We hear about “the Fed” or the Federal Reserve doing various things in the news, but what exactly is the Fed?
How can one institution be responsible for rising and falling interest rates, and why does the stock market bounce around every time the Federal Reserve Chairman speaks?
Understanding the Federal Reserve System
How can you understand a quasi-Federal agency that is still independent, has mysterious meetings that impact the nation’s economy, and can cause the stock market to go wild?
Here are some key areas to understanding what the Federal Reserve is, what it does, and the tools it uses to achieve its goals.
What is a Central Bank?
The Federal Reserve is the United States’ Central Bank. A central bank is a quasi-government institution that manages its country’s money supply and interest rates. Most central banks also are in charge of regulating the banking environment of the country.
A central bank is quite the odd concept. It can increase or decrease the money supply (which devalues the currency in its citizens’ wallets) in a variety of ways including changing lending interest rates, changing the required amount of capital that banks must keep on hand, being the bank for the government, and lending money to banks in a deep financial crisis. They are often called “the banker’s bank” and “the government’s bank.”
The overall goal of most central banks is currency stability and slow, gradual, dependable inflation. Having a currency’s value go up and down drastically will cause chaos within an economy. Having a small inflation of 1-3% per year that can be depended on to make financial decisions also provides stability. Additionally the central bank also wants to achieve a normal rate of employment (usually between 3 and 5% unemployment).
Central banks also control the physical money supply. They are in charge of printing or minting all currency and distributing it to the banks that consumers and businesses use.
What is Monetary Policy?
In a broad sense monetary policy is a set of tools that the Federal Reserve (and any other central bank) uses to influence the money supply in the country. How quickly the monetary supply grows in turn influences interest rates. Effective monetary policy helps the Fed reach its goals of stability within the currency and normal inflation.
Effective monetary policy leads to price stability due to low inflation. Consumers and businesses know that they can buy goods and services within the economy at a similar cost from day to day.
It also leads to somewhat consistent economic growth. Part of this is tied to price stability; a business knows it can invest its capital in tools, factories, and so forth and the price of what they’re producing isn’t going to be cut in half due to currency issues.
The Fed Earns Income
On top of its duties the Fed also earns an income from a variety of activities. The income is used to fund operations and any excess is diverted to the United States Treasury. Income is generated from holding government bonds, holding foreign currency that goes up in value, and interest on loans to banks.
The Fed’s Main Tools of Monetary Policy
The Federal Reserve has three main tools it uses in monetary policy:
1. Reserve Requirements
Of the three tools, reserve requirements are the easiest to understand. Banks are required to hold a certain amount of money on hand and the rest can be lent out again. For example, if the reserve requirement is set to 10% that means a bank with $1 million in deposits could potentially only have $100,000 on hand. The remaining $900,000 is back out in the economy earning income for the bank.
If the Federal Reserve raised the requirement to 20% then the bank would have to essentially pull $100,000 out of the economy. Doing this on a national scale will decrease the money supply.
Right now deposit institutions with net transaction accounts between 11.5 and $71 million are required to reserve 3% of liabilities. Those with accounts above $71 million have a 10% requirement.
2. Open-market operations
The most frequently used tool by the Fed is called open-market operations.
The Fed buys and sells US government securities in the open, public financial markets. The purchasing and selling of securities change the price of credit based on what the Fed is buying and selling. Their trades also change the level of reserves throughout the financial system.
For example, if the Fed announces it will slowly begin to purchase fewer US Treasuries that means the demand for those Treasuries will go down. When demand goes down on an investment, the price drops. When a bond’s price goes down the yield goes up. In purchasing fewer Treasuries — or just announcing that it will buy fewer Treasuries in the future — the Fed can increase the yield on US Treasuries throughout the market.
You may have heard the term Federal Funds Rate. This is the rate that banks loan to each other overnight in order to meet their reserve requirements. The Fed sets a target rate it believes will be best for economy. They then buy and sell securities to affect the supply of money that banks are holding.
So what does this have to do with the economy?
When the Fed wants to stimulate, or grow, the economy they target a low Federal Funds Rate. This means they make it cheaper to borrow money. When a bank has cheap money to borrow it tends to lend out more, knowing it won’t cost a lot to meet their reserve requirements. If the Fed wants to slow the economy it targets a higher Federal Funds Rate. When money is more expensive to borrow then it becomes more expensive for everyone else. This slows economic growth.
You may have noticed another affect of the Federal Funds Rate in your savings account. Your savings account rate tends to follow the Fed Funds Rate. As the Fed Funds Rate goes up, so does the interest rate you earn on savings. As it goes down your interest rate on savings goes down.
3. Discount rate
As mentioned above the Federal Reserve is the banker’s bank. Banks can borrow funds from the Fed, and they are charged an interest rate. The short-term lending rate is called the discount rate. This is a rate that is made public and is used as an indicator of what the Fed’s plans for the rest of monetary policy will be.
The discount rate is set in such a way to encourage bank institutions to find money elsewhere before they come to the Fed (in other words they charge enough interest so other places would rather borrow elsewhere).
And this leads leads us to another important function of the Federal Reserve…
Lender of Last Resort
When all else fails and an institution has nowhere else to turn for credit the Federal Reserve has the authority to extend credit to bail them out. This is usually only done when a bank’s collapse would seriously affect the economy.
Should I Pay Attention the Federal Reserve’s Monetary Policy Moves?
In the long run what the Fed does can impact every aspect of your life. If monetary policy is managed poorly we can end up with unstable prices and high inflation. It can also wreck havoc on savings and CD rates.
However, in the short term there are other areas of life that are more important to focus on. You can’t control whether the Fed will keep bond yields high or low. For the average American focusing on paying down debt, building up saving, and consistently saving for retirement is more important than watching the Fed’s every move.
