Created in 1913 as a reaction to the many economic “panics” the U.S. economy had experienced in the century prior and as a direct result of the Panic of 1907, the Federal Reserve (the “Fed”) filled the underlying need to have a central banking system and lender of last resort for the country. Before the Fed, the U.S. had been without a national banking system since the dissolution of the Second Bank of the United States in 1836, and in the years that followed, the country experienced significant volatile swings in economic activity as it grew.
Once the Fed was established, congress gave the Fed three primary objectives or ‘mandates’ concerning monetary policy:
- Maximizing employment,
- Stabilizing prices, and
- Moderating long-term interest rates.
Most economists and analysts consider the third of these mandates to be superfluous. That is, if employment were maximized to the extent that it could be and inflation was kept in check, long-term interest rates would not deviate significantly any one direction. In this way the Fed seems to have more of a “dual” mandate, focused primarily on the first two objectives.
Tools
The Fed has many tools at its disposal to achieve these aims. Three of the more important and most well-known are below:
- Federal Funds Rate – A closely watched and reported number, the federal funds rate is the interest rate at which banks lend reserves to each other overnight. The Fed sets a target for this rate, typically in 0.25% increments. Adjusting this rate influences other interest rates throughout the country, affecting consumer and business loans, mortgages, and savings. Lower federal funds rates generally encourage borrowing and spending, while higher rates can encourage saving, which can help combat inflation as demand for goods and services softens.
- Open Market Operations – A direct intervention into supply and demand, this is a frequently used tool involving the buying and selling of government bills, notes and bonds in the open market. When the Fed buys securities, it injects liquidity into the banking system, lowering interest rates and encouraging borrowing and investment. Conversely, selling securities withdraws liquidity, raising interest rates and cooling off an overheating economy. During times of economic crisis, the Fed has purchased other types of securities, including mortgage-back securities (in 2008) and corporate bonds (in 2020), and may do so again in the future.
- Reserve Requirements – These are regulations set by the Federal Reserve that dictate the minimum amount of reserves a bank must hold against its deposit liabilities. This is meant to ensure that banks maintain a certain level of liquidity to meet customer withdrawals and promote stability in the banking system. When these requirements are increased, banks can lend less of their reserves and economic activity is expected to contract, and vice versa.
While the Fed may not stand out as a terribly exciting topic (no offense to its Board of Governors), a quick review of arguably the most important central bank in the world might provide additional context when the Fed is in the news.
Peter T. Toscani, CFA, CFP®