In the CFA exam, you are asked to understand the goals and targets of Federal Reserve and also the tools it uses to achieve the goals. Let’s use the sub-prime mess example to illustrate the concepts you need to understand.

CFA exam: The goal of the Federal Reserve is to keep inflation low while at the same time make sure the economy is growing at a reasonable rate. Moreover, reduces the magnitude of the business cycle’s expansions and recessions.

Due to the sub-prime mess, there is credit crisis. Money is not enough. This will cause recession if it is not properly addressed. In order to achieve the goal (make sure the economy is growing), the Fed first release money through open-market operations, to make sure the federal funds rate is at the target of 5.25%. This successfully stabilized the stock market in the Friday before last week.

CFA exam: To achieve the federal fund rate, the Fed has 3 tools:

1)      Open market operations: selling or buying government securities to absorb or inject money into the market.

2)      Discount rate: Different from Federal Funds Rate which is the rate of inter-bank loans, discount rate is the rate bank has to pay when borrowing money from the Fed.

3)      Bank Reserve Requirements: Percentage of deposits the bank must retain. (For example if you deposit $100 in the bank, the bank must retain, e.g. $20 for 20% reserve, and the other $80 can be used to make another loan). So the reserve determines the money supply.

But obviously, open market operations were not enough and the stock plummeted again last week. Last Friday, the Fed announced to reduce the discount rate from 6.25% to 5.75%. This is a big move and financial institutes which need money in urgent can then borrow cheaply from the Fed. And the stock on Friday came back, followed by the jumps in the Asian markets this Monday.

If this still doesn’t work, what can the Fed do? It can try to reduce the Federal Funds Rate target in the next meeting. However, don’t forget that another goal of the Fed is to keep the inflation low. Economic data in the last few months showed that there is still quite a lot of inflation pressure. It may be difficult for the Fed to do so. So, let’s see how the Fed is going to walk along the thin line.