The economy of the United States is a seemingly complex (but actually simple) engine for continuous growth, driven by fluctuations in the amount of money that exists. Because of this deceptive disguised simplicity, relatively few people actually understand how our economy operates. Inherent to an understanding of the American economy is an understanding of the Federal Reserve System, or “Fed”. The Fed itself is often misunderstood, and there is a lot of misinformation about its powers and actions. Everyone seems to agree that it is important and powerful, but how and why remains somewhat obscure.
EXECUTIVE SUMMARY
There has been a lot of news about “The Fed,” and they seem to have some sort of impact on the movement of the markets. But, just exactly what is the Federal Reserve Bank, what does it do, and what is this mystical power it has over us and our economy? Let’s try to clear up the obscurity, at least a little bit.
The Federal Reserve System was created in 1913 to stabilize the banking system by becoming the central bank for the United States. To prevent the Fed from falling prey to partisan politics, it is distanced from the government—in its day-to-day business, the Fed operates independently of any governmental authority. The Fed is not a single institution. There are 12 Federal Reserve Banks in major cities and 25 additional branches in smaller cities, led by a seven-member Board of Governors headed by a Chairman, currently Ben Bernanke, and a twelve-member Federal Open Market Committee (FOMC). Members of the Board of Governors are appointed by the President—the only direct political control the Fed is subject to. Individual banks are part of the Federal Reserve System—membership is required for all national banks, and state banks may also join.
The primary responsibility of the Fed is to regulate the money supply—currency in circulation and the deposits and reserves held by banks. If the Fed believes the rate of our economic growth is too rapid, it will reduce, or “tighten” the money supply; if growth is stagnating, the Fed will increase, or “loosen” the money supply. The amount of money in circulation in turn influences the rate of borrowing—it becomes a matter of supply and demand. When more money is available, it is easier to borrow (lower rates, looser credit); when less money is available, the reverse is true. Unfortunately we are a borrowing nation. There is more than $2,545,000,000,000 (trillion) in outstanding consumer debt owed by you and me.
The difference between the federal funds rate and the prime rate is known as the “spread.” (It is typically three percentage points, although not exactly and not always.) When the cost of borrowing drops because the supply of money increases, demand for borrowing increases. The opposite is true when reserves decrease and the federal funds rate increases. In this case, the prime rate increases, the price of borrowing increases, and demand for loans decreases. Reduced borrowing slows spending, which in turn slows economic expansion.
In the long term, higher interest rates tend to curb growth and lower stock prices, while making bond and cash equivalent investments more attractive; alternatively, lower rates may boost securities prices, as growth makes more investors become comfortable accepting additional risk. The power group is the FOMC. It holds regular meetings, at which it decides to loosen, tighten, or not change monetary policy, and issues a “Risk Statement” about current economic conditions. These statements are considered reliable indicators of what the Fed plans to do in the future. When the Fed talks, analysts and traders listen and speculate. Suppose the Fed gave an indication that interest rates were going to be cut. Enter the speculators: “How Much?” If the speculators think that rates will be cut by ½ % and the Tuesday Fed announcement is for ¼ %, the markets will drop. Period. On the other hand, if the guessers think ¾ % would be nice and it turns out ¾ % is cut, like last week, markets go up.
So, even speculation about future Fed action can influence the pace of trading on securities markets, altering securities prices. Public statements by the Fed, especially by the Fed chairman, have a substantial effect on market activity. But we investors put way, way too much emphasis on guessing what the Fed will do. The media fuels much of this by devoting endless hours of coverage to the subject. While we cannot control the actions the Fed takes at their meetings, we can control the way we react to Fed actions. Don’t over react!
So, are higher or lower interest rates better for you and me? The answer is simply,“Yes.”
The Federal Reserve System, created in 1913, is the central bank for the United States. The primary responsibility of the Fed is the regulation of the money supply (including all currency in circulation and the deposits and reserves held by banks). The amount of money in circulation in turn influences the rate of borrowing. When more money is available, it is easier to borrow money; when less money is available, the reverse is true. The rate of borrowing in turn has a significant effect on the rate of growth. Hence, the Fed regulates economic growth without regulating economic growth. More precisely, the Fed regulates the money supply, and leaves the regulation of the rate of borrowing, and therefore economic growth, to the forces of supply and demand (“The Invisible Hand” of Free Market Economics). Before 1913, there was no real centralized control over the money supply, and bank “panics” and other minor financial crises were frequent. The Fed was designed to stabilize the banking system—a job it does admirably, and with considerable finesse.
If the Fed believes the rate of growth is too rapid, it will reduce, or “tighten”, the money supply; if growth is stagnating, the Fed will increase, or “loosen” the money supply. To prevent the Fed from falling prey to partisan politics, it is distanced from the government—in it’s day-to-day business, the Fed operates independently of any governmental authority.
The Fed is not a single institution. There are 12 Federal Reserve Banks in major cities and 25 additional branches in smaller cities, led by a seven-member “Board of Governors” headed by a Chairman, and a twelve-member Federal Open Market Committee (FOMC). Individual banks are also part of the Federal Reserve System—membership is required for all national banks, and state banks may also join. Members of the board of Governors are appointed by the President of the United States—the only direct political control the Fed is subject to.
The primary function of the Fed is to maintain the health of the economy. This ideally means low inflation, high employment, moderate interest rates, strong financial markets, and a stable currency. This is a delicate balance, since high employment can lead to inflation, undermining financial markets; however, ameliorating the effects of inflation may slow down the economy, weakening markets. Some variation is normal; the Fed is responsible for preventing things from getting out of control.
The regulation of the money supply is known as “Monetary Policy”. The primary tool used by the Fed in setting Monetary Policy is the careful manipulation of Short-Term Interest Rates. Banks typically adjust their interest rates in lockstep with short-term rates both in terms of loan rates and interest paid on deposits. Fed actions, or even speculation about future Fed actions, can also influence the pace of trading on securities markets, altering securities prices. In the long term, higher interest rates tend to curb growth and lower stock prices, while making bond and cash equivalent investments more attractive; alternatively, lower rates may boost securities prices, as growth makes more investors become comfortable accepting additional risk.
The FOMC holds regular meetings, at which it decides to loosen, tighten, or not change monetary policy, and issues a “Risk Statement” indicating current economic conditions. These Risk Statements are considered a reliable indicator of what the Fed plans to do in the future. As mentioned above, the relative tightness or looseness of Monetary Policy determines the rate of borrowing, which influences the rate of economic growth.
Open Market Operations
To translate its policy decision about the money supply into action, the FMOC authorizes the New York district bank to trade securities on the open market. While the Fed is authorized to conduct open market operations in any type of security, such as stock or corporate bonds, it traditionally trades only U.S. government bonds.
What that means, in practice, is that the Fed either buys or sells government bonds from banks and investors. The Fed buys to loosen the money supply and sells to tighten the money supply. When it buys, it credits the reserve account of the bank that sells the bonds, increasing the reserves that bank has available to lend. When subsequent lending occurs, more money goes into circulation (this can be thought of in terms of newly printed Federal Reserve Notes, although most of the money in circulation is in the form of checkable deposits that are really only electronic data recording the contents of accounts). As borrowers spend what is loaned to them, the money is deposited and redeposited in other banks, which then have additional reserves to make loans themselves.
When the Fed sells in order to tighten the money supply, the reverse is true: it debits the cost of the bonds a bank buys from the bank’s reserve account, reducing the amount the bank has available to lend.
Changing Interest Rates
When the money supply is changed, interest rates also change. In fact, an increase or decrease in short-term rates is what the Fed is trying to achieve in authorizing its open market operations. This is done indirectly, through utilizing the market forces of supply and demand, rather than through direct control over economy.
As reserves increase and the money supply expands, the interest rate known as the federal funds rate drops. That is the rate that banks charge each other for very short-term, overnight loans. A drop in the federal funds rate results in an immediate drop in the prime rate. That rate determines the interest rate banks charge on consumer and business loans. And when the cost of borrowing drops because the supply of money increases, demand for borrowing increases. The opposite is true when reserves decrease and the federal funds rate increases. In this case, the prime rate increases, the price of borrowing increases, and demand for loans decreases. Reduced borrowing slows spending, which in turn slows economic expansion.
While the federal funds rate may change in response to supply and demand without Fed action, it always changes when the Fed buys and sells.
The difference between the federal funds rate and the prime rate is known as the “spread”. It is typically three percentage points, although not exactly and not always. For example, if the fed funds rate is 2.25%, the prime rate is 5.25%. If the Fed raises rates to 2.50%, the prime rate will rise in lockstep to 5.50%.
In addition to direct control over Interest Rates, the Fed influences the money supply by raising or lowering the “Reserve Requirement” and the “Margin Requirement”, as well as through what is known as “Moral Suasion”. The Reserve Requirement is the percentage of deposits a bank must keep liquid in it’s own account; increases will tend to slow borrowing, and decreases will tend to have the opposite effect. The Fed has not used this particular tool in some time. The Margin Requirement is the amount of real money a investor must put up when buying securities on Margin; increases will slow investor margin orders, and decreases will do the reverse. This tool has also not been used in many years. Finally, moral suasion in the form of public statements by the Fed, especially by the Fed chairman, can have a substantial effect on economic activity. For example, if the Fed releases a report predicting economic growth in the near future, this may spur otherwise hesitant investors to action.
Besides setting Monetary Policy, the Fed also provides a clearinghouse for all checks that pass through the domestic banking system, manages the circulation of currency, regulates the activities of member banks, and handles the day-to-day banking requirements of the US Government. For practical purposes, many of these responsibilities are delegated to regional banks. Perhaps the most important responsibility of the Fed beyond setting Monetary Policy is in serving as the lender of last resort.