Fed Policy: What it is and How it Works
October 15, 2009The Chairman of the Federal Reserve (Fed) has been called the second most powerful job in the world, second only to the President of the United States. Testimony by the Federal Reserve Chairman, or statements from the Federal Open Market Committee (FOMC), can have a major impact on stock, bond and currency markets. Yet for many, the role and function of the Federal Reserve is a mystery. This article attempts to briefly answer some important questions about the Fed and monetary policy.
What is the Role of the Fed?
The Federal Reserve System (Fed) is the Central Bank of the United States. It was founded by Congress in 1913 to establish a safe, flexible, and stable financial system. The Fed is charged with supervising and regulating the banking industry, maintaining stability of the financial system, serving as the banker for banks and the U.S. government, and conducting the country’s monetary policy.
What is Monetary Policy?
Monetary policy is the process by which the Federal Reserve controls the supply of money and credit for the economy. The Federal Reserve Act of 1912 charged the Fed with using monetary policy “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Fed policy is meant to keep both inflation and unemployment low. When the economy is slowing down and unemployment is rising, the Fed attempts to stimulate the economy by loosening monetary policy. Conversely, in a high growth economy, the Fed will tighten monetary policy in an effort to rein in the economy and curb inflationary pressures. Sounds straightforward, but there is much debate about whether the Fed is really able to accomplish these goals and truly help the economy over time.
How Does the Fed Implement Monetary Policy?
The U.S., like other major global economies, operates under a fiat monetary system. That means the currency is not convertible into a precious commodity such as gold or silver but is backed by the creditworthiness of the issuer, in this case the U.S. government. Because the currency is not tied to a physical commodity, the Fed controls the supply of the currency. Decisions to increase or decrease the money supply are made through the Federal Open Market Committee (FOMC).
The primary tool the FOMC uses to implement monetary policy is the Federal Funds Rate. The Federal Funds Rate is the interest rate that banks charge each other for overnight loans. This is the rate cited by the media in statements like “the Fed lowered rates by a quarter of a point.” The Fed uses Open Market Operations to adjust the Fed Funds Rate, increasing or decreasing the overall money supply, by buying or selling government securities (usually treasury bills or bonds).
How do Changes to Monetary Policy Impact the Economy?
Although the Fed only controls the Federal Funds rate, changes to it have ripple effects that percolate throughout the financial system. Since the Federal Funds Rate is the cost for banks to borrow money overnight it acts as a floor on interest rates. It impacts short-term interest rates such as money market rates and the yields on treasury bills and commercial paper (short-term loans made to businesses) most directly. However, it also impacts longer-term loans such as consumer loans, auto loans, mortgage rates, and corporate bonds. Changes in interest rates indirectly impact spending decisions for individuals and businesses. Lower cost mortgages and auto loans make cars and houses more affordable and increase demand.
Changes in corporate bond rates impact the price of corporate bonds but also the price of stocks since investors demand a greater expected return for stocks than for bonds given their increased level of risk. U.S. interest rates also impact the foreign exchange value of the dollar. And, the exchange value of the dollar affects imports and exports by making imported goods cheaper or more expensive.
Monetary Policy is Not an Exact Science
Monetary policy is an abstract concept and uncertain science. It is difficult to gauge the impact of policy decisions on a dynamic, global economy. Throughout its history, the Fed has played a majorrole in shaping the economy (for good and bad) by regulating important financial terms for the banking industry. Recent actions have been aggressive and historic in response to the financial crisis and major global recession. The results of these policy decisions are still to be determined, but one thing is clear: the Fed, always important, has become the key player for government impacting the economy in real time.
