Federal Reserve; Bonds Verses Stocks

Federal Reserve: Bonds verses Stocks

The Federal Reserve uses treasury bonds, gold, and notes or bills to support the nation’s economy. The Federal Reserve has traditionally conducted open market operations through the purchase and sale of government bonds. Could the Federal Reserve without drawbacks conduct monetary policy through the purchase and sale of stocks on the New York Stock Exchange?

No, I do not think the Federal Reserve could conduct monetary policy through the purchase and sale of stocks on the New York Stock Exchange. The values of stock change or affect the prices of stock just by the actual actions of buying stock. If the Federal Reserve came into the stock market, then the Federal Reserve would increase the demand level and with increasing demand the prices would go up.

The New York Stock Exchange has over decades been a way from many people to make money; however, just like any thing the exchange has its ups and downs. The stock exchange’s daily Dow Jones Average swings upward and sometimes falls downward, because of this a link between monetary policy and the stock exchange would be quite interesting and almost devastating. Stock prices are among the most closely watched asset prices in the economy and are viewed as being highly sensitive to economic conditions. Stock prices have also been known to swing rather widely, leading to concerns about possible bubbles or deviations of stock prices from fundamental values that may have adverse implications for the economy. Changes in the monetary policy affect the stock market at the time they are announced, but these changes are not the major influence on equity prices, it is the unanticipated changes in monetary policy that affects stock prices. It affects stock prices not by influencing expected dividends or the risk-free real interest rate, but rather by affecting the perceived riskiness of stock. For example, if the monetary policy is tightened, investors began to view stocks are riskier investments and thus to demand a higher return to hold stocks. To achieve getting this higher demand, a fall in the current stock price will have to take effect.

Higher interest rates lower or depress the stock prices. This happens because to hold the value of future dividends, an investor must discount them back to present, because higher interest rates make a given future dividend less valuable in today’s dollar (higher interest rates reduce the value of a share of stock). Also, the higher interest rates make investments other than stocks, such as bonds, more attractive raising the required return on stocks and reducing what investors are willing to pay for them. Also, the news of impending recession could raise stocks and affect stock prices, which in turn, have people spending less money and a smaller cushion to support the lifestyles that they are accustomed to living.

Unless there is a stock market crash, the effects of changes in stock values induced by monetary policy would be more concentrated on investment spending and less on consumption spending. The results of the changes in stock values in the long run could be devastating because the response would not be as fast as what the Federal Reserve would do to correct the situation.

Let’s also look at all the stock market crashes that have happened since