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The Federal Reserve

Some may argue that the most powerful person in the world is not the President of the United States. The most powerful person in the world is the Chairperson of the Federal Reserve. Certainly, when the Fed talks everyone listens–the markets, Congress and even the President.

So who is the Federal Reserve and why is this entity so important? The Federal Reserve was founded by Congress in 1913 as the central bank of the U.S. The Federal Reserve (Fed) conducts the nation’s monetary policy and regulates our banking institutions.

The Federal Open Market Committee consists of twelve members including the seven members of the Board of Governors of the Federal Reserve System and the President of the Federal Reserve Bank of New York. The FOMC meets eight times each year and may meet by telephone at other times. For example, the FOMC met unscheduled directly after the terrorist attacks of September 11th and directed a Federal Funds rate decrease before a scheduled meeting which took place the first week in October, in which this rate was lowered again.

Open market operations–purchases and sales of U.S. Treasury and federal agency securities–are the principal tool for implementing monetary policy. Fiscal objectives are achieved partially through the setting of a target for the federal funds rate, which is the interest rate at which depository institutions lend balances at the Fed to other depository institutions overnight. These institutions may need such money to stay within reserve requirements set by the Fed.

The highest the Federal Funds rate has been in the past generation has been 8%.  It was lowered to virtually zero during the financial crisis of 2008 and kept there for a significant amount of time.

The Fed also provides financial data on the state of the economy and rates. The “Beige Book” is a report on economic conditions and is published eight times a year based upon anecdotal evidence gathered by each Federal Reserve Bank. The Fed also publishes reports on interest rates, monetary assets, industrial production and consumer credit. One such report, H.15, is released daily with information on a variety of interest rate denominated instruments from Treasury Bill rates to mortgage rates. The Treasury Constant Maturity Indices published by the Fed are used as the basis for adjustments for many adjustable rate mortgages.

So how does the Fed affect interest rates? By lowering the target for the federal funds rate, there is a direct effect upon short-term interest rates–especially the prime rate and three, six and one-year “T” bills. Banks typically lower or raise their prime lending rates as soon as Fed actions are announced. Many second mortgages, including home equity lines of credit (HELOCs), contain payments based directly upon these prime lending rates.

The effect on long-term rates is not as direct. If the markets perceive that the Federal Reserve is not being diligent against inflation (the federal funds rate is too low), long term rates may rise in response to “lax” monetary policies. If the economy slows suddenly, long-term rates may decrease before the Fed takes appropriate action.

The Fed can also affect long-term rates by using its access to funds to purchase Treasury, mortgage and other long-term securities. This was a tool the Fed used in the aftermath of the fiscal crisis and was dubbed “Qualitative Easing (QE).”  In the wake of the fiscal crisis, the Federal Reserve bought massive quantities of mortgage-backed securities at a time in which the secondary market for mortgages had collapsed, thereby bolstering the secondary market for mortgages. 

This support, as well as near zero benchmark for the federal funds rate, existed for almost a decade in the aftermath of the crisis and currently the Fed still holds massive quantities of mortgages.

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