Federal Reserve

Federal Reserve

Federal Reserve

- Federal Reserve and monetary policies Perhaps the part of the U.S. economy most closely watched by investors, the Federal Reserve is a somewhat misunderstood institution. Most investors think of the Federal Reserve as being Alan Greenspan and the Federal Open Market Committee (FOMC). While this group might be the most influential within the Federal Reserve System, it is a small part of the whole picture. This section will provide a brief overview of the Federal Reserve and its different parts, as well as looking at how the FOMC sets monetary policy and attempts to guide the economy.
The Federal Reserve System Basically, the Federal Reserve System is America's central bank. It was established in 1913 to maintain a sound and stable banking system throughout the United States and to promote a strong economy. The Federal Reserve System is composed of 12 regional banks in major cities around the country and the Central Bank, which is run by the Board of Governors and is based in Washington, D.C. The Board of Governors is made up of 7 members that are appointed to 14-year terms by the President and approved by the Senate. Almost all banks are a part of the Federal Reserve System, which requires that those banks maintain a certain percentage of their assets deposited with the regional Federal Reserve Bank. These "reserve requirements" are set by the Board of Governors and by changing the requirements, the Federal Reserve System can greatly impact the amount of money supply in the economy. Because of the great impact of changing the reserve requirement, the Federal Reserve rarely does this.

The Federal Reserve System wears a great number of hats. First, it serves as a bank for banks: many transactions between banks are processed through the Federal Reserve System. Financial institutions are also able to borrow money through the Federal Reserve, but only after attempting to find credit elsewhere; the Federal Reserve System provides credit only when it cannot be found in the markets or in cases of emergency. Second, the Federal Reserve System acts as the government's bank. The tax system processes incoming and outgoing payments through a Federal Reserve checking account. The Federal Reserve also buys and sells government securities. The Fed even issues the U.S. currency, although the actual production of the currency is handled elsewhere. Third, the Federal Reserve System acts as a regulatory agency. The Fed polices the banking industry to make sure that things run smoothly and that the rights of consumers are protected

FOMC and Monetary Policy Simply put, monetary policy is economic policy implemented through the control of the money supply. By increasing or decreasing the amount of money flowing through the economy, monetary policy can impact the growth rate of the country. The Federal Reserve System has several methods to implement monetary policy. For example, the regional banks, with the approval of the board of governors, can alter the money supply by changing the reserve requirements for banks within the system. However, the most powerful entity within the Federal Reserve System in terms of monetary policy is the Federal Open Market Committee (FOMC). This group, headed by the Chairman of the Federal Reserve Board, currently Alan Greenspan sets interest rates either directly (by changing the discount rate) or through the use of open market operations (by buying and selling government securities which affects the federal funds rate). The discount rate is the rate at which the Federal Reserve Bank charges member banks for overnight loans. The Fed actually controls this rate directly, but it tends to have little impact on the activities of banks because these funds are available elsewhere. This rate is set during the FOMC meetings by the regional banks and the Federal Reserve Board. The federal funds rate is the interest rate at which banks loan excess reserves to each other. While the Fed can't directly affect this rate, it effectively controls it in the way it buys and sells Treasuries to banks.

The voting part of the FOMC is made up of the 7 members of the Federal Reserve Board of Governors and 5 of the 12 Reserve bank presidents. The president of New York's Reserve bank is always a voting member (the open market operations are actually executed through his/her bank) while the other four members are rotated every year in equal proportions. The other presidents of the Reserve Banks attend each meeting and provide input, but do not vote. There are 8 scheduled meetings during the course of each year. However, when circumstances dictate, the Fed can make inter-meeting rate changes. While these are fairly rare, the inter-meeting rate changes signal an aggressive move by the Fed and can have a big impact on the markets. At regular meetings, the FOMC sets the federal funds rate by determining a plan of open market operations. The group of 19 also sets the discount rate, which technically is set by the regional banks and approved by the Board. Recently, the FOMC has begun announcing its actions at the end of every meeting. At these announcements, the chairman will generally announce what the committee has decided to do with the discount rate, the federal funds rate, and what the committee's "bias" is. With the discount rate, the committee can increase it, decrease it, or leave it unchanged. Increasing interest rates, or raising them, is called "tightening" the money supply because in the long run it will reduce the amount of money flowing through the economy. Lowering interest rates, or cutting them, is called "easing" because it increases the money supply. Generally, analysts believe that changes in the discount rate will have little direct effect on things because banks can get credit from outside sources fairly easily. Instead, changes are viewed with respect to how they will affect future changes to the federal funds rate. The Fed has the same three options with the federal funds rate. Generally, moves are made in increments of .25%. This is referred to as "a quarter point" or "25 basis points". A more significant move is a half-point (50 basis points, or .50%). In particularly desperate circumstances, the Fed might make a 0.75% change to the rates, but this is not typical. These changes are actually undertaken through open market operations. By carefully buying and selling government securities, the Fed can actually change what other banks charge each other for short-term loans. Over time, as these changes take place, the money supply changes, affecting the economy as a whole. But, this does take time. Most analysts believe that monetary policy takes at least 6 months to start affecting the economy. So, in addition to all its other concerns, the members of the FOMC have to be able to predict what the conditions will be when these rate changes take hold, and this can be difficult. Finally, with its bias, the Fed indicates what it is thinking it might do in the future. Usually the announcement will say that the Fed continues to be concerned about increasing inflation (a tightening bias), that it continues to be concerned about slow growth (a loosening bias), or that it is not concerned about either (a neutral bias). Of course, the remaining question is why the Fed wants to make all these changes to monetary policy and the economy. The mission of the FOMC is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." The way it tries to maintain this is by creating a sustainable level of growth in the economy. If growth is too fast, the goal of stable prices will be lost due to inflation. If growth is too slow, unemployment will rise, meaning the Fed is not properly maintaining maximum employment. Therefore, the Fed tries to use monetary policy to maintain a sustainable level of growth for the economy that will keep inflation and unemployment under control. Of course, there isn't some interest rate level that is "correct" and will maintain sustainable growth; as circumstances change domestically and globally, the optimal interest rate for the U.S. will change. As an example, when the Japanese economy fell apart, it greatly affected the amount of exports sent to Japan. This in turn slowed down the U.S. economy, forcing the Fed to cut interest rates in an attempt to increase growth. Generally, the Fed is trying to execute what is known as a "soft landing." If the economy is growing too fast, this is when the Fed raises rates to the point where the economic growth slows to a sustainable level, but not so tight that the economy slips into a recession (a decline in GDP for two or more consecutive quarters). If the economy is growing too slowly, the Fed will cut interest rates enough to spark sustainable growth, but not create increased inflation.

As a side note, when you hear someone refer to "the Fed," they generally mean the Federal Reserve System. Sometimes it will sound as if the FOMC or the Federal Reserve Board is being called the Fed, but that is only because this committee sets policy for the system as a whole.

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