Mark H. Smith, Inc. Blog

All Eyes Are on the Fed

Written by webmaster | Nov 24, 2015 9:20:57 AM

By Mark H. Smith, Founder

As we close out 2015 the credit union system will complete its seventh year hobbled by historically low interest rates. The Fed pushed the rates down to these historic lows in the fourth quarter of 2008. Most of us assumed that it would be a temporary condition and rates would return to traditional levels within a year or two. Yet here we are almost a decade later with no end in sight. So who, exactly, is the Fed and who’s really in charge?

The Federal Reserve Bank of the United States is the government’s bank and functions as the nation’s central bank. It is an independent agency. It is controlled by a board of seven governors who are nominated by the President and confirmed by the Senate. It also reports to the Congress on a regular basis. It maintains a high level of autonomy.

The “Fed” as it is called, serves numerous functions. It participates in the regulation of commercial banks and plays a key role in the systems which clear checks and electronic payments nationwide. Its most important role and the one which may impact us the most is its mandate to manage the economy of the United States in such a way that it will prosper and create jobs without stimulating an inflationary spiral.

Interest rates are one of the Fed’s primary tools to stimulate the economy when it’s lagging and to cool off the economy when it is accelerating too fast. Low rates stimulate the economy by encouraging borrowing and economic growth. High rates constrict the economy by making money more expensive and difficult to borrow.

The Fed influences interest rates through its monetary policy. Monetary policy differs from fiscal policy. Fiscal policy refers to the operations of the government with respect to its taxation and spending policies. The Executive Branch and Legislative Branch of our government determine and execute fiscal policy. Monetary policy refers to the supply of money in the economy and the resulting levels of interest rates and economic activity. The Fed determines and executes monetary policy.

The Fed has three primary tools to influence overall interest rates. First, it can manipulate the reserve requirement ratio that banks are required to maintain for liquidity purposes. Second, it can adjust --up or down-- the discount rate for borrowing at the Fed Discount Window. Third, it can influence the Federal Funds rates that are charged for inter-bank investing and borrowing.

The reserve requirement ratio is very straightforward. By manipulating the ratio of cash or cash equivalent reserves that banks are required to have on hand, the Fed directly increases or decreases the lending capacity of the banks. Decreasing the reserve requirement will allow more money to be lent and will exert a downward influence on interest rates. Increasing the reserve requirement will have the opposite effect.

The second tool available to the Fed to influence interest rates is control over the discount rate or the rate at which financial institutions can borrow at the Fed Discount Window. However, the Discount Window is often the lender of last resort and is not often used in the day-to-day operations of the nation’s financial institutions. It’s said that a stigma often attaches to institutional borrowing at the Discount Window. Accordingly, the discount rate may not be a very effective tool to influence overall interest rates.

Lastly is the Fed’s ability to influence the rate charged for Federal Funds. Most short-term borrowing among financial institutions is in the form of Federal Funds (Fed Fund). Fed Funds are short-term, usually overnight, unsecured borrowings between banks and other financial institutions. Many banks rely on the purchase or sale of Fed Funds to invest surplus short-term funds or to purchase short-term cash reserves. The terms are negotiated between the lender and borrower. Both lender and borrower are sensitive to the return/cost on the transaction. Although the Fed facilitates the transactions, it is not a direct participant in the transaction and does not set the terms. Effectively, the terms for Fed Fund are set based on the supply and demand for money. When the price for Fed Funds is low, lending and the economy are stimulated. It is the opposite when the price for Fed Funds is high.

The Fed cannot directly set the Fed Funds rate. However, it can greatly influence the rate through its ability to impact the money supply. Through purchases and sales of US Government securities as well as repurchase and reverse repurchase transactions, the Fed can expand or constrict the money supply, causing interest rates to move downward or upward. The job of controlling the money supply and, in turn, the Fed’s impact on the Fed Funds rate, falls to the Federal Open Market Committee.

The Federal Open Market Committee (FOMC) has 12 members. It is comprised of the seven members of the Federal Reserve Board plus the president of the Federal Reserve Bank of New York. The remaining four seats on the committee are filled on an annual rotating basis of one-year terms by the presidents of the remaining regional Federal Reserve Banks. The chair of the Federal Reserve holds great power to persuade the voting of the committee with respect to monetary policy. The chair of the Fed and the FOMC is currently Janet Yellen.

The FOMC has significant resources at its disposal to determine and forecast the state of the U.S. economy. The members of the FOMC are usually well-educated and knowledgeable with respect to the economy. When the Fed determined, through its resources, that the economy needed to be stimulated (as it did in 2008) the Committee chose to lower interest rates with the objective of making money available to businesses to expand and increase prosperity and employment. Low interest rates encourage consumers to borrow and purchase, which stimulates the economy. When the economy is expanding and the Fed determines that inflation is imminent, the Fed may choose to apply the brakes by increasing interest rates, causing businesses to pay more for borrowing and hold back on expansion and hiring. When rates are high, consumers are dissuaded from borrowing and purchasing high-priced consumer goods, such as automobiles. There are times when the Fed chooses to be neutral--neither pursuing a tight-money nor easy-money policy.

To achieve its goal of managing the Fed Funds rate, the FOMC sets a target rate, or range. It then buys or sells U.S. Government securities in the open market to manipulate the Fed Funds rate toward its target. The FOMC may employ instruments such as triparty repos and additional sophisticated strategies to augment the purchase and sale of securities. At the present time the target range set by the FOMC for Fed Funds is zero to 25 basis points. When the Fed wants to lower rates it will typically buy securities on the open market, flooding the economy with money. By the laws of supply and demand, when supply increases, the rate decreases. The current level of interest rates (- and their long sojourn near zero percent) was greatly impacted when the FOMC implemented a historic purchase of US Treasury Securities and debt guaranteed by the US Government. When the Fed sells securities or enters into repo agreements, the money supply contracts, less money is available for lending, and interest rates move upward as a result of supply-and-demand.

We have presented a simplified version of a very complex organization and process. There is little certainty in forecasting the direction the Fed will take in the future. Economists are often of differing opinions. The actions of the Fed board and FOMC may not be unanimous and can be controversial. It’s been said that if you laid all of the economists in the world end to end they would never reach a conclusion. That may now be changing. In the Wall Street Journal (November 12, 2015) it was reported that 92% of US economists were forecasting a Fed-mandated increase in interest rates at its December meeting. That’s probably as close to a consensus as we will ever get.