So far we've learned about the structure of the Federal Reserve and its duties, the Federal Open Market Committee (FOMC), the tools of monetary policy and the federal funds rate. Now we're going to put it all together to see how the Fed uses the tools at its disposal to influence the economy.

The FOMC Decision
The FOMC typically meets eight times each year. At these meetings, the FOMC members decide whether monetary policy should be changed. Before each meeting, FOMC members receive the "Green Book," which contains the Federal Reserve Board (FRB) staff forecasts of the U.S. economy, the "Blue Book," which presents the Board staff's monetary policy analysis and the "Beige Book," which includes a discussion of regional economic conditions prepared by each Reserve Bank.

When the FOMC meets, it decides whether to lower, raise or maintain its target for the federal funds rate. The FOMC also decides on the discount rate. The reason we say that the FOMC sets the target for the rate is because the rate is actually determined by market forces. The Fed will do its best to influence open-market operations, but many other factors contribute to what the actual rate ends up being. A good example of this phenomenon occurs during the holiday season. At Christmas, consumers have an increased demand for cash, and banks will draw down on their reserves, placing a higher demand on the overnight reserve market; this increases the federal funds rate. So when the media says there is a change in the federal funds rate (in basis points), don't let it confuse you; what they are, in fact, referring to is a change in the Fed's target.
If the FOMC wants to increase economic growth, it will reduce the target fed funds rate. Conversely, if it wants to slow down the economy, it will increase the target rate.

The Fed tries to sustain steady growth, without the economy overheating. When talking about economic growth, extremes are always bad. If the economy is growing too fast, we end up with inflation. If the economy slows down too much, we end up in recession.

Sometimes the FOMC maintains rates at current levels but warns that a possible policy change could occur in the near future. This warning is referred to as the bias. The means that the Fed might think that rates are fine for now, but that there is a considerable threat that economic conditions could warrant a rate change soon. The Fed will issue an easing bias if it thinks the lowering of rates is imminent. Conversely, the Fed will adopt a bias towards tightening if it feels that rates might rise in the future.

Why It Works
If the target rate has been increased, the FOMC sells securities. If the FOMC reduces the target rate, it buys securities.

For example, when the Fed buys securities, it essentially creates new money to do so. This increases the supply of reserves in the market. Think of it this way, if the Fed buys a government security, it issues the seller a check, which the seller deposits in his or her bank. This check is then credited against the bank's reserve requirement. As a result, the bank has a greater supply of reserves, and doesn't need to borrow money overnight in the reserves market. Therefore, federal funds rate is reduced. Of course, when the Fed sells securities, it reduces reserves at the banks of purchasers, which makes it more likely that the bank will engage in overnight borrowing, and increase the federal funds rate.



To put it all together, reducing the target rate means the fed is putting more money into the economy. This makes it cheaper to get a mortgage or buy a car, which helps to boost the economy. Furthermore, interest rates are related, so if banks have to pay less to borrow money themselves, the cost of a loan is reduced.

Why is Everybody Always Talking About Alan Greenspan?
Many investors have watched Alan Greenspan with the utmost attention. As the former chairman of the Fed, he guided U.S. monetary policy between 1987 and 2006, making him an extremely powerful man. Few had the power to make the markets move like Greenspan. When he spoke, he carried the weight of the Federal Reserve, forcing professional investors to analyze his every word. He was designated chairman by presidents Reagan, George H.W. Bush, Bill Clinton and President George W. Bush. He was succeeded by Ben Bernanke on February 1, 2006.


Next: The Federal Reserve: Conclusion »



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