The Federal Reserve, What Is It Good For!

I was reading the headlines this morning, and I can save you the trouble of doing so yourself. Economically speaking, it's all in the crapper. Dollar disappoints, growth will be slower than expected (and you can be assured those expectations weren't exactly Himalayan), various big companies report disappointing earnings, another bank is feeling the pain of sub-prime mortgage hangover, and the Fed is doing this and that. Which got me thinking, what exactly does the Fed do and why does everyone care so much?

Okay, so I know a vague answer. But not enough to post on it, so I thought I'd take a stab at it. And hours of online research later, here we go... The US Federal Reserve was started by my buddy, historically speaking, Alexander Hamilton. You gotta love a guy that was an orphan and an immigrant (just like me!), a born-out-of-wedlock leading architect for both the US Constitution and the US economy, a Revolutionary War hero who fought alongside George Washington at a time when wars were fought with bayonets, and a New Yorker with a gun and a slow draw at an inconvenient time. Nevermind the fact that the Federalist Papers are nothing to sneeze at. I bring up Hamilton because the beginnings point to the present.

The American Revolution was largely fought over economic reasons, one of which was the right of the colonies to print their own currency (denied). To say that after the American Revolution the economy was in shambles is putting it lightly. To fight the war, practically starving minutemen were robbing and stealing from households as they marched along. The war was financed by the printing of Continentals, and to keep up with expenses they just kept printing and printing like the Energizer bunny. By the end of the war a Continental was worth one thousandth of its nominal value. It's like leaving home to go shopping with a thousand dollars in your pocket, and by the time you get ready to pay it's magically been reduced to a one dollar bill. The chaos between creditors and lenders was more than dramatic, it was often violent. During colonial times, actual British currency was scarce (hence wampum and certificates for tabacco), the Spanish peso was widespread, and after the flood of Continentals it was all a mess. The US Federal Reserve was created to bring peace and harmony to an economic mudslide. It is a role it competes for to this day.

The Federal Reserve is the central banking system of the United States, who first and foremost directs the traffic of money flow. And here's the part where you can lose interest. So let's talk about the here and now.

Open market operations- If the Fed sells US Treasury bonds, people like your grandma will buy a bond and for the next fifty years, or however long it takes you to find where you hid it, that money she handed over to the gov't for your bond is out of circulation. This would help curb inflation's enthusiasm. The formula goes like this, when the Fed buys government securities (ie you finally found Grandma's bond and want to cash it in) it is putting money into circulation, so there's more money around, interest rates go down, and more money is borrowed and spent. The reverse- when the Fed sells a bond to your grandma, Grandma's money is taken out of circulation, interest rates go up so it's harder to borrow money and spend. Substitute Grandma's bonds with China's US Treasuries, and we're talking our entire federal budget for years on end. In other words, some unfathomable amounts of currency are put in and out of circulation.

The alteration of reserve requirements. Yikes, there's a mouthful! The Fed decides what percentage of a bank's (ie Citibank) deposits must be held in reserve at a Federal Bank (there are 12 scattered around the country). The percentage only applies to transaction accounts, like your checking account, not savings and time deposits (CDs). The reserve requirement is currently 10% for big banks- so again it is a way to remove money from circulation, which theoretically means lower inflation. I say theoretically because banks can pay the Fed a premium to borrow the reserves it needs, but that's another story.

And most famously, the Fed decides key interest rates. I won't get into them all because my poor brain is tired by now (and hooray to you for reading this far!), but the most famous one is the recent spotlight hog, the nominal federal funds rate. Remember that previous 10% I mentioned? Private banks lend money to to each other, yes it's just a one night stand, and it's that interest rate that has everyone's panties in a jam. Which is why you hear phrases like key short term interest rate that impacts consumer loans.

So what's the big deal? Well, if you lower the rate at which a consumer can borrow money you supposedly let us all go hog wild and shop until we drop. Which is exactly what we've seem to have done (that would be the headlines about consumer spending slowing down). The other thing, banks make big money loaning each other money overnight. And you thought it was your direct deposits. So when things like "credit crunch" and "liquidity fears" are tossed around, you better believe that the rate at which they can borrow money is important.

So that's the long and the not at all short of it. Now you know why the news just says "The Fed lowered the interest rate"! There are much more informed individuals out there who can wax mathematical poetic on the rate cut (feel free to chime in), and there's plenty of basics I still don't get. But with an unkempt economy, any action of the Federal Reserve is both an ongoing discussion and, apparently, a lesson for me in economics.