The Fed What it does and why do I care

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The Fed What it does and why do I care?

• The Federal Reserve System a Brief Tutorial

2
Federal Reserve Background

• A central bank created by the Federal Reserve Act
  of 1913 to prevent bank panics.
• System serves as both the governments bank
  and the bankers bank.
• Responsibilities now include fostering economic
  growth.
• The Fed consists of Board of Governors,
  Regional Reserve Banks, Federal Open Market
  Committee.
• Semi-autonomous governance helps ensure
  operational isolation from political pressure.

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Board of Governors

• 7 Governors named by President/ confirmed by the
  Senate long terms support policy stability.
• By law the Board of Governors is responsible to
  set banking regulations.
• Governors participate in economic studies.
• Key links are to policy-making/ education
  (reporting to Congress) and to policy execution
  (through the FOMC).

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Regional Reserve Banks

• 12 districts each served by a regional bank with
  its own bank president/ board
• Boards represent public and private interests.
• Most have branches Houston is a branch bank.
• Responsibilities are to the government, member
  banks, public
• Currency ops, government disbursals/ investments,
  participation on the FOMC
• Inter-bank lending, reserve monitoring,
  clearinghouse ops, commercial bank supervision
• Research and advocacy for the public interest

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Locations of Reserve Banks/ branches

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Federal Open Market Committee

• Led by the Chairman of the Board of Governors the
  FOMC meets 8 times per year to set monetary
  policy. Special role of the New York Fed.

• Challenge is to grow the money supply at a
• rate that both supports economic growth
• and keeps inflation in check.

- If growth is too fast prices rise rapidly.
- If interest rates are too high growth is
suppressed.

• Anomalous period low interest/ high growth.

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The Money Supply

• Money is not net worth.

• Money is defined more narrowly
• M1 transactions money cash,
• checking accounts, NOW accounts
• M2 M1 marketable securities and money
• market accounts
• M3 M2 institutional money-market funds,
• agreements among banks, jumbo CDs

• Money is created primarily through M1.

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How the Fed Impacts the Economy

• In theory, the Fed has leverage through
• Reserve requirements
• Discount rates
• Federal funds rate
• It is the federal funds rate that is key today.
• The FOMC sets a target for funds rate that is now
  announced immediately post-meeting, along with
  guidance for the future.

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How the policy is implemented

• The New York Fed buys/ sells government
  securities on the open market.
• What happens to money supply if the Fed buys
  government securities?
• Sells?
• What happens to interest rates?
• But thats not the whole story

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New money gets multiplied

• Say the Fed creates new money by buying 10,000
  of government securities
• 10,000 cash is deposited in the sellers account
  in BigBank and is now transactions money.
• But banks want to lend out money.
• So, BigBank lends to someone who now has a claim
  on the use of the lent money.
• The money supply would grow unfettered if it were
  not for one thing

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Growth of money supply is limited

• BigBank can not lend it all. It must retain a
  reserve percentage (RR) in vault currency or as
  a Fed balance.
• If the RR is 10, money supply grows
• Stage 1 10,000
• Stage 2 9,000
• Stage 3 8,100etc.
• The maximum multiplier is 1/RR.

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Fed actions not the only factor

• Money supply may not grow to the max

• The bank may not want to do further
• lending at some point.

• Loan demand may not materialize animal
• spirits and the Japanese experience.

• The public may choose to hold more money
• as currency (e.g. the Y2k phenomenon.)

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Other Fed Functions

• Audit banks for compliance have moved toward
  process review
• Protect consumers from fraudulent lending
  practices
• Lender of last resort
• Provide funds to manage seasonal demands (e.g.
  agribanks) or unanticipated liquidity crunches
  protect the system

• But, the Fed is a liquidity lender

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So, why do you care?

• Financial literacy?
• Personal financial management?
• Institutional financial management?
• Interest rate expectations and financing
• Portfolio management

Question Why is the market exquisitely
sensitive to Fed guidance?