Understanding the Federal Reserve, Part One: The Basics

This is part one of a series on Understanding the Federal Reserve.

The Federal Reserve, also referred to as the Fed, is the central bank of the United States. It makes policy decisions based on economic data and various indicators. Investors keep a close watch on everything the Fed does, including changes to interest rates and monetary policies. The central bank’s decisions not only impact investments in the U.S., but they can also have broader impacts on other markets.

History 

The Federal Reserve was created in 1913 when the U.S. enacted the Federal Reserve Act. Congress and then-President Woodrow Wilson created the Fed in response to the Panic of 1907, a three-week financial crisis during which the S&P 500 plummeted nearly 50% from its peak the previous year. The Fed takes a number of steps to ease financial crises and keep the economy in check during times of expansion, with the goal of preventing it from overheating.

As the central bank of the U.S., the Federal Reserve also oversees the U.S. currency. The first attempt to create a national currency was during the Revolutionary War. However, problems erupted due to over-printing and counterfeiting by the British, so the value of the currency plunged. States were also issuing currencies, which complicated the matter further. 

The first central bank wasn’t created until 1791 when the First Bank of the United States was created. However, Congress wouldn’t renew its charter in 1811, so the central bank folded. The Second Bank of the United States was set up in 1816, but it lasted only 20 years. Both of the first two central banks were based on the Bank of England. It wasn’t until the Federal Reserve was established in 1913 that the U.S. got its first true central bank.

Since the Federal Reserve Act, a number of other laws have been enacted to govern monetary policies. The most recent was the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law after the 2008-2009 financial crisis.

Structure

The Federal Reserve is governed by a board, and there are 12 regional Federal Reserve Banks in cities across the U.S. The president appoints members to the Federal Reserve Board, which contains seven members and oversees the 12 District Reserve Banks. 

The 12 district banks are located in Chicago, New York, Boston, Philadelphia, Atlanta, Kansas City, St. Louis, Dallas, San Francisco, Richmond, Cleveland and Minneapolis. Each of these 12 banks manages a number of member banks which are located in their districts. Member banks elect six of the nine members of each District Federal Reserve Bank’s board of directors. 

Another important part of the Federal Reserve is the Federal Open Market Committee (FOMC), which is made up of 12 members. Seven of them are from the Fed’s board of governors, and five are the presidents of the regional Federal Reserve Banks. The FOMC oversees policies on the open market, which means it makes important decisions on interest rates and the nation’s money supply. 

Interest rates

The Federal Reserve Act gave three main objectives for the central bank. Maximizing employment and stabilizing prices are widely considered the Fed’s dual mandate, although the third one, managing interest rates, is equally as important. Interest rates are essentially a tool used to accomplish the dual mandate.

The Fed can take many different actions to influence the cost and availability of money and credit. There are three main monetary policy tools that can be used to influence the money supply in the nation’s private banks. They are discount rates, the sale and purchase of bonds and changes to the amount of funds banks must keep in reserve.

One of the most important functions of the Fed is to deal with interest rates. The key rate is the federal funds rate, which is the rate banks pay to lend money to each other. The federal funds rate is impacted by all three of the Fed’s mtools, and the FOMC is tasked with making adjustments to it. The federal funds rate is actually a short-term interest rate, but it impacts the rest of the longer-term rates which are set all across the rest of the economy. 

The Fed also sets the discount rate, which is the interest rate member banks get on overnight loans from the Fed. The discount rate is usually about 100 basis points higher than the federal funds rate that’s being targeted. It’s higher than the federal funds rate because the Federal Reserve is considered to be the lender of last resort, so member banks are pressed to look for a loan elsewhere first. 

Together, the federal funds rate and discount rate impact the prime rate, which is generally approximately three percentage points higher than the federal funds rate. 

Open market operations

A key part of adjusting the federal funds rate is what the Federal Reserve describes as “open market operations.” The central bank can adjust the supply of money that’s available in the banking system to balance its dual mandates. The Fed adjusts the money supply by buying and selling government bonds. It buys Treasuries from primary dealers, which have accounts at banks.

The process is called open market operations because dealers compete for the Fed’s business by offering lower prices than others. When the Fed wants to increase the amount of money reserves, it purchases securities by depositing funds into the Federal Reserve account of the primary dealer’s bank. On the other hand, when the Fed wants to reduce the amount of money that’s available, it sells securities and pulls money from those accounts. 

Other tools to affect monetary policy

From time to time, the Fed introduces new tools to adjust monetary policy. For example, the central bank introduced three new tools to manage the subprime mortgage crisis and housing bubble. The four tools are the Term Auction Facility, the Term Securities Lending Facility, the Primary Dealer Credit Facility and the Term Deposit Facility. 

The Federal Reserve uses the Term Auction Facility to inject cash into the nation’s banking system by offering funding to banks in the form of credit through a bi-weekly auction. It uses the Term Securities Lending Facility to inject Treasuries instead by auctioning off a set amount of lending of Treasury general collateral. In exchange, the Fed receives residential mortgage-backed securities. 

The Fed uses the Primary Dealer Credit Facility to loan money to primary dealers at the current discount rate for up to 120 days. Under the Term Deposit Facility, Reserve Banks offer term deposits to banks which are eligible to receive earnings on their balances at the Reserve Banks. 

Quantitative easing and tightening

Another important aspect of the Federal Reserve’s responsibilities is keeping the economy in check, which it does using the tools already mentioned above and rounds of so-called “quantitative easing” or “quantitative tightening.” 

Quantitative easing involves buying securities from the market to boost the amount of money that’s available and encourage investment and lending. By increasing the money supply, the Fed increases banks’ liquidity, making it easier for them to invest and lend money to others. This makes it easier and less expensive for individuals and businesses to borrow money, which means more money is available to everyone. 

In most cases, quantitative easing is done when interest rates are so low that they’re at or close to 0%. Usually the securities being purchased are government bonds. The Fed used quantitative easing after the 2008 financial crisis to give the economy a lift. 

One drawback with quantitative easing is that it can increase inflation, which becomes a serious problem if it occurs while the economy is not growing. The result is what’s referred to as “stagflation,” meaning the economy is stagnant while inflation is occurring. Quantitative easing is only as effective as the participation of banks because if banks aren’t willing to offer easier lending terms, then the increased supply of money will not filter down to individuals and businesses. 

The opposite of quantitative easing is quantitative tightening, which involves reducing the amount of money that’s available to banks for lending and investment. When the Fed is enacting a round of quantitative tightening, it’s trying to normalize interest rates, bringing them back above 0% to a more standard rate. The central bank tightens the money supply to fight back against inflation. Generally, quantitative easing causes asset prices to increase, while tightening pressures asset prices. 

The rest of the articles in this series will go into each of these aspects of the Federal Reserve more in depth.

About the Author

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