The Federal Reserve

As defined by the Federal Reserve Act of 1913, the mission of the Fed is to “maintain long-run growth of the monetary and credit commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” In other words, the Fed needs to keep inflation low and ensure resources are used to their full capacity.

The Fed has greatly expanded the quantity and quality of information it now delivers to the public. Several years ago, the Fed never announced its monetary policy decisions; markets would guess what was decided by the Federal Open Market Committee (FOMC). During the last several years, Fed Chairperson Bernanke has doubled the number of the Fed’s annual economic forecasts to four.

The FOMC still meets ~ 8 times a year; 19 attend the meetings but only 12 are entitled to vote on monetary policy, the 7 members of the Board of Governors, and 5 representatives from the regional Federal Reserve banks. By tradition, most decisions are unanimous. Minutes are published three weeks after the meeting. Although monetary policy is set by the FOMC; it is implemented by forward-looking financial markets. Since markets discount the Fed’s reaction to economic data, in effect, it is validating previous market moves.

Decentralization and collegial decision-making are important Fed advantages. Fed minutes’ reflect genuine debate at the committee and highlight concerns of individual members. In fact, whenever issues arise that may eventually lead to policy changes, markets do not get blindsided because they can see in advance what somebody on the FOMC is thinking. Unlike Greenspan, Bernanke has been working to depersonalize decision-making at the FOMC and to bring collegial aspects more to the fore.

Monetary Tools

1. Open-Market Operations—The Fed’s most frequently used tool involves the purchase or sale of government securities (normally T-bills) in an effort to fine-tune money supply growth. When the Fed buys T-bills, it simply writes a check, thereby boosting the money supply. Conversely, if the Fed wants to pursue a tight money policy, it steps up its sales of T-bills. Proceeds from the sales of T-bills enter the central bank’s account and reduce its money supply. This process is sometimes referred to as “quantitative easing.”
2. Changes in Key Short-Term Interest Rates—The most visible aspect of monetary policy is a Fed decision to raise or lower rates. In this manner, the central bank signals its intentions about interest rates. The rates in question include the discount rate, which is what the Fed charges banks for overnight loans to build up their reserves, and the federal funds rate, the rate banks borrow short-term from each other.
3. Setting Reserve Requirements for Banks—The Fed can change the amount of total deposits banks must keep idle in reserve. Lowering requirements allows banks to loan a greater percentage of their total deposits to customers, thereby expanding money supply. Small changes in this ratio can have a dramatic impact on the money supply; the Fed rarely uses this tool.