By MO BARAKAT Special to the Daily Press
The Federal Reserve System, commonly know as the “Fed,” is simply an independent central bank established by Congress in 1913 which steers the economy by periodically raising and lowering federal fund rates.
Perhaps no institution has more power to affect the nation’s economy than the Fed. The Federal Reserve System has a structure designed by Congress to give it a broad perspective on the economy. It is a federal system, composed basically of a central, governmental agency — the Board of Governors — in Washington, D.C., and 12 regional Federal Reserve Banks located in major cities throughout the nation.
While the Fed is under the leadership of its influential chairman, Alan Greenspan, decisions are actually made by the 12-member Federal Open Market Committee (FOMC) which has eight scheduled meetings per year. The Board of Governors is comprised of seven Fed governors, including Alan Greenspan, who are appointed by the president of the United States for 14-year terms. All are permanent members of the FOMC.
Most developed countries have a central bank whose functions are broadly similar to those of the Federal Reserve. The U.S. Federal Reserve states that they have four main objectives. First, they conduct the nation’s monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices. Secondly, they supervise and regulate banking institutions to ensure the safety and soundness of the nation’s banking and financial system and protect the credit rights of consumers. Third, they maintain the stability of the financial system and contain systemic risk that may arise in financial markets. Finally, The Federal Reserve provides financial services to the U.S. government, the public, financial institutions and to foreign official institutions, including playing a major role in operating the nation’s payments system.
The central bank generally raises rates to prevent the economy from overheating and to keep inflation in check. In June 2004, the Fed raised rates for the first time in four years, ending a long cycle of rate cuts.
Higher interest rates on credit cards and mortgages can cool consumer spending, which accounts for about two-thirds of economic activity. Higher interest rates tend to attract investment into bond and other fixed-income investments, pushing down stock prices. Furthermore, higher interest rates also can make it more difficult for businesses to get loans to expand. Unemployment tends to rise which eases wage inflation.
On the flip side, the Fed generally cuts rates when inflation is subdued and the economy needs a boost. Lower interest rates can create economic activity by inducing consumer spending. For example, lower mortgage rates can spark home sales and mortgage financing. Lower interest rates also can tend to boost stock prices because bond and other fixed income investments are no longer so attractive. Furthermore, lower interest rates cut costs for companies, boosting profit and encouraging expansion.
Of course, monetary policy does not always work exactly as described above. For example, the Fed has raised short-term interest rates three times since June 30 for a cumulative increase of 75 basis points or three quarters of a percentage point, yet longer-term interest rates have fallen over the same period. On June 29, the yield on the 10-year Treasury note was 4.7 percent. Now it is hovering around 4 percent.
This is contrary to what typically happens. It also questions just how much of a drag a less accommodative monetary policy stance by the Fed will have on the economy. After all, longer-term interest rates, including mortgage and corporate bond rates, tend to have more influence on the pace of economic activity than short-term interest rates.
Remember to seek the help of a qualified personal financial advisor to further understand rates and rate fluctuation and how they may affect your goals and financial plans. (Mo Barakat is a senior financial advisor in Santa Monica specializing in retirement planning, asset management and risk management. Barakat is a registered representative of American Express Financial Advisors, Inc., member NASD/SIPC. For more information call (310) 582-3500, ext. 242).
Originally published in the Santa Monica Daily Press print edition on January 6, 2005. Read the original PDF.