|What is the FED and why are they so important to our country's economic future?|
|Posted on Monday, July 23, 2012 at 10:30 AM|
Throughout the last five years since the financial crisis began, we have heard a lot about the Fed. What is the Fed and why are they so important to our country’s economic future?
The Federal Reserve System was established by Congress in 1913 to bring order and uniformity to the banking system in this country. Prior to its establishment, banks were privately owned businesses and their practices and rules varied widely. Also, there were no credit requirements for banks so there was no guarantee that you could withdraw the money you had on deposit any time you wished; all the money could have been lent to others with no money remaining to pay you. Congress wanted to stabilize the banking system so they created a network of national banks (12 in all) which were part of the new Federal Reserve System. They created a Board of the System which has the authority to establish and enforce banking regulations, set reserve requirements and certain interest rates. On the latter point, the Fed (as it is now known) has direct control over the Federal Funds Rate, the rate at which banks borrow from each other overnight to meet the established reserve requirements. All other interest rates in the market generally are set in relation to this rate, although the only rate directly controlled by the Fed is the funds rate.
The Federal Reserve was created to be an independent body not subject to the control of Congress or the President. The thinking was that people did not want the nation’s banking system to be potentially manipulated for political purposes. The President appoints, and the Senate confirms, the seven members of the Board of Governors who serve for 14 years. The President selects from among the existing Governors a Chairman and Vice Chairman who serve a 4 year term and may be reappointed. The current Chairman is Dr. Ben Bernanke, formerly the economics department chair at Princeton University. He replaced Alan Greenspan who served for 18 years.
Over the years, it has become the Fed’s job to set monetary policy for the government. Monetary policy basically focuses on the money supply, i.e., how much currency is in circulation. Congress sets fiscal policy which focuses on tax and spending. The Treasury Department actually prints or mints (in the case of coins) the money but only to the extent that new money is replacing old money dollar-for-dollar. Any decision to increase or decrease the money supply is made by the Fed based on current and projected economic circumstances. These days, the Fed increases the money supply buy purchasing government securities from banks and crediting the banks’ accounts with the Fed; there is no need to print more money – they just electronically create it. Conversely, the Fed would sell government securities it owns to banks in order to remove money from the system. Since 2008, the Fed has bought government and mortgage-backed securities to the tune of close to $3 trillion which has increased their balance sheet (the total value of the securities they own) tremendously. Recently, the Fed announced that it was extending Operation Twist, its latest bond-buying program, until year-end at a further cost of about $275 billion.
The Fed’s two mandates are to 1) achieve full employment and 2) keep inflation under control. During recessionary times, the full employment mandate gets most of the attention while prosperous times bring on the inflation challenge. The Fed has increased the money supply so dramatically in an attempt to get lending going which, in turn, is intended to spur economic growth and lead to more jobs. Despite their best efforts, most economists agree that the best the Fed can say so far is that things would have been a great deal worse if they hadn’t taken action. However, as the author of the linked article suggests, there is a limit to how much the Fed can further stimulate the economy. Remember that eventually they will have to remove the funds they infused from the economy or risk massive inflation (anyone remember the Jimmy Carter days?). Trying to take $3 or $4 trillion out of a $14 trillion economy won’t be easy.
So, the next time you here that the Fed did this or that, you should be able to put the news into a better context. As Paul Harvey used to say – “Now you know the rest of the story”.