ECONOMICS AND TRADE | Achieving growth through open markets
28 April 2008
U.S. Central Bank Works to Smooth Business Cycle
U.S. Federal Reserve’s actions affect economic growth, inflation
This is the second article in a series on the U.S. financial system and market regulation.
Washington -- On the day of the terrorist attacks against New York and Washington, September 11, 2001, the U.S. central bank issued a brief, typically opaque statement: "The Federal Reserve System is open and operating … [It] is available to meet liquidity needs."
But if the public was unaware of the statement and its significance, financial markets understood it and the following steps well. The damage from the attacks to the U.S. economy was minimal.
The Federal Reserve System of the United States, often referred to simply as the Fed, works to ensure that overall demand matches the potential supply of the economy. It expands or reduces the money supply by changing interest rates or the cost of borrowing money.
In time of recession, the Fed can inject more money into the economy, and thereby stimulate it, by lowering interest rates. In times of inflation or asset-price bubbles, it can raise interest rates and adopt other measures with the effect of taming inflation and protecting the integrity of the financial system.
The Fed alone cannot dictate the course of the economy over the long term, but it can smooth out the peaks and valleys of the business cycle.
FED STRUCTURE AND INDEPENDENCE
The Federal Reserve is unique in how it is organized and the ways in which it is both accountable to -- yet independent from -- the other branches of government.
The Fed consists of a board of governors in Washington, which oversees 12 Federal Reserve District Banks -- located in Boston; New York; Philadelphia; Cleveland; Richmond, Virginia; Atlanta; Chicago; St. Louis; Minneapolis; Kansas City, Missouri; Dallas and San Francisco.
By law, the Fed is accountable to Congress, not to the president, reflecting the view that the institution controlling the nation's money supply should be separate and independent from those who administer the government's tax and spending decisions.
THE FED TOOL KIT
The mission of the Federal Reserve is to promote sustainable economic growth and employment along with stable prices. Ensuring prosperity is no small task. The Fed must balance the need to support economic growth by assuring an adequate supply of money against the constant threat of inflation, which undermines the value of the currency.
Nobel Prize-winning economist Milton Friedman once compared inflation to alcoholism. "When you start drinking or when you start printing too much money, the good effects come first, he said. The bad effects only come later. ... When it comes to the cure, it's the other way around."
The Fed's most powerful tool is the innocuously named Federal Open Market Committee (FOMC), which determines what is called the overnight "federal funds rate." That is the interest rate the Fed charges to banks that need to borrow money to maintain the amount of funds required by law.
If the Fed wants the funds rate to fall, the committee buys government securities from the Reserve Banks. The money collected from the Fed increases the banks' reserves. The banks, in turn, then can loan out these fresh funds to other banks and financial institutions.
In other words, the committee’s purchase creates a ripple effect that increases the supply of money and causes the federal funds rate to decline, indirectly lowering interest rates in general and encouraging greater economic activity.
The FOMC reverses the process to lower the money supply and dampen inflation prospects. It sells government securities and receives payment from banks, lowering the supply of reserves in the banking system and raising the funds rate.
A second tool to maintain market liquidity is the "discount window," which allows qualified banks to borrow directly from the Fed. The discount rate can be a useful tool, especially at times of financial disruptions.
A BANK FOR BANKS AND GOVERNMENT
The Federal Reserve conducts a wide array of other regulatory and banking functions. As a "bank for banks," the Fed oversees and provides a range of services to the nation's banks, credit unions and savings and loans including collecting checks, electronically transferring funds and distributing paper currency and coins.
As a bank for the federal government, the Fed maintains the government's accounts at the Department of Treasury, collects federal tax deposits and processes government checks. The Fed also collects economic data and conducts analyses that are used by the government and private sector alike to make forecasts and decisions.
In the end, the Federal Reserve does not simply oversee financial markets, but interacts with them in complex ways that require a clear and constant flow of information.
As Board Governor Kevin Warsh told the New York Stock Exchange, "Markets inform and, in some cases, complement the monetary, supervisory, and regulatory actions of the Federal Reserve. ... The interaction is neither simple nor straightforward. You watch us and react to our actions, while simultaneously we monitor you and respond as best we can to the signals you provide about evolving economic and financial conditions."
"U.S. Monetary Policy: An Introduction," a document explaining the Fed and its operations is available at the Web site of the Federal Reserve Bank of San Francisco.
An interactive explanation of Fed history, functions, operations and financial services called Fed 101 and other information can be found at the Federal Reserve Web site.
