The Federal Reserve System, usually referred to as the Federal Reserve, or more casually, “the Fed”, is the United States of America’s central bank. The over a century old institution is bestowed with the sole responsibility of managing the US economy. It regulates the operations of all the financial organizations, serves as the government’s banker and conducts the nation’s monetary policy to ensure economic stability. However, Fed has historically faced sharp criticism and much scrutiny of its policy. Since the inception of the Fed system, America has hit a series of economic downturns and financial catastrophes. Fed critiques have also claimed that the institution progressively devalued the US dollar and destabilized the interest rates. Most recently, Fed’s huge venture in the bond market has provoked a debate on whether the institution has transformed into one of the US’ investment entities. It is on this ground that this paper reviews and discusses the roles of the Federal Reserve and its economical participation for the past five years.
The Federal Reserve System, as Emerson narrates, was founded in December 1913 through an Act of the US Congress (1). The formation of Fed in 1913 was the US’ third attempt to create a central banking body. The journey of establishing a central banking system begun with the formation of the First Bank of America in 1791. Its fall was followed by a five-year term of the unregulated financial system which ended with the creation of the Second Central Bank of America in 1817. Similar to the first bank, the Second bank also reigned for two decades and was disbanded upon the expiry of its 20-year charter. The two banks were accused of putting the US economy under the controllership a few people. With the disbandment of the US banks, the country experienced the confusion of private currencies issued by the commercial banks. Despite the countless number of Congress Acts that tried to create a financial system balance, the lack of a unique currency led to myriad of bank failures and consequently, the severe bank panic.
By 1907, the US was plagued with a catastrophic economic panic, commonly referred to as the 1907 monetary crisis. The people had lost assurance with their banks, following high rates of bank failures and were rushing to withdraw money from bank accounts banks. The commercial banks were, therefore, overwhelmed and needed a source of reserve to prevent them from being driven out of business. In addition, different banks were not willing to clear checks issued by other banks due to the uncertainty in the banking sector. This rendered the US a riskier investment ground for both the resident and international investors. In response to this panic, the US congress, with consultation with the leading economists, enacted the Fed, which was to restore the stability of the US economy. For the last one century, the mandate of the FED system has been expanded to encounter the demands of the developing economy. Its structure has also been altered with the occurrence of major economic events such as the 1930s Great Depression.
The Fed system is structured in a unique arrangement that encompasses both the private and public characterizations. Its organization is made up of various components that cater for both the decentralized, centralized aspects of leaderships. Firstly, the Fed is decentralized into twelve regional banks spread across the country. At the central level, the body is governed by a seven-member board of directors whose role is to direct monetary policy. The affiliates of the Board of Governors are allotted by the President, but they have to be endorsed by the Senate and sits for 14-year term. Another component is the twelve-member Federal Open Market Committee (FOMC) that includes the seven boards of governors and five heads of five of the 12 regional banks. FOMC oversees the operations of the open market through setting Fed funds rate, which in turn guides the national interest rate. Finally, the Fed’s structure is a completed by the numerous private commercial banks that owns part of non-transferable stocks in different regional federal reserves and a trail of staff economists who offers advisory services.
Broader Fed systems discharge a set of collective roles and responsibilities that aims at fostering a sound banking system and creating a healthy and sustainable economy. Firstly, each of the twelve regional reserve banks offers banking services to the government and the financial institutions. Fed banks offer the financial institutions with banking services, analogous to those that are rendered by banks to the common investors. Providing banking services to private banks has ensured safety and efficiency in cross bank money transfers. It has also created an efficient national payment system through cross banks cheque clearing. Similarly, Fed’s banking services extends to one of the largest in the US economy, the US government. The US government operates a cash deposit and withdrawals account with the Fed through which government collections and payments are controlled.
The framers of the Fed system also mandated it to regulate and supervise the operations of the commercial banks that operate within the US boarders. Under it’s the Department of Banking Supervision and Regulation Fed monitors the financial services that are offered to the individual persons. It oversees the banks that operate under its jurisdiction, including the state-chartered banks, US holding companies and the international banks that operate in the US. It ensures that financial institutions are complying with the pre-set requirements, thus fostering a stable and sound banking system.
While the banking and supervisory roles of Fed are equally important, the primary duty of the Federal Reserve is to invent and execute the government’s monetary policy. The framers of the Fed mandated it with two major policy goals; the first one is to maximize sustainable output and employment, and the second is to maintain stable prices that culminate to steady inflation rates. Fed achieves these two policy mandates by regulating the price and handiness of money and credit to attain the balance of output and employment versus the rates of inflation. However, economists have shown that the economy can hardly realize stable prices of commodities at full employment. When unemployment falls, workers demand high wages and hence the employers pass on the cost of wages to the consumers through an increase in price. Nevertheless, how does Fed balance the momentary policy to ensure that US foster economic growth while ensuring low unemployment and relatively stable inflation?
Although Fed is not in a position to dictate the market interest rate, it indirectly influences the cost of money in the market, hence regulating the unemployment, output and inflation. It does so by adjusting the federal funds rate, which is the interest that commercial banks levy each other for a one night loan. By law, every financial institution that operates in the US is required to maintain a specified amount of reserve with the Fed. The banks can in turn lend the amount held by Fed as reserve to other banks who falls short of reserves. The interest rates levied on such borrowings also known as the “federal funds rate” or just the “funds rate” is set by the Fed system. When the fund rate is high, the banks will charge its borrower a higher interest on loans since they are not willing to charge less than what they are charged with acquiring the reserve. In fact, normal interest rates are always higher than the fund rates since the bank anticipates earning profit from giving loans.
Although the funds rate is a short-term rate, often in an overnight borrowing, it regulates short-term interest and consequently the overall cost of credit. Fed adjusts the funds rate depending on its target action which is informed by the economic status. For instance, when Fed targets to increase economic activities, it cuts the funds rate, which subsequently cuts the cost of credit. Investors are likely to increase investments since the cost of loans is relatively low. When the inflation is high, for example, Fed applies monetary policy that raises the funds rate, usually referred to as “contractionary monetary policy” with an aim increasing the bank interest rates. On the other hand, Fed adopts policies that lowers funds rate, usually referred to as “expansionary monetary policy” during the economic recession period.
To discharge its monetary policy rule, Fed applies various policy tools. Historically, the institution has often used three traditional policy tools; mainly, the Open Market Operations (elsewhere in this article abbreviated as OMO), the discount rate and reserve requirements. However, the growth of the economy and changes in economic events has necessitated other monetary policy tool-kit. For example, the 2008 recession compelled the Fed to seek authorization from the Congress to be paying interest on financial institution’s reserve balances maintained at the Fed banks. Fed has also used several other temporary policy tools that respond to various upcoming economic events. For instance, following years of studies, economists have established that there are certain levels of unemployment have no effect on inflation as proposed by the Philips curve. Such realizations have led to the emergence of new monetary policy measures and disregard of some traditional actions. Some of these temporary toilets that have surfaced in the past five years will be discussed later on in this article.
Over the years, Fed has regularly used the OMO tool than the other two toolkits. The OMO tool entails the purchasing and selling of the US government bonds with the aim of regulation the amount of money exchangeable in the economy. This toolkit is normally implemented by the Fed bank of New York, which operates the national Fed’s exchange desk. When to buy or sell the government securities is determined by the FOMC through setting the target funds rate. When the FOMC decreases the targeted funds rate, the Fed Bank of New York buys securities from the various financial institutions. Conversely, if the FOMC increases its funds rate target, the Reserve Bank sells securities to the banks through its trading desk.
The buying transaction is accomplished by crediting the reserve accounts of various financial institutions, thus, raising the volume of money available in the economy. With the additional funds in the reserve accounts, banks will have sufficient fund in running their errands. The demand for federal borrowing will, therefore, lessen and hence, the funds rate reduces, consistent to the basic demand and supply rule. Consequently, the reduced funds rate will lead to a reduced short-term bank interest and hence reduced cost of credit. On the reverse, when the New York Reserve Bank sells the government securities, thus collecting money from the financial institutions. This reduces the amount of reserve at the banks’ disposal, hence increasing the need for federal borrowing. By law of market forces, increased central borrowing raises the funds rate and consequently the overall market interest level. Eventually, the cost of credits becomes exorbitant, which discourages economic activities, thus keeping inflation in check.
Apart from the loans given by one bank to another through the Fed Reserves, banks may also acquire loans from the Federal Reserve Bank itself. This introduces another regulatory tool that is applied by the Fed in managing the economy; the discount rate. Discount rate denotes to the interest that the Fed levies on the loans lent to financial institutions on a short-term basis. The process by which financial institutions borrow money from the central bank is normally described as “loans on discount window”. Converse to the OMO policy where the funds rate is set by the forces of demand and supply, the discount rate is fixed by the Fed boards, subject to the approval of the seven-member governors. Fed’s loans to other banks is usually charged at a lower rate than the funds rate to encourage the financial institutions borrow money from fed as opposed to any other source. A Discount rate tool is often used when Fed intends to add money in the economy. For example, when the normal functioning of the banking system is disrupted, Fed responds by lending the last resort to ensure that consumers’ confidence in the banking system is intact.
The third Fed monetary tool, the Reserve Requirement, has not been common like the first two. However, Fed has been able to project when to adjust the funds rate by observing the trends in the reserve deposits. Constitutionally, Fed requires every financial institution operating in the US to set aside a given percentage of their total deposits as reserves. Therefore, Fed can assess the amount of money obtainable for economic involvements and determine when to apply the open market operation. The minimum reserve requirement also lures the financial institutions into borrowing so as to meet the set deposit. This in itself creates the demand for credits and hence changes the funds rate. Additionally, Fed reserves the right to change the amount of reserve required so as to influence the volume of money accessible. However, history indicates that this option is rarely applied since the minimum reserve deposit has remained relatively constant.
In addition to the three traditional monetary tools, the past few years have seen Fed adopt numerous modern tools that have not been listed in their list of the toolkit. While some of the modern tools are one-off temporary measures, others have authoritatively been adopted as part of the traditional tools. For instance, Interest on Reserve that was used in response to the 2008 recession can now be used at the pleasure of the Federal Reserve. Similar to the discount interest, interest on reserve is normally set by Fed depending on how they wish to stimulate the economy. Interest paid on the deposit reserve may be used to influence the economy in different ways. For instance, when Fed intends to withdraw excess money from the circulation, increasing the interest paid on reserve encourages the banks to increase their reserve deposits. This move does not only withdraw money from the economy, but also raises the funds rate since banks will not be willing to lend at a lower rate that what they gain by depositing the money on reserve.
How has Fed’s employed its monetary tools for the past five years? It is important that the US economy has, for the past five years, been in the process of recovering from the great recession of 2007-2009. This recession began with the bursting of the real estate bubble in December 2007, is said to have taken a toll on the country’s economy, raising questions on whether the Fed committee would have prevented it. The period was marked by huge losses of wealth and the highest rates of unemployment. Several financial institutions were experiencing financial distress, calling on for the Federal Reserve to chip-in. In its response, Fed exploited every policy that would see the restoration of the financial market. While some of Fed’s response policies such as providing excess liquidity have been criticized as having worsened the economic situation; nonetheless, fed was able to contain the recession by mid-2009. Although various economists applaud Fed’s efforts that led to containment of the recession, the rate of recovery has not been impressive enough, and the country’s economy is yet to stabilize.
Among the strategies that Fed has applied post the 2008 recession has been to maintain the fund rates at close to zero and hence relatively lower market interest. This has largely been achieved by buying US Treasury bonds among other securities under a program that ensures money is pumped into the economy. Under a program known as the “quantitative easing”, QE, Fed’s purchase of securities has raised the reserve balances to over $1 trillion way from less than $20 billion before the recession. This move has, however, attracted much criticism from the economists who argue that low-interest rates can in the long run lead to lower economic growth. While reduction of interest rate may be a necessary tool at some economic situation, Fed’s prolonged QE policies have unhealthily reduced the interest late. Eventually, US investors are complaining of low returns to the extent that the US stock market is freaking out.
Finally, what is the most appropriate move for Fed in the next one to two years? The writer of this article is of the opinion that Janet Yellen led Federal Reserve should end the cheap money game as soon as possible. Fed should reverse its securities buying program; however, this should be approached with much caution so as not shock the much delicate US economy. The nearly zero interest rate can be said to have born fruits since the unemployment rates has hit its lowest level since the 2008 recession. On the other hand, low-interest rate has not reported gross negative impact on inflation since the rate has remained been as low as less than 2%. Nevertheless, Feds proposal to raise the low-interest rates by mid-2015 is anticipated to bridge a balance between growth in output, minimum unemployment and stable inflation rates.
Emerson, Chad. “Illegal Actions of the Federal Reserve: An Analysis of How the Nation’s Central Bank Has Acted outside the Law in Responding to the Current Financial Crisis, The.” Wm. & Mary Bus. L. Rev. 1 (2010): 109.