Impact of the Federal Reserve System

By Carrie Coghill, CFP

He could make markets tumble with just a sneeze if he had a cold. People have studied how he carries his daily paper to work to see if that somehow indicates his mood or thoughts. The Wall Street Journal only needs to refer to him as “Greenspan.”

He serves at the whim of the president, and three have granted him job security because they didn’t want to rock the boat. For what it’s worth, he’s probably more powerful than the president. When he speaks, he doesn’t have to worry about partisan political attacks.

Everyone knows the name of Alan Greenspan, the chairman of the Federal Reserve System, which is the central bank of the United States. Since he took the post in 1987, inflation has generally declined and the economy has seen its longest peacetime expansion in U.S. history. But what exactly does the Fed do, and why should we care?

The Nation’s Bank

The Fed consists of three entities: 12 Reserve banks scattered across the country, the Board of Governors, and the Federal Open Market Committee (FOMC).

Congress established the Fed in 1913 to counteract a series of banking crises that began in the 19th century. Now, its purpose is to ensure a secure banking system for both consumers and the government, foster a healthy economy and keep inflation under control. It operates free from political influence to make sure all this can be done.

The Fed calls itself “a decentralized central bank” because it must balance the interests of both the government and the banking industry. As a result, its structure has both private and public elements. Congress oversees the Fed: its officials must testify before Congress each quarter and the Senate must confirm the president’s appointee for chair. However, the Fed’s decisions do not need the approval of any branch of the government. And the Reserve banks operate autonomously, like private-sector banking corporations.

Yet, none of the Federal Reserve System is funded by tax dollars or government money. Instead, it supports itself through interest it earns on investments in government securities and bank loans, and from charges for the services it provides to financial institutions, like check processing and clearing. Any net income the System makes goes to the U.S. Treasury. The Fed is the watchdog of the U.S. money flow. The Fed actually issues our currency when levels get too low (the Treasury Department only produces it) and distributes it to banks and financial institutions.

The Reserve banks watch their local economies for trends that may affect the national economic picture. They also supervise commercial banks, distribute cash to banks and financial institutions, and provide electronic clearing systems to them to process payments.

The Board of Governors, also known as the Federal Reserve Board, makes most of the Fed’s monetary policy decisions, oversees the Reserve banks and makes sure the economy is running smoothly. The seven members are appointed by the president and confirmed by the Senate to serve 14-year terms. This way, governorship spans numerous presidential administrations and Congressional rosters to ensure that no member is beholden to specific political patron. Each governor is also a member of the FOMC.

The FOMC is comprised of the seven governors and five of the 12 Reserve bank presidents. It is in charge of the buying and selling of government and federal agency securities. This encourages or maintains economic growth, steady employment, and stable prices.

So How Does This Affect Me?

Actually, in many ways. The FOMC sets the federal funds rate, which is the rate that commercial banks charge each other for overnight loans. This, in turn, affects the interest rate that banks charge borrowers. The FOMC can raise or lower the rate, or keep it unchanged.

This is when you probably hear about the Fed (the press uses the Fed and FOMC interchangeably), as speculation about the interest rates sets Wall Street abuzz. While Greenspan is often credited with making the rate decision himself, it’s actually voted on by the entire FOMC.

The Fed is probably the most influential institution on the American economy. Think of the economy as an engine. The FOMC can use the interest rate either as a brake or a gas pedal, depending on what the Fed wants to accomplish.

If the FOMC raises interest rates, as they have 10 times in the past two years, it’s probably because it thinks inflation is, or will be, a problem. At the current time, the Fed is concerned that rising energy costs will be inflationary to the system, as was the case during the 1970s. Increases in interest rates make bonds more attractive to new investors. However, rate increases have a negative affect on the prices of existing bonds. Stock prices have a tendency to struggle as higher interest rates also cool down consumer and business spending. People are less likely to take out mortgages and max out their credit cards. Businesses have a hard time getting loans for capital expansion, and they may cut back expenses by laying off workers.

The FOMC lowers interest rates when inflation is in check and the economy is sluggish. The Fed began a number of aggressive rate cuts in January 2001 to stimulate activity, which resulted in near-40-year-lows of just over a percent. Stock prices improved as corporation began to grow again. As interest rates decline, the yield on bonds also decline: therefore, they are not as attractive to investors. Companies benefit from lower costs, which increase their profits and encourages them to expand. This can lead to more spending and hiring.

Consumers obviously benefit when lenders like credit card and mortgage companies don’t get as much of their money. Homeowners refinance, would-be homeowners buy, and everyone ends up with a bit more money in their pockets. And with that extra cash, consumers will naturally spend it, and put big-ticket items on those credit cards.

Although investors don’t like to see interest rates going up, it is a positive sign that the economy is doing well. If the economy becomes overheated, inflation can spin out of control. Interest rate increases are the necessary evil that helps to avoid inflation. On the other hand, when interest rates are declining, this is a sign that our economy is not doing so well and needs some help. Finding the “sweet spot” with interest rates is nearly an impossible task, considering the dynamics of our economy.

Any changes to the interest rate can take between six to twelve months to cycle through the economy, so the FOMC’s decisions are far-ranging-and certainly more so than if Greenspan had a cold!

All of the speculation surrounding Alan Greenspan will come to a close in January 2006, when he retires. President Bush is in the process of selecting Greenspan’s successor. We will begin a new era of understanding the implications of why the new chairman carries his paper a certain way and what he “really” means when he testifies before Congress.

Carrie Coghill, CFP is President of D.B. Root & Company Financial Planning based in Pittsburgh, Pa.