Today, the Federal Reserve announced it would shift from buying $85 billion dollars of bonds each month to buying $75 billion. The news of the $10 billion drop sent the stock market soaring. This post tries to explain what the bond buying program does.
First, you need to understand that bond prices are inversely related to interest rates. What does that mean? When bonds prices go up interest rates go down. When bond prices go down interest rates go up. The detailed reasons for this are explained in chapter 15 of my book “Business Macroeconomics”.
Buying either $85 or $75 billion of bonds each month is a lot of purchases. This means the Fed is shifting the demand curve for bonds to the right. At every given price for a bond there are now more people who wish to buy the bond than there would be if the Fed was not involved. When the Fed shifts the demand curve right, the price rises. Since bond prices are inversely related to interest rates, this means interest rates fall. The situation is graphed below.
A reduction from $85 billion to $75 billion means the demand curve each month is not being shifted to the right as much as before. However, given the $10 billion reduction is only about a 12% change, it appears Wall Street traders don’t think the reduction will have any major economic impact. Will the traders be right or wrong? Only time will tell.