The Federal Reserve

U.S. Federal Reserve Building
U.S. Federal Reserve Building

On Wednesday September 18, 2013, Federal Reserve Chairman,Ben Bernanke, is expected to announce exactly how much the FED plans to taper from it’s monthly “buy back” of Mortgage Backed Securities. Currently, the FED purchases $85 billion dollars in MBSs every month. The majority of economists suggest the figure will be $20 billion while others expect a smaller cut of $10 billion. So, investors, traders and financial institutions across the globe are sitting on the edge of their seats anticipating what “Big Ben” will say this time.

U.S. Federal Reserve Chairman Ben Bernanke
U.S. Federal Reserve Chairman Ben Bernanke

Understandably, this week’s announcement is very important, but what’s more important is FED’S purpose and how it works exactly. Granted, economists, financial analysts and bankers alike, are privy to such information but the average tax payer doesn’t have a clue. So here it is:

The United States Federal Reserve, also known as the FED, was created December 23, 1913 under the Federal Reserve Act and is responsible for implementing monetary policy in the U.S.. Consequently, the list of objectives needed to achieve its goal consists of maximizing employment, moderating long-term interest rates and maintaining stable prices for goods and services. Since the FED cannot control inflation or employment directly, it indirectly influences the conditions surrounding the market place, primarily interest rates, by utilizing its set of tools solely or in concert with one another.

In order to influence the conditions in the market place, the FED must manipulate the money supply in the economy. There are three essential tools at the FED’s disposal used to influence monetary policy. Specifically, the FED can change the discount rate at which banks borrow from the FED, change the reserve requirement ratio or use the open market to buy and sell U.S. securities in the financial markets.

First and foremost, U.S. commercial banks must comply with the reserve requirement ratio set by the FED. This ratio is the amount of physical funds that financial institutions are required to hold in reserve against bank deposits. For instance, at a reserve requirement ratio of 20%, banks would need $100 million in reserves to back $500 million in bank deposits. If the FED were to lower the ratio to 10%, then $50 million would be needed on reserve and the excess $50 million could be freed up and used to lend more money or make more investments. By raising or lowering the reserve requirement ratio, the FED can restrain or accelerate the money supply in the economy.

Excess Deposits and Fed Asset Purchases
Excess Deposits and Fed Asset Purchases

Equally important is the discount rate provided by the FED. Commercial banks are allowed to borrow money from the FED. To accommodate banks and influence bank borrowing, the FED can lower the interest rate the banks are required to pay. This is what is known as the discount rate. When the interest rates are lowered, banks are enabled to lend more money and therefore increasing the money supply. The discount rate should not be confused with the Federal Funds Rate, which is the interest rate the depository institutions lend money to each other. The rate in particular is extremely important because it is a visible and tangible account of the FED’s monetary policy.

In addition, the FED is also authorized to purchase and sell U.S. securities in the financial market. These actions are called Open Market Operations. The Federal Funds Rate previously mentioned, is directly influenced by the FED’s purchasing or selling of assets in a broad and active market, more specifically the Treasury Securities market. When the FED purchases these securities, the reserves in the system expand.

Seal of the U.S. Federal Reserve
Seal of the U.S. Federal Reserve

On the other hand, when these securities are sold, the reserves contract and therefore regulate the money supply in the economy. The Open Market Operations tool is by far the most significant at the FED’s disposal. This brings the post full circle to the current actions of the Federal Reserve and more on the FED will be discussed in future posts.

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