What's the fed's role?

The Federal Reserve System was created in 1913 when Congress passed the Federal Reserve Act. This Act established the Federal Reserve Board together with 12 regional Federal Reserve Banks which essentially act as our central bank to handle government transactions, coordinate and control commercial banks and, most important to help control the nation’’ money supply and credit conditions.

The most powerful committee within the FED is the Federal Open Market Committee (FOMC). It consists of twelve members five of who are representatives from the 12 districts and a seven-man Board of Governers. They meet every six weeks and it is there duty to establish a current position on the interest rate climate. If they believe that the economy is over heated, they will tend to tighten interest rates and if the economy is contracting, they will tend to ease interest rates. While there are several methods used to ease and tighten credit, the most prevalent is changing the discount rate. This is the rate at which commercial banks can borrower from the FED. The theory if the commercial banks can borrower at lower rates then they should make lower rates available to their customers who are the consumers. Conversely, if the cost of borrowing increases to the commercial banks, the banks will pass that onto their customers.

An example of how this works is as follows. If the economy is sluggish and the FED wants to increase economic activity they will attempt to motivate the consumer to increase spending (since 2/3 of the economy is the result of consumer spending activity). If you have a consumer sitting on the sideline not wanting to purchase that car, refrigerator, computer etc, if you make the cost of borrowing cheap enough, at some point the consumer will ultimately make that purchase which in turn will help the economy expand out of that sluggish phase. Conversely, if the economy is over heated (expanding too rapidly resulting in increased inflationary pressure…..too many dollars chasing too few goods), the FED will act by increasing the discount rate which will ultimately make the cost of purchasing that item much higher and a decision not to purchase will be made by the consumer. This ultimately will result in an economic slowdown.

Too simplify this activity, in theory then the FED’s job is to maintain the economy within a relatively narrow band….when the economy is heating up they tighten rates to slow it down and when it is contracting, they lower rates to create activity. Under the leadership of Alan Greenspan, the FED has performed this task quite admirably and there is no reason to assume that this will change anytime soon.

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