What's in the Fed's Toolbox?

It's difficult to overstate the impact the Federal Reserve has on our financial lives.

Officially, the Fed works to ensure maximum employment and stable prices using tools that influence both the supply of money and the cost of borrowing it. In turn, these tools help determine everything from the interest rate on your mortgage to the trajectory of the stock market.

Let's take a look at four such tools—from the ordinary to the extraordinary—and how they can influence the economy and the market.

• Federal funds rate: The Fed sets the base interest rate that banks charge one another for overnight loans, which in turn affects the interest rates banks charge businesses and consumers. When the economy is weakening, the Fed can lower the federal funds rate to stimulate borrowing and spending. When the economy is overheating, the Fed can raise the federal funds rate to dampen borrowing and spending.
• Open market operations: The Fed buys T-bills and other short-term securities when it wants to increase the flow of money and credit, and sells those securities when it wants to reduce the flow of money and credit.
• Quantitative easing (QE): When the federal funds rate and open market operations are insufficient to keep the economy afloat, the Fed may make large purchases of longer-term securities in order to keep long-term interest rates low and encourage lending and investment. To stimulate economic growth, for example, the Fed can purchase mortgage-backed securities, which increases the amount of money that banks have on hand to lend to businesses and consumers.
• Tapering: As the economy moves from recession to recovery, the Fed can gradually pull back its quantitative easing. As the Fed slows the pace of its large-scale asset purchases, the supply of money to lend and invest decreases, making borrowing more expensive—driving up interest rates—and triggering steep, if temporary, stock market declines (a.k.a., "taper tantrums").

It's important to understand how the Fed's actions affect the economy and market. However, it's just as important to pay attention to what the Fed is saying. Sometimes the mere hint of a policy change can move markets. That's not to say you should make investment decisions based on such news, but it can help you understand why the markets are acting the way they are even in the absence of Fed action.