The Federal Reserve & its Working Mechanism

  • Kanan Arora
  • Jul 12, 2021
  • Financial Analytics
The Federal Reserve & its Working Mechanism title banner

 

Central banks hold the reins of monetary policy and regulate the national financial systems. The origin of the central banking system dates back to the advent of The Federal Reserve System which today serves as the most elaborate framework of checks and balances to maintain equilibrium and financial stability amongst all central banks. 

 

This blog explores the structure of the Federal Reserve, establishes its role and then explores the various ways in which the Federal Reserve fulfils its duty towards the stability of the United States economy and essentially, the world economy.

 

 

Structure of the Federal Reserve

 

The establishment of the system dates back to The Federal Reserve Act which was signed by President Woodrow Wilson into law on December 23, 1913. The Act wrote into law a system aimed at diffusing power between regulators and government by the establishment of three components of the system: 

 

  • Board of Governors, 

  • the Federal Open Market Committee (FOMC) and 

  • the Federal Advisory Council apart from the Federal Reserve banks. 

 

The President of the United States nominates the members of the Board of Governors and they are approved by the US Senate. The FOMC is in charge of setting national monetary policy. The decisions of the FOMC affect the cost and availability of borrowers' credit and the returns received by savers. It decides on the operation of free-market practices and the setting of the policy interest rate, the federal funds rate. 

 

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Role of the Federal Reserve

 

The Federal Reserve is accountable to the U.S. Congress and the public and to ensure financial accountability, the financial statements and annual reports of the Federal Reserve Banks and the Board of Governors are audited annually by an independent, outside auditor. 

 

Though a case can be made for both sides: for and against the independence of the Federal Reserve, the elaborate framework along with an independent revenue stream ensures both the instrumental and goal independence of the Fed.

 

In essence, the goal of the Federal Reserve is to manage monetary policy maintaining a state of financial stability in the economy by ensuring stable prices, minimum unemployment level and moderate interest level in the economy. 

 

All of these goals entail maintaining a sense of confidence in the economy and its constituents by providing sufficient liquidity while ensuring the solvency of the financial system through regulation of the banks guiding a sufficient capital level. 

 

Although employment and inflation form the dual mandate of most central banks - the goals of some Central Banks may differ according to the respective macroeconomic issues faced by the nations.

 

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Federal Reserve’s Working Approach


Now that the role of the Federal Reserve is established, this section explores the various tools used by the Federal Reserve in fulfilling its responsibility towards the United States and the whole world.

 

  1. Interest Rates 

 

The quintessential weapon to get a handle on all these seemingly unlinked variables is the fund rate - which guides the prime rate i.e. the inter-bank lending rate which in turn shall pass through the entire cycle of interest rates built one over the other. The fund rate is based upon the Fed’s outlook on inflation and unemployment levels in the economy. 

 

In case of a slowdown in economic activity, the Fed can reduce the interest rate guidance which shall, in turn, be taken up (and usually is) by the leading banks who will then adjust their inter-bank lending rates downwards. 

 

In effect, this shall reduce the cost of funds for the banking system leading to a reduction in lending rates to corporate and retail customers, while at the same time reducing the interest rate on deposits in order to match the reduction in the prime rate. Overall, this implies that people shall get a lower interest on their deposits and will get cheaper loans at the same time. 

 

For individuals, this leads to an increase in spending and eventual flow of money parked in term banking products to the financial markets as they become a more lucrative option for gaining returns. 

 

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For corporates, this leads to a spur in growth on the back of a lower cost of credit.

 

Both these actions on the part of people and corporations lead to a rise in economic activity, creating jobs and spurring back the engine of the growth, heralding the economy into an expansionary phase. 

 

This stance of Fed where it reduces interest rates is called “accommodative”, currently due to the slowdown inflicted by the pandemic of Covid19 – Fed stands with an accommodative stance and has committed to near-zero interest rates for the medium term, which has helped to stabilize the global equity markets and has led to easier availability of credit to the ailing corporates.

 

It took the same stance post the slowdown inflicted after the Y2K crisis where it similarly held low-interest rates until 2003, but this led to an unrestrained flow of credit to individuals and corporates which was essentially unsustainable in nature driving up inflation. So, Alan Greenspan, the Chair of the Federal Reserve, then, had taken steps to cut down excess liquidity in the market increasing the fund rate. 

 

Credit had already been doled out on a rather loose set of checks and balances by banks and financial products without proper due diligence had been sold to institutional investors and banks. In turn, all of this led to the global financial crisis of 2008, where borrowers started defaulting on their mortgages due to rather high-interest payments and credit default swaps started exploding, risking the entire financial system. 

 

Therefore, the key to sustainable development lies in balancing the growth cycles through necessary interventions in the credit market thereby providing a stable growth environment to the economic constituents. Hence, the current policy of the Fed is to maintain close to 2% inflation in the long term so steady growth can be achieved. 

 

Investors have historically shown a preference for lower volatility in the growth cycles of economies to hold investments within nations – and hence, stable returns are more valued by investors globally rather than higher yet unsustainable and riskier ones. In order to provide guidance, the Fed also comes out with a target fund rate in order to provide a stable and transparent outlook to all market participants.

 

The guidance provided by Fed helps individuals and corporations to plan their financial decisions and provides a stable outlook on both interest rates based upon Fed’s estimate on inflation.

 

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  1. Open Market Operations

 

Though the federal fund rate changes govern the prime lending rate in the market – this is not a frequent tool applied by the Fed. 

 

In order to maintain the prime rate within the targeted range, another powerful tool in the Fed’s hand is open market operations, where Fed purchases government securities held indirectly by banks in the open market in order to hit a target fund rate.

 

 In essence, this governs the supply of reserves in the banking system, thereby affecting interest rate changes. In case the Fed wants to bring down the effective prime rate, it will buy government securities through the open market operations, run through the New York Fed trading desk, thereby injecting money into the banks, which in turn shall be given out at a lower rate due to demand-supply dynamics in the market, in order to maximise treasury income for the banks.  

 

 

  1. Federal Funds Rate: 

 

The federal funds rate refers to the interest rate that banks charge other banks for lending to them excess cash from their reserve balances on an overnight basis. 

 

By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. The amount of money a bank must keep in its Fed account is known as a reserve requirement and is based on a percentage of the bank's total deposits.

 

In response to the Covid-19 crisis, the Federal Reserve has cut its goal for the Federal Funds rate by 1.5% since March last year. Currently, the fed funds rate is at the 0% to 0.25% range, as described by brookings.edu.

 

 

  1. Forward Guidance: 

 

The forward guidance provided by the Federal Reserve reaffirms its accommodative stance and provides confidence to entities worldwide. The Federal Reserve’s affirmative forward guidance puts downward pressure on the long-term rates.

 

 

  1. Quantitative Easing: 

 

Quantitative easing is done by the Federal Reserve by purchasing massive amounts of securities and thereby infusing liquidity into the financial system. The Federal Reserve has made no policy changes regarding the $120 billion per month cash infusion programme currently in place in the latest FOMC meeting held last month.

 

Apart from the weapons discussed above, the Federal Reserve employs lending facilities to securities firms at low rates, expands the scope of its repo agreements, reduces the reserve requirements, provides special credit facilities to support loans to small businesses, etc. to revive the economy in a holistic manner.

 

In response to Covid-19, one of the most daunting challenges faced by the Fed where the lockdowns imposed onto the market derided economic activity while investor confidence tumbled as the pundits forecasted the work economy to enter into a long-term recession, Fed used all the weapons in their arsenal from the fund rate, OMO to liquidity facilities, swap lines and reserve requirements.  

 

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In order to reinforce confidence in global markets, the Fed reserve went so far as to provide Central banks and other international monetary authorities with accounts at the Federal Reserve Bank of New York and extended repurchase facilities to them, in effect, providing unprecedented amounts of liquidity to the global markets backstopping the risk faced by investors who were pulling away money from the markets.

 

 

Final Note

 

All in all, the Federal Reserve’s major goal is to provide financial stability to the economy and it accomplishes the same through an array of weapons at its disposal. The intended purpose to establish the Federal Reserve System was to augur a stable economic development path for the US, but with an unprecedented scale of globalization through the past few decades, it has become the bearer of one of the most important guiding lights to the international credit markets. 

 

As Covid has helped us understand, the Federal Reserve plays an important role in stabilizing the world economy to a significant level. 

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