Showing posts with label The Fed. Show all posts
Showing posts with label The Fed. Show all posts

What is the Fed?


The Fed

The Federal Reserve, also known as the "Fed", "lender of last resort" and a "bank to other banks" is the central bank of the United States that determines U.S. monetary policy. This means that it controls the national money supply which enables it to control national interest rates. This is used to keep two major indicators in check- unemployment and inflation. The Fed also provides short term loans (a kind of "stimulus") to banks in times of stress.


History

For a long time, people feared central banks had too much power in too few hands. However, in 1907, the Knickerbocker Trust Co. went bankrupt which led to a run on the banks and the banks didn't have sufficient cash reserves to give customers their requested withdrawals. To quell the panic, J.P. Morgan and other private wealthy American individuals made loans to the banks to get past the crisis. It was at this point the need for a central banking authority was made clear to America.


What the Federal Reserve does

The United States developed the Fed as a way to keep the economy healthy and provide reserves when necessary to prevent panic. It is a tool, most notably in its control of the federal funds rate.

The Fed controls this "root" lending rate (or the rate which the Fed lends to banks) and this directly influences the rate at which banks lend to each other and ultimately, the rate trickles down to companies and individuals. This is what is referred to as "the Fed changing the interest rate".


  • Higher rates to cool a hot economy lead to more saving, less spending- a contraction of the money supply. Prices fall, lowered inflation.
  • Lower rates to stimulate a flagging economy lead to more spending, borrowing and investing- an expansion of the money supply. Prices rise, heightened inflation.


The Fed raises interest rates to check inflation and lowers rates to check stagflation. The Fed is essentially designed to keep money flowing and prevent any major disruptions in our economy. The goal is to keep the U.S. economy healthy.

To match its target, the Fed performs "open market operations" which traditionally is the buying and selling of short-term U.S. government securities. To fight more recent financial straights however, the Fed has resorted to buying and selling more long-term, non-governmental securities.

The Fed essentially performs a balancing act to ensure that there is always enough buyers and sellers or put another way, they ensure that too many dollars in circulation for too few people (specifically people spending cash/money) doesn't lead to runaway inflation and that too few dollars in too many hands doesn't lead to Recession or a tightening of overall lending that causes the economy stagnate or crash.


The Federal Reserve building in Washington D.C.


Fed criticism

The Infamous Fed Chairman Ben Bernanke line during the 2008 Financial Crisis "using a computer to mark up the size of the account" 👀 is not a typo or misquote. It is however, very misinterpreted by many. In normal times the Fed doesn't need to literally expand the money supply very often by printing dollars- it merely purchases securities with dollars to put those dollars back into circulation.

But when it is determined that the Fed doesn't have enough dollars to buy the securities required to stabilize the banking system it has to (heaven forbid) create dollars to match the need for lending during a lending freeze as was seen in the Financial Crisis of 2008, 2009 and Spring of 2020 when COVID-19 first ravaged the American economy. If you think about it rationally, the United States usually increases overall productivity year-over-year. With this increase in productivity, and increase in securities valuations, you need the physical dollars (or other tangible liquid assets like precious metals) behind the increased productivity and valuations otherwise when there is an adverse event and people go running to withdrawal money and liquidate their securities, there will not be enough money.

Printing dollars is necessary because our economic systems, and specifically the "cash paper/note" is man-made. And it cannot expand without human action (unless we put the economic into some kind of smart contract, but I'd advise against that).

If you expand the overall wealth in the U.S. by 3% or 5%, should the money supply not also expand to reflect this expansion?

If it doesn't, then $1 in current USD value would probably be worth about $3,378 dollars. It makes small transactions impractical. And I suppose we could instead print more "coins" but coins are more expensive to make and they are heavier.


The need for the Fed

There will never be enough money to autopilot the U.S. economy or obviate the need for the Fed and its independency. There will always be a need to do the balancing act of adjusting interest rates, the printing of money to match productivity and lending needs and the extreme rescue measure of printing money to create extremely large loans in order to keep key so-called "too big too fail" institutions solvent.

And that is to be expected. All of this is due to human nature and the fear instinct. When things go really bad (usually due to lack of regulatory oversight and/or financial fraud), people are going to run to the bank for cash and attempt to liquidate securities. And when peoples' and companies' bank and IRA balances are tied to institutions that evaporate overnight, the FDIC can't help beyond $100,000 per account. For companies and individuals with very high balances, you cannot expect the bank to have all the cash on hand to match everyone's balance (to say nothing of the ability to liquidate any of the myriad securities banks now offer to customers).

Banks are in the lending business, not the saving business. And there is a general expectation that there won't be a run on the bank and that all customers will not run to liquidate long-term assets all at once. So when these kinds of things happen (or when things start to tip in that direction)- the Fed steps in to provide everyone their "tomorrow money", today.

This act and the act of controlling the interest rates lever may not look very fair but it is necessary to rescue the economy in times of a major adverse event and to counter economic booms and busts and limit inflation.

When the next financial crash occurs, I'm not counting on Elon Musk and Bill Gates to be as generous as J.P. Morgan.




References:

https://www.youtube.com/watch?v=M7nj2X-yl_U

https://www.youtube.com/watch?v=qoUmSer2IxA

https://www.nytimes.com/2020/03/21/opinion/-coronavirus-stimulus-trillion.html