The following blog was written by Nancy Lottridge Anderson, Ph.D., CFA
The Federal Reserve was created by the Federal Reserve Act of 1913. It was a response to the busts and booms of the late nineteenth century, with the final straw being the Panic of 1907. A small group of financiers met at Jekyll Island in secret to form the framework of a central bank. The idea wasn’t to make recessions things of the past but to smooth out the business cycle, making its gyrations tolerable for regular folks.
Alexander Hamilton first argued for a central bank at the beginning of our history as a country. The idea was resisted. Should we interfere with natural economic forces? Wouldn’t we cause more harm than good? It’s the basic argument between two prominent economists, Keynes and Hayek.
Hayek’s theory is that self-correction will occur. Gradually, supply and demand will align, and an equilibrium will be reached. This is true, but how long will it take for this to occur? As Keynes said, “In the long run, we’re all dead.” Keynes’s argument was a winning one for politicians being pressured to “do something” to alleviate the suffering of the everyman who was subject to the whims and poor decisions of those at the top.
The Federal Reserve, affectionately known as The Fed, was created to handle one side of the equation in dealing with a financial crisis. Monetary policy, the control of interest rates, is the purview of The Fed, and is the surest and quickest way to have an impact on the overall economy.
How does The Fed control interest rates? They have three tools.
1. Adjust the reserve requirement. Each member bank must maintain a certain portion of their deposits in their Federal Reserve account. Reducing the reserve requirement encourages banks to use more cash for loans. This will lower interest rates. Increasing the reserve requirement forces banks to reduce lending and results in higher rates. The Fed rarely uses this tool.
2. Adjust the discount rate. This is the rate the Federal Reserve charges member banks for loans. Lowering the discount rate gives member banks cash to loan out, hence lower rates overall. Raising the discount rate discourages lending and results in higher rates. Again, this tool is not used often but may occur when The Fed “opens the window,” meaning they are lending money to member banks.
3. Use open market operations to target a particular Fed Funds Rate. This is the rate member banks charge EACH OTHER. Open market operations involve the buying or selling of Treasury securities from member banks to change the amount of money in the system available for lending. Buying Treasuries from members puts cash into the system—lower interest rates. Selling Treasuries takes cash out of the system—higher interest rates. This is the tool of choice.
There are 12 regional banks in the Federal Reserve System. Each has its own Governor who participates in meetings. Five of these Governors will vote in an Open Market Committee Meeting at any one time. Voting status rotates. There is a 7 member Board of Governors, appointed by the President, and they all vote each time. So 12 votes at each meeting to determine the direction of rates.
There are 8 meetings a year. On Wednesday, at 2 pm EST, their decision is announced. Each member studies data from their region and from the overall economy to come to consensus. They indicate their rate forecast on a Dot Plot, giving business and market participants a heads up about rate direction. Telegraphing their intentions is crucial, as surprises can have far reaching effects.
Members serve for 14 year terms, meaning each will outlast any one Presidential administration. Independence is important and gives all market participants confidence in the system. In 1951, the independence was formalized in the Treasury-Federal Reserve Accord.
Many other countries’ central banks have only one job—price stability—but our central bank, the Federal Reserve, has two jobs. It is the dual mandate. They are charged with keeping prices stable so they pay a lot of attention to inflation measures. When inflation raises its head, they increase rates which slow down the economy. They must also promote full employment and economic growth. When the economy slows down, they lower rates to spur activity. The problem is they can’t do both at the same time.
And that’s why they are having such a difficult time now… inflation is still an issue and may rise further with the filtering through of tariffs but this is also coming at a time of slowing employment. What’s a Fed Governor to do?
So they lowered the target range by 0.25%, and it is a range, not a definite number. But that action will bleed through the economy and have an impact on all kinds of loans—mortgages, car loans, business loans, credit cards, etc. It’s the reason it’s critical that their decisions remain independent of politics and dependent on sound data.
