The Federal Reserve in Washington D.C.
With all this unprecedented fiscal stimulus going on, it may not hurt to get a refresher on what the Fed actually is.
For starters, it is a central bank, which is an institution that manages the currency and monetary policy of a state or formal monetary union, and oversees the commercial banking system. It is able to control economic policy through its control of the money supply, and acts as a “lender of last resort” in times when the financial system begins to break down or grind to a halt. It is supposed to be “independent from political interference,” although that hasn’t stopped politicians in the past (and present) from berating acting heads of central banks and attempting to influence central bank actions. In the case of the United States, one thing the Fed does not do is print money- the US Treasury does that (more on this in a separate post).
Ultimately a central bank’s purpose is to promote economic growth and through its actions, target low inflation (2-3% is considered healthy) and unemployment rates, among other things. Inflation isn’t necessarily bad- it is the natural result of economic expansion. Population growth, higher incomes, and other variables factor into inflation. Inflation is to be expected, but when it gets out of hand, it can be bad news for the economy.
Deflation, when general price levels fall, can create a vicious downward cycle for economies. In a deflationary environment, companies earn less revenues, and in turn, less profits, and as a result, reduce costs to adapt to new conditions. This includes decreasing capital expenditures and of course, layoffs. And with less people working, general incomes fall, bringing down consumption along with it, and so on and so forth.
High inflation, when price levels increase at a rate higher than 3%, can also reduce economic activity. Consumers’ purchasing power falls, being able to afford less things. People begin hoarding the things they do have or can get their hands on (toilet paper, anyone? [isolated example]). Additionally, the prevailing currency is worth less (or with hyperinflation, it becomes worthless). If you used to be able to buy a hot dog for $1, and it now costs $5, your one dollar bill is now worth less. It’s purchasing power is one fifth what it used to be. Why? Because there’s more dollars in circulation- the money supply has grown. As a general economic principal, the more you of something you have, the less it is worth to you. One hamburger to me is worth one million dollars, but if I had one hundred hamburgers, the marginal utility of one additional hamburger is almost zero.
Anyway, back to the Fed (a central bank- I’ll talk about its history in a separate post- for now, I’ll talk about what it does). It has various tools at its disposal, the main ones being interest-rate-setting and open market operations.
With interest rates, it’s important to remember what we’re talking about here- a central bank. When you borrow money to buy a car, a home, or anything else, you usually borrow from a financial institution of some kind- usually a bank. Let’s say you pay 5% on a loan you take out to buy a car. The bank you’re borrowing from borrowed the capital they’re lending out at a lower interest rate- let’s say 3%. The difference between the rate they’re lending to you - 5% - and the rate they’re borrowing at - 3% - is their spread- their operating profit, so to speak. Although in reality there are intermediaries between the Fed and the banks that lend to consumers, for all intents and purposes- high level, this is how it works. In the real world, the prime rate is about 3.25% (what you borrow at) while the Fed funds rate is 0.25% (what you bank borrows at, for all intents and purposes).
So as you can imagine, with the lower interest rates, the more market participants are inclined to borrow to then lend to corporations and consumers alike, spurring economic activity. If people are feeling great about their future prospects, they tend to spend more. When incomes rise, generally, so do price levels. If this gets out of hand, the economy is said to get “hot” and that’s when the Fed steps in by raising interest rates with the goal of slowing down economic activity. Raising and lowering interest rates, you’ll see, is a balancing act.
Open market operations, on the other hand, is the Fed’s process of buying and selling Treasury securities (bills, notes and bonds- the different names indicate different maturities [weeks, months, years, decades]- we’ll use bonds interchangeably for the duration of this post). The Fed and the Treasury are independent bodies that work together on economic policy. There is a common misconception that the Fed prints money. As mentioned above, it does not- it only has the ability to lend. Now- how do open market operations affect the money supply?
First, we’ll talk about the Treasury. The Treasury is an agency under the executive branch. When you hear about the US running a deficit, that just means we’re spending more than we’re receiving in tax receipts. How do we fund the deficit? We borrow. The Treasury is the entity doing the borrowing in the form of, you guessed it, Treasury bonds, which are sold at auctions in a competitive bidding process.
When the Fed wants to expand the money supply, it buys Treasury bonds, which show up on its balance sheet. When it does this, these amounts show up on member banks’ own balance sheets as credits in the form of reserve deposits. This is known as “monetizing debt.” With more reserves in hand, banks then have the ability to lend more money. This is how the Fed doesn’t actually print money- it indirectly lends money. The member banks control whom to lend to, of course, but their main business is to lend, so that’s what they end up doing (generally speaking).
Conversely, when the Fed wants to reduce the money supply, it sells its holdings (reduces its balance sheet), resulting in an inflow of money into its coffers and out of the money supply, thus reducing how much money is out there. The money supply is broken out further in the form of M1 and M2, but that’s a topic for another day.
So high level, that’s how the Fed (and central banks in general) operate. More posts to come on this and related topics, but for now, feel confident that you now have a better understanding of how the Fed works.