So What Exactly Does the Federal Reserve Do?
One of the top business headlines from the Associated Press at the end of the day on Friday read “Stocks Flat Ahead of Fed Meeting.” If you read any business news coverage over the past week, you may have noticed that many headlines were some variation on the theme of the approaching Federal Reserve meeting. Based on the amount of attention that the Fed gets in the news it’s obviously important, but let’s take a step back for a minute and take a look at what exactly the Fed does and why it’s important.
The Federal Reserve was established in 1913 to direct US monetary policy and helps keep the economy stable and running like a well oiled machine. Monetary policy refers specifically to the amount of money in the economy, and is important because the amount of the money available has a major impact on the interest rates that lenders charge.
Low interest rates tend to encourage borrowing and stimulate economic activity. While this is often a positive, low interest rates can also stimulate activity above the economy’s capacity and drive inflation. Inflation is a whole topic in and of itself, but when it is high and unpredictable it can have destabilizing effect on the economy and discourage economic growth.
So the challenge for the Fed is to adjust the US money supply so that the economy expands smoothly and at the same time maintains a low and stable rate of inflation. To do this, the Fed has three tools at its disposal: the discount rate, reserve requirements, and open market operations. Each of these tools allows the Fed to either increase or decrease the supply of money.
The most widely used and best known of these tools, open market operations, is controlled by the Federal Reserve entity known as the Federal Open Market Committee (FOMC). The FOMC has the ability to either buy government securities to increase the money supply or sell securities to decrease the money supply. The current policy of the FOMC is to set a target for the Federal Funds Rate and then buy and sell securities to try to pinpoint that rate.
Which brings us back to the news headlines and the importance of the upcoming Federal Reserve meeting. Typically, these stories refer to a meeting of the FOMC (there are eight at least eight FOMC meetings per year). At the FOMC’s meetings, the members, led by the Chairman of the Federal Reserve, discuss current economic conditions and decide whether there should be a change in the Federal Funds Rate target.
The current Federal Funds Rate target is 5.25% and it has been there since the FOMC’s meeting in July of 2006. The next Fed meeting is scheduled for tomorrow, and the turmoil that’s sprouted from the housing and credit markets have many expecting that the Fed will cut rates by a quarter or half percentage point to try to relieve some of the pressure.
Interpretations of what a rate cut would mean varies. Some believe that a rate cut would go a long way to help prevent the situation in the credit markets from escalating further and view a potential rate cut as a positive development. Others, though, focus on the fact that a rate cut — particularly one of a half percentage point — suggests that the Fed sees the problems as major threats to economic growth.
Of course, following tomorrow’s meeting we’ll have much more to analyze. So stay tuned for a look back at what the Fed had to say and what it means for the stock market.
