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Course Objectives and Syllabus
Terms to know BEFORE reading the article:
monetary policy, discount rates, and open market operation |
Warning! This is a
long one...
The Fed
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.
Before the Federal Reserve was created
in 1913, there were over 30,000
different currencies floating
around in the United States. Currency
could be issued by almost anyone -- even
drug stores issued their own notes.
There were many problems that stemmed
from this, including the fact that some
currencies were worth more than others.
Some currencies were backed by silver or
gold, and others by government bonds.
There were even times when banks didn't
have enough money to honor withdrawals
by customers. Imagine going to the bank
to withdraw money from your savings
account and being told you couldn't
because they didn't have your money!
Before the Fed was created, banks were
collapsing and the economy swung wildly
from one extreme to the next. The faith
Americans had in the banking system was
not very strong. Banking in the US was a
mess. This is why the Fed was created.
There are many internet sites that claim
the Federal Reserve Bank is at its very
essence unconstitutional, that Woodrow
Wilson was a tool of some huge
international conspiracy to take over
the US when he signed the bill to create
the Fed in 1913, that the very bill
proposed by Congress was a con job by a
handful of co-conspirators that had the
bill voted on during a Christmas recess,
and that JFK was even murdered because
he signed Executive Order 11110 into
law...you get the idea. This is where
our attempt to create an educated
citizen with a fully developed BS
Detector is so critical. (We're
referring to you students out there!) As
Ronald Reagan used to say, "Trust, but
verify."
The Fed is a Good
Thing
The Fed's original job was to organize,
standardize and stabilize the monetary
system in the United States. It had to
set up a method that could create "liquidity"
in the money supply -- in other words,
make sure banks could honor withdrawals
for customers. It also needed to come up
with a way to create an "elastic
currency," meaning it had to
control inflation by making sure prices
didn't climb too quickly, and
it needed a way of increasing or
decreasing the country's supply of
currency in order to prevent inflation
and
recession. In the next two sections,
we'll discuss both inflation and
recession.
Inflation
Inflation
is not a
good
thing
because
it slows
down
economic
growth.
Inflation
is when
interest
rates,
prices,
and,
ultimately,
way
behind
the
curve,
wages,
tend to
go up a
lot all
at once.
It's not
a good
thing.
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.
Recession
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.
The Fed's Job:
The Fed regulates financial
institutions, acts as the U.S.
government's bank, acts as a bank's
bank, and is responsible for managing
the nation's money. The Fed has two
divisions: One group, the Board
of Governors, is responsible
for setting monetary policy and managing
the nation's money; the other group, the
12 regional Reserve Banks,
acts as the service division that
carries out the policy and oversees
financial institutions. The regional
Reserve Banks represent the private
sector. Both of these groups have the
same goals.
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. In the following
sections, we'll discuss the goals and
the way the Fed goes about achieving
them.
Fed Tasks: Monetary
Policy
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 increase or decrease 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.
Fed Tasks: 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.
Fed Tasks: 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.
Fed
Tasks:
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.
Coin
and
paper
currency
produced
by the
U.S.
Treasury's
Bureau
of the
Mint
and
Bureau
of
Engraving
and
Printing
is
distributed
to
financial
institutions
by the
Fed as
part of
its role
as the
government's
bank.
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.
The Fed
Tool
Box: The
Reserve
Requirement
The most
important
job the
Fed has
is to
manage
the
nation's
money
and the
overall
economy.
Controlling
the
inflation
rate and
maintaining
employment
and
production
aren't
easy
tasks.
The Fed
has to
have
some
pretty
hefty
tools up
its
sleeve
in order
to
influence
the
economy
of an
entire
country
--
especially
one the
size of
the
United
States.
The Fed
has to
be able
to
affect
the rate
at which
consumer
banks
and
financial
institutions
create
"checkbook"
money
for
customers
through
the
loans
they
grant
and
investments
they
offer.
They do
this by
influencing
short-term
interest
rates
and the
amount
of money
in
circulation.
But how does it do that? The Fed uses three tools:
- The reserve requirement
- The discount rate
- Open market operations
The Reserve Requirement
In order to combat the problems of insufficient cash reserves (and the inability to pay depositors) that were faced before the creation of the Federal Reserve System, banks now have to set aside a certain amount of cash in "reserve." The reserve balance that banks must maintain is typically a percentage of their total interest-bearing and non-interest-bearing checking account deposits (currently 3% to 10%). In other words, the amount of a bank's required reserves will fluctuate depending on their account totals. The reserve is very important because it helps to ensure that the bank will always be able to give you your money when you ask for 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 Fed Tool Box: 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")
The Fed Tool Box: 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 Fed Setup: Decentralization & Board of Governors
The Federal Reserve System was established in 1913 when Congress passed the Federal Reserve Act. Although the Fed is independent of the government, it is ultimately accountable to Congress because Congress can amend the Federal Reserve Act at any time. Its actions, however, do not require any kind of approval from the government.
The Fed is called a "decentralized" central bank, which in itself seems to be a contradiction. It works, however, because the Fed is uniquely structured to eliminate government control but still remains accountable to both the government and the public. The Board represents the interests on the government side, and the regional Reserve Banks (whose boards of directors consist of local citizens) represent the interests of the private side. In order to operate independently of the government, the Fed finances its own operations.
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.
The Fed Setup:
Directors, Regionals, FOMC
District Directors
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.
FOMC
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.
Economic Indicators
In order to develop the nation's monetary policy, the FOMC looks at many economic indicators. This gives the FOMC a feel for what the economy is doing and what direction it may be taking. It also looks to the The Beige Book, which is a report that summarizes comments received from businesses and other contacts outside of the Federal Reserve. This, in addition to economic indicators, forms the basis for the FOMC's monetary policy.
The Federal Reserve chairman accesses data about the economy every half hour or so when things in the economy are calm, and every 15 minutes when things aren't. This is simply to make sure nothing is happening in the economy that the chairman doesn't know about. The chairman can also tap into a network of business contacts that provide insight into a wide range of businesses, revealing who is buying what and in what amounts. By staying on top of where the economy is right now and where it is going, the Fed can project future changes and act accordingly.
Here are the economic indicators examined by the Fed:
- Consumer Price Index (CPI) - This indicates the change in price for a fixed set of merchandise and services intended to represent what a typical consumer might purchase over a given period. It is compiled monthly by the U.S. Department of Labor's Bureau of Labor Statistics. By keeping track of the rate of change in the CPI, the Fed can get an accurate measure of inflation.
- Real Gross Domestic Product (GDP) - The GDP is the total of all of the goods produced in the United States, regardless of who owns them or the nationality of the producers. The measurement is produced quarterly and accurately represents national output, meaning it uses real terms so inflation doesn't distort the numbers. It is used as an indicator of the performance and growth of the economy.
- Housing Starts - Because housing is very sensitive to interest rates, this indicator is tells the FOMC how financial changes are affecting consumers. Housing starts are an estimate of the number of housing units that started construction in a given period. The report is produced monthly.
- Nonfarm Payroll Employment - This measurement includes the total number of payroll jobs that are not in the farming business. It is produced each month by the U.S. Department of Labor's Bureau of Labor Statistics and also includes information about the total number of hours worked and hourly wages earned by workers. It is helpful to the FOMC as an economic indicator because it indicates the pace (or changes in the pace) of economic growth. The average hourly earnings number also shows trends in supply and demand.
- S&P Stock Index - The Standard & Poor Index shows the FOMC the changes in price in a very wide variety of stock. S&P compiles the index daily. The value of watching this index as an indicator of the economy is that it often indicates the confidence consumers and businesses have in the economy. If the market is rising, then investments and spending will rise; if the market is low or falling, then investments and spending will also slow down.
- Industrial Production/Capacity Utilization - This measures industrial output both by product and by industry. It is compiled by the Board of Governors each month and is useful because it tells the FOMC about the current growth of the Gross Domestic Product. By understanding the level of capacity utilization, the FOMC can understand how well resources are being utilized. All of this can indicate future changes in the rate of inflation.
- Retail Sales - This is a total of all merchandise sold by retail merchants in the United States. The numbers are presented in dollar amounts, and are adjusted for seasonality but not for inflation. The U.S Department of Commerce produces this report each month. This measurement tells the FOMC how much consumers are buying. This is called the personal consumption expenditure and indicates future growth or lags in the economy.
- Business Sales and Inventories - This is a measurement of the total sales and inventories for the manufacturing, wholesale, and retail sectors. This report is compiled monthly by the U.S. Department of Commerce and can be a good indicator of growth or slow downs in the economy because it shows the level of inventory and whether it is moving or not. Inventory that isn't moving indicates a future slow down; inventory that is moving may indicate an increase in future production.
- Light-Weight Vehicle Sales - Because changes in car sales can account for a large portion of the change in the GDP from quarter to quarter, this measurement has to be taken into account. The report is compiled by Ward's Automotive Reports and the American Automobile Manufacturer's Association, and seasonally adjusted numbers are generated by the U.S. Department of Commerce and the Bureau of Economic Affairs.
- Yield on 10-year Treasury Bond - This is simply the current market rate for U.S. Treasury bonds that will be maturing in 10 years. This is good as an indicator because mortgage rates tend to follow it. Changes in mortgage rates, in turn, indicate future changes in the housing industry.
- M2 - Because there is often a link between the supply of money and the growth of the GDP, this measurement is yet another indicator that the FOMC looks to when making decisions about monetary policy. The report is produced by the Board of Governors weekly and monthly.
Economic Indicators: Leading, Coincident, Lagging
Economic indicators are categorized as leading, coincident, or lagging. Leading indicators anticipate the direction in which the economy is going. Coincident indicators tell the Fed about the economy's current status. Lagging indicators help the Fed determine how long a downturn or upturn in the economy will last because these indicators are affected months after an upturn or downturn has begun.
By studying the indicators as they fall into these categories, the Fed can determine the phase of the business cycle that the economy is in at the time. The four phases of the business cycle are:
- Expansion or recovery
- Peak
- Contraction or recession
- Trough
The categories of "leading," "coincident," and "lagging" indicate the turning points of the economy relative to the business cycle. As the economy moves from one phase to the next, these indicators change.
For more detailed information about how economic indicators work, check out Economic Indicators on the Fed 101 Web site. The cartoon below may be a bit harsh, but it really drives home the idea of "Economic Indicators!"
How does the Fed support itself?
In order to remain independent of the U.S. government, the Federal Reserve totally supports itself. It generates its income for the most part from interest. This interest comes from many sources, including:
- Government securities that it acquires through open market operations
- Foreign currency investments
- Bank/depository institution loans that the Fed makes using the discount rate
The Fed is also paid fees for services it provides such as funds transfers (Fedwire), check processing, and automated clearinghouse (ACH) operations. (ACH options are electronic alternatives to the paper-based check system. Examples include automatic payroll deposits and electronic bill paying.)
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.
Checks and Balances
The structure of the Federal Reserve was carefully laid out to incorporate a strong system of checks and balances. Its decentralized status and broad range of participants eliminates the chances of any one group having too much control.
Each of the Fed's tools is under the authority of a different group within the system. For example, the Board of Governors has the authority to change bank reserve requirements; the boards of directors for the individual Reserve Banks can initiate changes to the discount rate (which then has to be approved by the Board of Governors); and the open market operations (the most important tool) is controlled by the FOMC, which represents both groups.
These checks and balances, along with the overall structure of the Federal Reserve, make sure that partisan interests don't have too much control and ensure that the Fed's decisions represent the broad interests and needs of the entire United States.
For more information on the Federal Reserve System and related topics, check out the links below:
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Homework:
Create an InfoGraphic in the form of Graphic Notes that encompasses
everything there is to know about the Fed. The information for your
InfoGraphic is provided here.
Success comes in cans, failure in can'ts.
-
Author Unknown
Opportunity is always knocking. The problem is that most people
have the self-doubt station in their head turned up way too loud to
hear it.
- Brian Vaszily
Opportunity dances with those who are already on the dance floor.
- Jackson Brown
People often say that motivation doesn't last. Well, neither does
bathing - that's why we recommend it daily.
- Zig Ziglar
Life is not about how fast you run, or how high you climb, but how
well you bounce.
- Unknown
Maximum Employment
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.
How do loans
"create" money?
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.
Money Supply Measures
The Fed categorizes money based on
its liquidity. It is divided into
three categories:
-
M1
- The actual cash money supply,
spending money, checking accounts
and currency
-
M2
- A larger category that includes
M1, small savings accounts and time
deposits at banks, and money market
mutual funds
-
M3
- Larger and less liquid, including
corporate CDs, etc.
You'll hear these terms when you
listen to the Nightly Business Report on
NPR.
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