March 06, 2012

Fed Up

The Seal of the Federal Reserve System
“The Fed,” “the central bank,” “the counting house,” “the clearing house,” Ben Bernanke - all are commonly and currently used as synonyms for the Federal Reserve, the banking system of the United States. The Federal Reserve has periodically been in the news since its creation in 1913, but lately, it seems like it is the news. Some politicians praise the Fed for preventing a double-dip recession, while others blame the Fed for creating the first dip. Some economists believe in the power of the Fed to preside effectively over the economy, while others think the Fed should have never been created in the first place. What drives me crazy is how so many people have such absolute opinions on a topic that is extremely complicated! Do they even understand the Federal Reserve? Come to think of it, do I even understand the Federal Reserve?

I agree with Henry Ford when he said, “It is well that the people of the nation do not understand our banking system, for if they did, I believe there would be a revolution before tomorrow morning.” Now I don’t claim to entirely understand the banking system either, but I am fed up with all the misinformation about the Fed that we hear from some of our politicians and media. So today, let me tell you what little I do know, and maybe you can help me straighten everybody out!

As I mentioned earlier, the Federal Reserve System, also known as “The Fed,” is the central bank of the United States. In plain terms, it is a bank for banks, and it's the bank of the federal government. The Fed is made up of a network of twelve Federal Reserve Banks and a number of branches that fall under the oversight of the Board of Governors. The board is made up of seven members appointed by the President and confirmed by the U.S. Senate. Ben Bernanke is the current chairman.

The Fed is charged with being responsible for providing financial services to the federal government, distributing coin and paper money to the nation’s banks, supervising and regulating banks to ensure they are safe places for people to keep their money, protecting consumers’ credit rights, and conducting the nation’s monetary policy. With all the economic volatility in recent years, it’s that “conducting monetary policy” bit that has been in the media, and that is the part I want to really focus on.

You see, the Fed is supposed to conduct the nation’s monetary policy to maintain or increase employment, stabilize prices, and keep interest rates low. The Fed has three tools to do this:

1.       Open Market Operations- buying or selling of U.S. government bonds to control the amount of cash  available in the banking system.

2.       The Discount Rate- the interest rate charged by the Federal Reserve Banks to other banks on short-term loans.

3.       Reserve Requirements- the portions of deposits that banks must maintain in their vaults.

·         If the Fed buys bonds, lowers the discount rate, or lowers the reserve requirements, then the supply of money available to the market increases, interest rates go down, the economy should grow faster, and employment should increase - all positives. However, prices will also rise (inflation), which is potentially a big negative.

·         If the Fed sells bonds, raises the discount rate, or raises the reserve requirements, then the supply of money available to the market decreases, interest rates go up, economic growth should slow, and employment should decrease - all negatives. However, prices will also fall (deflation), which is potentially a good thing.
Not so easy sounding is it? Well at least we now know some of the basics about the Fed.
Perhaps you will agree with me that it is not always clear what the Fed should or should not do. However, it is clear that the Federal Reserve’s actions do have an impact on the economy. Regardless of the Fed's decisions, I conclude that the Fed doesn’t ever deserve all the credit or all the blame for the results.

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