What Does the Federal Reserve Do?
And why it may be like a pot of stew?
Or why it may be like Goldie Locks and the Three Bears?
Allow me to begin with an official sounding definition filled with jargon and then I will explain in English. First the official / jargon filled: The US Central Bank, commonly known as the Federal Reserve or “Fed” influences the money supply and credit conditions to accomplish several goals: 1) promote steady prices and full employment; 2) promote the stability of the financial system; 3) facilitate sustainable financial growth.
Before I get to the English explanation, let me explain that the Fed is not truly a government institution and not funded with tax dollars. This is one of the safety valves in our financial system. It’s decisions and actions do not require Presidential or Congressional approval and therefore are independent of political pressure. Fed decisions are made by the 7-member Board of Governors. The Board Governors are nominated by the President and approved by Congress. Board members serve a fourteen-year term which helps them remain independent of politics.
If you listen to the news closely during economic hard times, you will hear comments about “fiscal policy” and “monetary policy.” Fiscal policy involves the use of government spending and taxation to affect growth and reduce poverty. This is how the Congress and the President, “working together,” can make life better for all (?) Americans.
Monetary policy involves actions by the Fed to achieve a sustainable economy. The primary tool of the Fed is controlling the money supply. Money Supply is the total of cash, coins and balances in bank accounts. When the money supply is high it encourages spending. When you or a major corporation has money in the bank / check book you are apt to spend which will stimulate the economy. A lower money supply discourages spending which in turn slows the economy.
Money is like most other goods and services in how the price changes. When money is plentiful, it becomes less expensive as interest rates fall. If money is scarcer, money becomes more expensive and interest rates increase. By changing the supply of money in circulation, the Fed changes the price of money and the rate of growth of the economy.
The supply of money in the economy is controlled by the “Federal Open Market Committee” which is made up of seven members from the Fed’s Board of Governors and five Reserve Bank Presidents from around the country. FOMC has three tools to manage money supply:
- Changing reserve requirements for banks. Reserve is the amount of cash and securities banks have on hand relative to the amount of money with which they make loans. If reserve requirements are increased, banks have less money they can loan and the loans get more expensive because the banks charge higher rates. When reserve requirements are lowered, banks have more money to lend and the money is cheaper and interest rates decline.
- Buying or Selling Treasury and Federal Agency securities (bonds and notes) on the open market. When the Fed is buying, they are putting more money into circulation, making it cheaper, and stimulating the economy. When the Fed is selling Bill & Bonds, they are taking money out of circulation and therefore, making it more expensive and increasing interest rates.
- Changing the rate that the Fed charges banks to directly borrow money. This is known as the “Discount Rate.” These short-term loans from the Fed to banks allow them to bolster their reserves. When the Fed lowers this rate, banks in turn will reduce what they charge their customers to borrow. When the Fed increases the rate it charges banks, banks will charge their borrowers more. Changes in the Discount Rate in turn affects other rates like credit cards, mortgages and bank loans.
I promised an explanation in English without a lot of jargon and probably failed up to now. Hang with me a few more paragraphs and I’ll get to the pot of stew and Goldie Locks.
Loan interest is the “cost of money.” When money is “cheap” or rates are low, people and companies are more apt to borrow money to spend on furniture, cars and homes or new factories, upgraded equipment or more inventory. In most situations, cheap money serves as an economic stimulus and is used by the Fed to shorten or minimize the effects of economic contraction (fancy word for recession).
The best example is the recession of 2008 caused by the collapse of the housing market. At that time, Federal Reserve Chair, Ben Bernanke along with Central Banks around the world, drastically reduced interest rates to prevent the US and global economy from collapse. President George Bush and Treasury Secretary Hank Paulson worked with both Democrats and Republicans in Congress to formulate “fiscal policy” to create legislation to prevent the collapse of banks and industries that would be critical to the recovery.
This a great example of the Fed, the President and Congress working together for the common good. Unique concept and it can work. The dramatic effect of the collapsing of the US and global housing market, huge drop in US and foreign stock markets and rises in unemployment was mitigated and turned around by a combination of actions.
- The Fed increased reserve requirements to halt the hazardous lending practices of many banks and prevent future failures.
- The Fed lowered the Discount Rate which in turn reduces the interest rate making money cheaper which in turn encourages borrowing, spending and stimulates the economy.
- The Fed began a series of programs to buy Treasury and Agency Debt in the open market. This put money back into the economy to stimulate growth. These were known as QE1 and QE2 (quantitative easing).
- Congress passed into law several fiscal plans that provided loans and bailouts to many major companies, industries, and under-water homeowners.
Without these dramatic actions, the world may have seen a repeat of the Great Depression.
Many of these monetary policies have remained in effect until right now, February 2022. But not for much longer. Remember, the four actions listed above were implemented to end the Great Recession of 2008 and grow the economy. Globally, we have experienced twelve years of economic growth – with a couple of minor recessions most of us don’t even remember. While the economy was growing gradually and steadily inflation remaining below the Fed target of 2%. This was good. Moderate inflation is necessary for economic growth.
Deflation is when prices go down. This bad is for the economy. When prices go down people will defer spending until later. With less spending the economy doesn’t grow but shrinks. This is bad.
After ten years of growth, the Fed began saying they would soon start selling off their portfolio of Treasury and Agency bonds they own to tighten the money supply and increase interest rates in order to prevent potential, future rapid inflation. But because inflation was less than 2%, the Fed waited and waited and waited some more.
Then we get the COVID-recession of March 2020. Unemployment goes from 4% to 10% in a matter of weeks. Small businesses, schools, gig workers, major employers are all locked down. The credit markets (ability to get loans) are nearly frozen which further chokes the throat of the economy. The stock market drops 32% in 23 trading days. No one can know when this will end. It was like jumping from the sauna into an ice bath. It took your breath away.
- Fiscal policy from Congress authorizing direct payments to the unemployed for enhanced unemployment benefits, direct payments to poor families with children, PPP and other loans to businesses both big and small to help them survive.
- The Fed caused interest rates to remain low by lowering the discount rate even further and continuing to buy Treasury and Agency bonds.
- Shortest recession in history.
- With the enhanced unemployment benefits and aid to families with children our households were flush with cash (increased money supply).
- After laying off thousands of employees and receiving cheap or free government loans (that often did not need to be repaid) many businesses big and small were also cash rich.
- Other fortunate businesses, due to the unique circumstances of this recession, thrived and grew.
- People began to spend money…and spend with a purpose…making up for lost time…or as a reward…or out of boredom.
- Business could not keep up with demand for goods. Due to covid-closures of factories, mines and mills, many were caught by surprise by the immediately increased demand. Lumber, glass, and copper are in short supply for construction. Construction workers found other careers. Computer chips in cars, appliances, and almost everything are in short supply, so it is difficult to get a new dish washer or new car. At the outset of Covid and uncertain of its impact, oil production, lumber mills, chip plants lowered their capacity. Now with demand in excess of 2019, it will take time to ramp back up. Demand has increased for all these items, yet supply is limited, so prices go up. Employers in all industries find it more difficult to hire and keep employees. They need to pay more to get the staffing they need. Workers in meat packing and poultry plants infected with Covid are out of work and many have not returned to work. Companies that used to have three shifts are down to two. Workers want higher wages.
- Now in early 2022…..Inflation.
Prices for many items have increased over the last twelve months at a level not seen in forty years. What is the Fed going to do?
The Fed is saying it will: 1) Increase interest rates to make money more expensive to slow down borrowing and therefore slow economic growth. 2) The Fed will also begin to stop buying and begin selling Treasury and Agency bonds from their portfolio. This will also reduce the money supply and make money more expensive. All of this is meant to cool off the economy and reduce future inflation.
The Fed’s job is rather like cooking a large pot of stew. You put your ingredients together in a pot of water on the stove. You turn up the heat to warm the contents…just like the Fed increases the money supply to stimulate growth in the economy. You want that pot of stew to reach low boil or simmer….just like the Fed wants unemployment at around 4% (meaning just about the same number looking for jobs as there are jobs) and inflation over 2% but not more than 3%. These are ideal conditions.
You leave the room and check the pot of stew later to find it boiling rather vigorously. You turn down the heat so the stew doesn’t burn onto the bottom of your pot….just like the Fed increases interest rates to decrease the money supply to turn down the heat (stimulus) on the economy to cool it off before inflation gets too high.
When you later check the stew, it is not even simmering and you turn up the heat just a bit….just like the Fed when the economy slows during a recession and they lower interest rate to increase the money supply to stimulate (heat up) the economy to get it cooking again.
Repeat the cycle. The economy and the job of the Federal Reserve are both similar to cooking stew and also a bit like Goldie Locks and the Three Bears. They don’t want things too hot or too cold….but just right. It is a matter of ongoing adjustment and fine tuning in response to events that effect the economy, or your stew, or your porridge.
Your financial plan is that same process of ongoing adjustment to accomplish your financial priorities. Wollman Wealth Designs, Inc is a financial planning firm with an office in Escondido and partners with clients in San Diego County and around the country. Please call or email with comments or questions.
Securities and advisory services are offered through Cetera Advisor Networks LLC (doing insurance business in CA as CFGAN Insurance Agency LLC), member FINRA/SIPC, a broker-dealer and registered investment adviser. Cetera is under separate ownership from any other name entity. CA Insurance License #0604093