Hannah Boundy, CFA®, CFP®
Understanding the Federal Reserve
As markets continue to fluctuate in response to uncertainty in the global economy, the Federal Reserve has generated quite a few headlines in the news, and like many areas of the economy and the financial markets, monetary policy is not always black and white and often has unintended consequences, which is why it is important for us as investors to remain diligent in both our understanding of the underlying fundamentals and our approach to the markets.
The Federal Reserve is the United States’ central bank, making it one of the most powerful economic institutions operating in the global economy. Created by the Federal Reserve Act and signed into law by President Woodrow Wilson on December 23, 1913, the Federal Reserve consists of three main entities: the Board of Governors, the Federal Reserve Banks, and the Federal Open Market Committee.[i][ii] The Board of Governors is in charge of operating the Federal Reserve System and oversees the 12 Reserve Banks, while the banks themselves interact with other institutions in various capacities such as lending and payment services. The Federal Open Market Committee, or FOMC, helps direct U.S monetary policy. While the Federal Reserve is overseen by congress and communicates with both the legislative and executive branches, it makes decisions independently.
There are many key functions that the Federal Reserve is responsible for including supervising and examining member banks, ensuring liquidity in our financial system, distribution of our nation’s currency, serving as a bank for the U.S. treasury, operating the automated clearinghouse through which funds are transferred from bank to bank, enforcing consumer protection laws, and more. These are largely logistical features and aspects of the Federal Reserve that get little time in the headlines. When we do hear about the Federal Reserve in the news, it’s often concerning the FOMC and the economic effects of whatever policy they’re currently pursuing. For instance, in recent months there has been a great deal of focus on whether or not the Fed will cut interest rates. The decision to influence interest rates has to do with the Feds stated objective to oversee “open market operations” through what’s known as its mandate. When it comes to monetary objectives, there are three goals the Federal Reserve is tasked with pursuing: maximum employment, stable prices, and moderate long-term interest rates. The idea is that by maintaining these three major areas of our economy, the Fed can hopefully help keep the economy healthy so that consumers and businesses can thrive. It’s important to understand that propping up the financial markets is not one of the Federal Reserve’s mandate. While they are tasked with maintaining a stable economy, prices in the financial markets must be allowed to fluctuate in order for the markets to efficiently allocate resources. Otherwise, asset prices would no longer reflect the value of the assets themselves and bubbles would start to form, which could wreak real havoc down the road.
When it comes to enacting monetary policy, there are several tools available to the Federal Reserve and these “tools” are typically what we hear about in the news. As previously mentioned, the Fed can direct interest rates by targeting a specific federal funds rate. They can also influence the supply of currency in the market by selling and purchasing securities. In both instances, what they trying to do is balance out lending in our economy in order to stabilize prices and ultimately inflation. Put simply, when the Fed cuts interest rates it’s in an effort to encourage lending. The lower rates are, the more likely businesses and consumers are to borrow. When they borrow it’s often to grow their businesses and enhance their spending which often pushes prices up and we experience both economic growth and inflation. At the same time, we also don’t want inflation to get out of hand. If prices are rising too fast and the Fed wants to stabilize how quickly they’re rising, it may try to raise rates. This would make lending more expensive which causes inflation to slow.
When the financial crisis of 2008 happened, the Federal Reserve responded by cutting rates to zero, thereby encouraging lending and jumpstarting the economy. When you consider that businesses are more likely to hire when they’re doing well, you also begin to see why this strategy is effective in lowering unemployment rates – another of the Fed’s objectives. Of course, economic theory rarely plays out perfectly in reality. These policies work well in a vacuum, but in the real world, there are other things at play that complicate how policy is executed and can lead to unintended consequences. Things like trade and fiscal policy, as well as the political environment and market sentiment can all play into whether or not a course of action is effective and it’s important for us as investors to not only know how policy is intended to work, but also be mindful of the environment as a whole. At Sherwood FP, we’re committed to being appraised of what’s happening in the economy while simultaneously pursuing an investment strategy that’s built for weathering market volatility. If you’d like to learn more about us and what we believe, feel free to check out some of our other articles or our about page. If you’d like to learn more about the Federal Reserve and how it works, there are some great resources listed below in the endnotes.
[i] Johnson, Roger T. Historical Beginnings--: the Federal Reserve. Federal Reserve Bank of Boston, Public and Community Affairs Dept., 2010.
[ii] “Board of Governors of the Federal Reserve System.” Federal Reserve Board - About the Fed, The Federal Reserve, https://www.federalreserve.gov/aboutthefed.htm.