How the Fed
Steers the Economy
what does the Federal Reserve do really? The Federal Reserve
Act of 1913 states the role of the Fed as "to promote
effectively the goals of maximum employment, stable prices,
and moderate long-term interest rates". How curious.
If you take this goal apart you will see that it is in reality
in conflict with itself. Maximum employment would cause rapid
wage and price inflation; two outcomes in direct conflict
with each other. Absolutely stable prices would be the result
of a flat economy, which would likely become a declining economy.
Moderate long-term interest rates seems the most sanely achievable
portion of the task the Fed has been given. How does the Fed
juggle their seemingly conflicting tasks? A major vehicle
the Fed uses to direct the economy is to increase and decrease
liquidity and reserves in the banking system. By doing
so the Fed can influence interest rates and the money supply.
The Fed can increase liquidity by purchasing or selling government
securities with member banks. The Fed can also effect liquidity
and interest rates by increasing or decreasing the percentage
of reserves financial institutions need to keep on hand to
meet requests for funds from customers. A higher demand and
low supply will increase interest rates and slow down an overheated
economy. The reverse is also true. Excess bank reserves
are traded between lending institutions overnight to insure
they are in compliance with reserve requirements. A bank needing
extra reserves will borrow them from another bank with a balance
greater than reserve limits require. The rate of interest
charged will be at the Federal Funds rate. The Federal
Funds rate is the actual rate the Fed Board of Governors changes
when the media reports a Fed interest rate increase or decrease.
By increasing or decreasing the rates at which member banks
can receive overnight loans from other member banks determines
the domino effect of other rates paid by individuals and business.
These resulting interest rates will cause the economy to expand
or contract as the Federal Reserve deems is best for the economy
at that point in time. Banks can also borrow directly from
the Federal Reserve to increase liquidity at what is called
the discount window. Funds will be lent at the Federal Reserve's
The Fed has many tools in its toolbox
it can use to steer the economy. The Fed sets the percentage
that can be loaned to an investor to buy stocks in a margin
account, although many brokerage firms have even tighter margin
criteria for risky or more volatile stocks. How much an
investor can borrow on margin eases or tightens liquidity
and this can also help fuel or slow the economy. Although
a vehicle the Fed can use, the margin percentage is seldom
changed. The Fed can increase confidence and allay fears by
injecting liquidity into the system at a time of crisis or
hardship such as a crop failure, the massive Mississippi River
floods, or the fears surrounding the turn of the millennium.
The Fed keeps a watchful eye on the economy and is constantly
pushing the buttons and pulling the levers it deems necessary
to keep us rolling along as smoothly as possible.