank reserves in the financial system and how the selection of Kevin Warsh as the next Fed chair could affect the Fed’s balance sheet and financial markets. WEEKLY FOCUS – THINK ABOUT IT “Acting is not an important job in the scheme of things. Plumbing is.” ― Spencer Tracy, Actor ― Anonymous
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