How the Fed Works

The Federal Reserve Board has the power to influence credit market conditions and the supply of money.  Consequently, it has enormous influence on the overall direction of the economy, over who gets a job or a pink slip and over who has success in their business or is looking at bankruptcy.  But what exactly is it?

While it has become much more visible in recent years, the Fed has been a force in American economics for almost a century. Created by the Federal Reserve Act of 1913, the “Fed” is actually made up of a couple of different parts.

First is the Federal Reserve Bank system. There are 12 regional Fed banks, which are quasi-independent institutions located in major U.S. cities. They do many things, such as supervise banks in their regions and distribute currency to them.

Second, is the Federal Reserve Board of Governors which holds most of the power when it comes to interest rate policy.

Federal Reserve Board of Governors
The president appoints and Congress confirms seven members to the Washington-based federal agency. Members serve 14-year terms that are staggered to prevent the entire board from changing all at once. The president also appoints a chairman (currently Alan Greenspan) and vice chairman.

FOMC
In addition to their other responsibilities, board members all sit on the Federal Open Market Committee, or FOMC. They are joined by the president of the Federal Reserve Bank of New York and a rotating combination of four other regional bank presidents. The group gathers eight times a year to discuss the economy and decide how to proceed with regard to interest rates. If circumstances change between these meetings, which are usually five to eight weeks apart, members can teleconference or otherwise convene and make emergency rate changes.

The FOMC controls only two rates directly — the federal funds rate and the federal discount rate. To understand what those rates are, people first have to understand that banks are required to maintain a certain percentage of the money deposited with them by customers on reserve at the Fed. On any given day, some banks will find they have extra money on reserve while some will find they don’t have enough.

Those lacking reserves can borrow money to meet reserve requirements either directly from the Fed or from each other. When banks borrow from the Fed, they pay interest at the discount rate. That doesn’t happen very often, though, because discount rate borrowing is supposed to be used as somewhat of a last resort. For that reason, the discount rate isn’t all that important.

But financial institutions borrow from each other all the time. When they do so, the borrowing bank pays interest to the lending bank at the federal funds rate. Banks are more than willing to lend out their excess reserves, too, because they don’t earn any interest on the money they have to keep deposited with the Fed.

What happens when the Federal Funds rate decreases
The actual funds rate fluctuates all the time depending on market conditions. But the Federal Reserve Bank of New York can keep the rate near the target spelled out by policymakers at the last FOMC meeting by trading securities with private-market institutions. If the Fed wants to drive the funds rate lower, it increases the supply of available reserves in the marketplace by buying securities.

When that happens, banks can obtain money to lend out more cheaply. They pass at least some of the lower cost of operating through to their customers.

Whenever the funds rate falls, for instance, banks lower their prime rates. That, in turn, lowers the rates on products whose rates are tied to prime, including home equity lines of credit and credit cards. Banks also lower their rates on certificates of deposit, car loans, personal loans and the like.

So what impact does that have? The lower cost of financing a new car prompts consumers to go out and buy a new car. Dealerships start running out of cars and order more from their factories. Managers who fired workers months ago when demand slowed suddenly find they can’t keep the assembly lines running. They start placing “Help Wanted” ads on the Web and hire more workers, who suddenly find themselves with money to spend, too.

Meanwhile, investors who got wind of the improved car sales outlook start buying the stock of XYZ Motors and all of its suppliers. That makes the monthly mutual fund statements of Americans everywhere look better than they have in a long time, boosting consumer confidence and wealth. The cycle continues, the economy improves.

How does this affect mortgage interest rates? 
Although the Federal Reserve does not have any direct influence on long-term interest rates such as that on home mortgages, we’ve seen that expected changes in the target rate tend to trigger changes in the mortgage interest rates. 

This is because a change in the Fed’s target rate may have an indirect effect through altering the expectations of borrowers and lenders.  More important, Fed open market purchases of government securities to enforce a reduction in the target rate add to bank liquidity.  That increases the availability of loans, which tends to lower interest rates across the board.  However, it also tends to stimulate the economy.  That increases the demand for loans, which tends to raise interest rates.