What Does The FED Actually Do?

As follow up to my last article on the FED, I figured I would explain what exactly the FED is and does…

Born out of the 1913 Act the Federal Reserve Board was created.The Federal Reserve System, or more commonly known as the FED was created to carry out monetary policy. The FED is made up of the Board of Governors (7), including the Federal Open Market Committee (FOMC) which is made up of 12 different national banks of which 5 members are able to vote on monetary policies even though the 7 members of the board have the majority.

The objective of the FED is to maximize employment, keep prices stable, and oversee long term interest rates.

The FED has three tools to enact monetary policies to keep inline with their objectives. These are not to be confused with Fiscal Policy. Fiscal policy is enacted by Congress, which is why it is always easier to get monetary policy done.

1. Open Market Operations – Buying or selling treasury securities in the open market. When the FED buys they look to create other buying (liquidity) mainly from consumers. This is the primary tool the FED uses to impact interest rates. More importantly this is currently what the FED is doing. (anytime you hear about the FOMC this is what the committee is discussing)

2. Setting Federal Funds Rate or Discount Rates – Make short term loans, each of the 12 National banks lend to their respective areas. This is bank to bank transactions. When banks are in a bind they need money fast so by keeping rates low, banks can lend a lot or vice versa. This in turn gives those more local banks more or less money to lend to consumers.

3. Setting Reserve Requirements – Set the reserve required for each bank. This also allows banks to hold more or less in bank reserves, allowing more lending capability to consumers.

In short to see what the FED is doing just follow the money. If the FED is buying, they are trying to stimulate the economy; if they are selling then they are trying to curb the economy from accelerating to fast.

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