One of the more mysterious areas of the economy is the role of the Fed. Formally known as the Federal Reserve, the Fed is the gatekeeper of the U.S. economy. It is the central bank of the United States -- it is the bank of banks and the bank of the U.S. government. The Fed regulates financial institutions, manages the nation's money and influences the economy. By raising and lowering interest rates, creating money and using a few other tricks, the Fed can either stimulate or slow down the economy. This manipulation helps maintain low inflation, high employment rates, and manufacturing output.
In this edition of stuff.dewsoftoverseas.com, we'll visit the mystical world of the Fed and talk about terms like monetary policy, discount rates, and open market operation. We'll find out just what kinds of tasks fill Alan Greenspan's day, and see how his and the Federal Reserve Board's decisions affect our everyday lives.
Inflation is not a good thing because it slows down economic growth.
For example, when inflation is high, things cost more and people spend less. They also do less long-term planning that involves spending money, such as building houses and investing. Businesses are affected in the same ways. When inflation is high, it tends to fluctuate quite a bit. This uncertainty makes people wary of spending money for fear that inflation will increase even more and they won't be able to pay their bills.
High inflation also adds additional costs to long-term interest rates. These costs are to offset the risk associated with inflation. The additional costs make borrowing money less attractive. When people don't buy things (when demand is down), then the supply of goods gets too high, production has to decrease, and unemployment increases -- in other words, recession hits.
When prices are stable (when inflation is low), consumers make more purchases, investments, etc., production output is maintained and employment remains high.
When recession hits, the Fed can lower interest rates in order to encourage people to borrow money and make purchases. This works in the short run, but it has to be handled carefully so that inflation isn't impacted in the long run.
The Fed has to carefully balance the short term goals of increasing output and employment with the long term goals of maintaining low inflation.
Maximum employment doesn't necessarily mean that everyone is working. Economists have a "natural rate" of unemployment that is ultimately the goal. If the unemployment rate is pushed too low -- below 5% or so -- inflation rises because more money is in the economy, and that goes against the long-term Fed goal of stable prices.
In its role as money manager, the Fed has two primary goals:
Maintain stable prices (control inflation)
Ensure maximum employment and production output
It achieves these goals indirectly by raising or lowering short-term interest rates. Although these are two separate goals, the outcome of each is the same -- a stable economy.
Monetary policy refers to the actions the Fed takes to influence financial conditions in order to achieve its goals.
The Fed's primary control is in the raising and lowering of short-term interest rates. In doing this, the Fed can indirectly influence demand, which then influences the economy. For example, if interest rates are lowered, borrowing money to make purchases becomes less expensive, and people are more motivated to spend money because they can get a better deal on the loan. Spending money, in turn, stimulates economic growth, which is what the Fed is trying to do in that instance. If there is too much money in the economy, however, people spend more money and demand increases at a faster rate than supply can match. Prices rise too quickly because of the shortage of products, and inflation results. If there is too little money in the economy, people don't have excess spending money, and there is little economic growth.
The Fed watches economic indicators closely to determine in which the direction the economy is going. By forecasting increases in inflation or slow-downs in the economy, the Fed knows whether to raise or lower interest rates or increase the supply of money.
Influencing inflation takes a long time and has to be looked at as a long-term goal. Influencing employment and output, however, can be done more quickly and therefore is a short-term goal. Finding the balance between the two is key. The lags in the effects that monetary policy has on the economy are significant. This is why the Fed has to make forecasts of inflation prior to it actually happening -- one, two or even three years in advance. If the Fed waited until inflation were apparent, then it would be extremely difficult to catch up and get it back under control. We'll talk about the economic indicators shortly.
Financial Institution Regulator
As a regulator for financial institutions, the Fed establishes the rules of conduct that these institutions must follow. The regional Reserve Banks then carry out the supervision and enforcement of these regulations. These regional banks monitor the activities of banks within their regions and ensure that they are operating appropriately.
The Federal Reserve also watches out for the public interest by monitoring banks that are seeking to merge with other banks or holding companies. The Fed rules on these requests according to the impact the merger will have on the local community and general public interest.
A Bank's Bank
Just as banks serve their customers, the Fed acts as a bank for banks. The Fed keeps the pipeline of transactions flowing. It processes and clears one-third of all the checks processed in the country -- that's about 20 billion checks per year. The regional Reserve Banks provide these services to the banks within their regions. The transactions are done on a fee basis, which is part of how the Federal Reserve supports itself. Banks are not required to use the Reserve Banks; they can choose to use a private competitor. This helps to ensure that the processing fees being charged are kept under control.
The Government's Bank
The Fed maintains the checking account of the U.S. Treasury. As the largest bank customer in the country, the U.S. government does quite a bit of business and performs a lot of financial transactions, all of which are handled by the Fed. These transactions amount to trillions of dollars and include all of the tax deposits and withdrawals for U.S. citizens. It also includes securities such as savings bonds, Treasury bills, notes, and bonds that are bought by and for the U.S. government.
Photo courtesy U.S. Treasury Treasury Secretary Lawrence H. Summers and Treasurer Mary Ellen Withrow unveil the new five and 10 dollar bills in November 1999.
The Fed also monitors the condition of currency and either sends it back into circulation or has it destroyed. Because there are times during the year when people need more cash, currency is stored at Reserve Banks so that banks can order more paper money as they need it. These "orders" are paid for with funds from the bank's reserve account balance held with the Fed.
When banks loan money, that money is spent on goods or services. These goods or services create income for the people providing them, which they in turn spend on other good and services. When lots of loans are made, even more spending is done and more money is pumping through the economy.
When the Fed sees that too much money is going through the economy and prices are rising too quickly (inflation), they put the brakes on by selling securities. This reduces the amount of reserves available to banks, causing interest rates to rise, and banks will not make as many loans because it costs more for consumers to borrow. Ultimately, the economy slows down and inflation slows down with it.
This percentage of required reserves directly affects how much money they can "create" in their local economies through loans and investments. It is this connection between the required reserve amount and the amount of money a bank can lend that allows the Fed to influence the economy. If the reserve requirement is raised, then banks have less money to loan and this will have a restraining effect on the money supply. If the reserve requirement is lowered, then banks have more money to loan.
Reserve money is used to process check and electronic payments through the Federal Reserve and to meet unexpected cash outflows. These reserves can be held as "cash on hand," as a reserve balance at a regional Reserve Bank, or both.
Although the Fed has the power to do so, changing the amount of reserve cash a bank has to have can have dramatic effects on the economy; for this reason, this tool is rarely used. The Fed more often alters the supply of reserves available by buying and selling securities. When the Fed sells securities, it reduces the banks' supply of reserves. This makes interest rates go up. When the Fed buys securities, it increases the banks' supply of reserves. This makes interest rates go down.
All of this buying and selling is referred to as open market operations (discussed below).
In the event that a bank's money supply drops below the required reserve amount, that bank can borrow either from another bank or from a Reserve Bank. If it borrows from another bank's excess reserves, then the loan takes place in a private financial market called the federal funds market. The federal funds market interest rate, called the funds rate, adjusts according to the supply of and demand for reserves.
If a bank chooses to borrow emergency reserve funds from a Reserve Bank, then it pays an interest rate called the discount rate.
The Discount Rate
The "discount rate" is the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis. The Fed discourages banks from borrowing except for occasional, short-term emergency needs.
The discount rate often plays a larger role in the overall monetary policy than would be expected because it is a visible announcement of change in the Fed's monetary policy. Typically, higher discount rates indicate that more restrictive monetary policies are in store, while a lower rate might signal a less restrictive move.
Changes in the discount rate can affect:
Lending rates (by making it either more or less expensive for banks to get money to lend or hold in reserve)
Other open market interest rates in the economy (because of its "announcement effect")
Open Market Operations
The most effective tool the Fed has, and the one it uses most often, is the buying and selling of government securities in its open market operations. Government securities include treasury bonds, notes, and bills. The Fed buys securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow.
Here's how it works. The Fed purchases securities from a bank (or securities dealer) and pays for the securities by adding a credit to the bank's reserve (or to the dealer's account) for the amount purchased. The bank has to keep a percentage of these new funds in reserve, but can lend the excess money to another bank in the federal funds market. This increases the amount of money in the banking system and lowers the federal funds rate. This ultimately stimulates the economy by increasing business and consumer spending because banks have more money to lend and interest rates are lowered.
When the Fed wants to decrease the money supply, it sells securities. That transaction deducts the purchase amount from the bank's reserve (or the dealer's account). This reduces the amount of money the bank has to lend in the federal funds market and increases the federal funds rate. This move ultimately slows the economy down by decreasing the amount of money banks have to loan, which increases interest rates and typically reduces consumer and business spending.
These decisions are made by the Federal Open Market Committee (FOMC), which consists of the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four rotating members from the other eleven Reserve Banks. This committee has eight meetings per year to discuss and direct the monetary policy. Additional emergency meetings are called when needed. The FOMC specifies either a quantity of reserves to be purchased or sold or a specific change in the federal funds rate. (The federal funds rate is the interest rate at which banks lend reserves to other banks.)
The Board of Governors
The Fed has a seven-member Board of Governors and 12 regional Reserve Banks. The U.S. president appoints (and the Senate confirms) the seven Governors, whose 14-year terms are staggered to prevent a single president from being able to appoint too many governors. The chairman of the Federal Reserve, who serves a four-year term, is also appointed by the president.
Member Banks of the Fed
Any national bank that is chartered by the federal government is automatically a member of the Federal Reserve System. State banks have to meet specific standards that the Board of Governors sets in order to become members.
Member banks are required to buy stock in their regional Reserve Banks. This stock doesn't give the bank any kind of voting privileges and cannot be sold or used as collateral for loans. What the banks do get is a six percent dividend on the stock and the ability to vote for the Class A and Class B directors of the Reserve Bank.
Each of the 12 Reserve Banks has nine directors on its board. The directors are responsible for the overall operations of their banks and report to the Board of Governors. The directors are divided into three groups that represent a cross-section of ideas and interests for the region. These groups are called Class A, Class B and Class C. Class A represents commercial banks that are members of the Federal Reserve System. These member banks elect both the Class A and Class B directors. Class B and C directors do not come from the banking industry. They represent the economic interests of the local district, including agriculture, manufacturing, labor, consumers and nonprofits, and are elected by the Board of Governors. This allows both the private sector and the government/public sector to have representation.
Regional Reserve Banks
Each regional Reserve Bank president is appointed to a five-year term by the bank's Board of Directors, but the Board of Governors gets the final say-so in the appointment.
The Federal Open Market Committee (FOMC) consists of the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, who acts as vice chairman, and four members from the other eleven Reserve Banks that rotate at the end of each year.
Any money the Fed has left over after it pays all of its expenses are sent to the U.S. Treasury. Since the Federal Reserve System began in 1914, about 95 percent of the Reserve Banks' net earnings have ended up being paid into the Treasury.
Information about the income and expenses of the Federal Reserve Board can be found in the Board of Governor's Annual Report.