JUNO INVESTING ©

The Fed: A Peek Inside the US Financial Powerhouse

JUNO INVESTING ©
The Fed: A Peek Inside the US Financial Powerhouse

 

 

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WINTER 2017

By Chris Smith, CMC Markets

The United States Federal Reserve System is arguably the most powerful central bank in the world. Yet it is known in the financial world simply as ‘The Fed’. 

The financial markets are obsessed with the decisions made by its Federal Open Market Committee (FOMC) – which manages open-market operations and the buying and selling of government securities – and other policies the bank implements, because these can affect individuals and businesses around the world. 

Origins of the Fed

The Federal Reserve (Fed) dates back to 1910, when a group of politicians and businessmen gathered for a secret meeting on Jekyll Island, off the coast of southern Georgia. 

The group met to map out plans for a central banking body. This eventually became the US Federal Reserve, when President Woodrow Wilson enacted the Federal Reserve Act on 23 December 1913. Although the bank has ‘Federal’ in its title, in fact it isn’t a government entity and it’s privately owned by its members. 

The Fed was originally granted control over managing the purchasing power of the US dollar and credit available within the US financial system, and maintaining stability in the economy. 

During the 100 years since, the powers of the Fed have expanded dramatically and it has become a powerful force in the financial world. In 1994, Paul Volcker, chair of the Fed from 1979 to 1987, summed up its influence: “The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.” 

The decision-makers

The Fed was designed to operate independently of government and political pressure. 

The FOMC is made up of the governors of the Federal Reserve board plus five regional Reserve Bank presidents. It meets eight times a year to decide on US monetary policy. 

The 12 regional banks all opened on 16 November 1914 and are named after the locations of their headquarters – Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St Louis, Minneapolis, Kansas City, Dallas, and San Francisco. 

The chair of the board of governors delivers a press conference after four of the eight scheduled meetings and the regional members at the FOMC meetings rotate each year. However, the president of the Federal Reserve Bank of New York has a permanent voting seat.

Yellen in charge

Janet Yellen became instantly recognisable in the financial community when she took over the role of Chair of the Board of Governors of the Federal Reserve System in 2014. She succeeded the outspoken and high-profile former chairs Ben Bernanke (to whom Yellen was vice-chair) and Alan Greenspan. The powerful trio have all been on the cover of TIME magazine over the years.

Dr Yellen, an economist, is the first woman to head the Fed and has dedicated her working life to academia and the central bank. Interestingly, the Fed hires more PhD economists than most institutions in the world, with more than 300 on the payroll. 

Dr Yellen previously served as president of the Federal Reserve Bank of San Francisco between 2004 and 2010, over an important period of boom and bust in the state of California. 

She’s also the first Democrat since Paul Volcker to lead the Fed and is very much considered a ‘dove’ (someone who supports low interest rates) by Wall Street. 

More than setting interest rates    

The Fed is best known for moving and maintaining its benchmark US short-term interest rates (effectively, the price of money). But it has other important functions too. 

The FOMC has two main objectives: maximising employment and keeping prices stable at an inflation rate of around 2 per cent. 

To do that, Fed officials can raise and lower interest rates and buy up treasuries and other government bonds. Following various acts of Congress in 2008, the Fed now has the authority to buy and hold all sorts of assets on its balance sheet. 

Fed district banks also publish regular economic data and research reports, and supervise and regulate banking members to ensure the financial system stays robust.

The unexpected and unconventional

The Fed does not physically print money, as many people believe. (The US Treasury is responsible for this.) But it does have the ability to create credit in the system as the ‘banker’ for banks (its members). 

Unconventional policies, such as Quantitative Easing (QE), hit the headlines in 2008. Initially, this was a response to the dangers posed to financial system by the fallout from the US sub-prime mortgage crisis. At the time, the Fed purchased government bonds outright from member banks to add liquidity to capital markets, stimulate lending, cover collateral requirements, and reduce counter-party risks. 

Fed up with the Fed

The Fed’s 2 per cent inflation target was set relatively recently. Critics from within have questioned the policy, among them, Volcker, who asked in a Wall Street Journal interview: “Why do we want prices to double every generation?” No sound case can be made for central bank-created inflation in an economy, he argued. 

Volcker also commented on the Fed’s decision to provide long-term economic forecasts with greater frequency and in more detail. “The fate of the Fed cannot depend on forecasts it makes, and simply demonstrates to the public more frequently that forecasts are not that accurate.” 

The Fed has overseen one crisis after another, the scale of which has increased each time. They include the share market crash of 1987, the collapse of hedge fund management firm Long Term Capital Management in 1998, the Dotcom bust of 2000 and the sub-prime mortgage crisis of 2007. 

This has left many questioning the models the Fed uses to steer the economy and whether these
are now outdated, and asking if the Fed is in need of an overhaul. 

Some critics of the Fed also focus on the supervision errors that have led to too many financial crises that could have been foreseen and prevented. They point to the possible conflict of interest the Fed has in regulating institutions and member banks that have an ownership interest in it. Calls have been made for more transparency and regular audits of the Fed, which have also led to robust discussion in Congress, led by former Texas congressman Dr Ron Paul. 

Trump and the Fed: Friction ahead

The Trump administration and the Fed may soon be facing off. The Fed wants to normalise interest rates and gradually reduce its record US$4.5 trillion-dollar balance sheet (see Figure 1). But the Trump administration’s policies look likely instead to create more debt. These policies, such as tax cuts, could further increase an already-stretched national debt that has now ballooned to more than US$20 trillion, a legacy of previous administrations. 

The growing size of the US national debt is already soaking up more and more taxation revenue and there is a practical limit to how much the Fed can raise interest rates and continue to service the debt.

Janet Yellen’s term as Fed chair is coming to an end in January 2018, and the decision on whether she gets reappointed will be in President Trump’s hands. The world will be watching to see what happens.

DEFINITIONS

DOVE: A policymaker who promotes monetary policies involving low interest rates, based on the belief that low interest rates increase employment. 

HAWK: A policymaker who generally favours relatively high interest rates, in order to keep inflation in check.

MONETARY POLICY: The process through which a central bank controls the supply of money, using mechanisms such as inflation and interest rates.

OPEN-MARKET OPERATIONS: The trading of government securities in the open market in order to control the amount of money in the banking system.

QUANTITATIVE EASING (QE): A method of stimulating a national economy, by lowering interest rates and increasing the supply of money.

TREASURIES: An investment offered by the US Department of the Treasury, such as government bonds.