Fee Fi Fo Fed: Big Changes for the Federal Reserve

Classic vacation pictures such as this one have been inundating all college students' Facebook and Instagram newsfeeds. We get it-no filter!

Classic vacation pictures such as this one have been inundating college students’ Facebook and Instagram newsfeeds. We get it-no filter!

For the past month, you have undoubtedly found yourself in one of two situations: 1. You were in Puerto Rico, where you sipped martinis while basking in the sun’s rays under a cloudless sky at a picturesque beach- all, of course, while instagramming your newly tanned self and the breathtaking views ad nauseam, or 2. You lounged around the house eating everything in sight, went to sleep at an ungodly hour, and then woke up mid-afternoon, only to regret that decision, but to nevertheless repeat it as you searched inane videos on YouTube at 2 AM.  Unfortunately, with the return of the spring semester comes the return of reality. While you put all of your worries aside, the finance world was chugging along at full steam. A major newsworthy story that took place over break was the approval of a new chairwoman, Janet Yellen, to the Federal Reserve. The Federal Reserve plays a crucial role in the finance world, and her appointment will have profound effects on both the American and global economy.

Ben Bernake has been the Fed Chairman since 2006. Former president Bush appointed him; President Obama reappointed him in 2010.

Ben Bernanke has been the Fed Chairman since 2006. Former president Bush appointed him; President Obama reappointed him in 2010.

Before delving into any details, I will note that from here on out, I will refer to the Federal Reserve as the Fed. Everyone in business calls it by this shorthand name; calling it by its proper name is akin to calling Bed-Sty by its full name, Bedford-Stuyvesant. (As a native New Jersey resident, I once did that, only to be mocked incessantly in the following weeks for my naiveté regarding New York.)

In early 2013, chaos erupted in Cyrus as people attempted to withdraw the contents of their bank accounts at banks, fearing that they might lose their savings. Ultimately, the government stepped in and restricted large withdrawals to prevent banks from running out of money.

In early 2013, chaos erupted in Cyrus as people attempted to withdraw the contents of their bank accounts at banks, fearing that they might lose their savings. Ultimately, the government stepped in and restricted large withdrawals to prevent banks from running out of money.

The Fed was established in 1913, in response to the Panic of 1907. As the name suggests, there was pure chaos at the time. The New York Stock Exchange plummeted 50%, when there was already a painful recession. Worrying about the fate of their money, a deluge of people swarmed to the banks to withdraw the contents of their accounts, an event known as a bank run. Nowadays, when you see a bank is “FDIC insured”, you are assured by the federal government that no matter what happens to the bank, you are guaranteed the safety of up to $250,000 in your account. People with more than that, however, get nervous when a bank might go under since they could potentially lose their money.

Go to any bank in America and you should see this sign (or a variation).

Go to any bank in America, and you will see this sign (or a variation).

The structure of the Fed is such that there are 4 different parts: The Board of Directors, the Federal Open Market Committee (FOMC), the Federal Reserve Banks, and the Board of Directors. While the parts frequently overlap, each has a distinct role that creates a sense of checks and balances that similarly characterize many aspects of the American government.

During a recession, the reserve ratio requirement was heavily slashed, in order to allow banks to loan out more money.

During a recession, the reserve ratio requirement was heavily slashed in order to allow banks to loan out more money.

The Board of Governors is the main governing body of the Fed. The president appoints all 7 members, who have 14-year terms. Of these members, there is a chairman and a vice chairman, who are chosen by the president and are confirmed by the Senate. The ultimate responsibility of this group is to form the monetary policy. The Board of Governors accomplishes this role in two ways. The first is through setting reserve requirements. As the Central Bank, the Fed is a financial hub flocked to by all banks. Banks make money by loaning out money, and profiting off of the interest. It is therefore in their best interest (pun intended) to lend out as much money as possible. However, to keep these banks in a healthy position-meaning, to prevent greediness that would result in a bank collapse-the Fed requires a certain percentage of total deposits, called the reserve ratio, to be kept on hand. The amount of money that must be left in the bank is considered on reserve. The higher the amount on reserve, the less the banks can lend.

Secondly, the Board of Governors sets the discount rate. The money that banks lend out to you is not grown on trees-surprise! The discount rate is the interest rate they are charged when borrowing from the Federal Reserve Banks. Whenever you borrow money, you are charged a higher interest rate than the bank was; you pay the discount rate the bank must pay in addition to the bank’s own interest rate. Since banks want to pay the lowest amount possible, the higher the discount rate, the less money available to loan out.

When they decide to buy or sell securities, they need the New York Fed president- they can immediately notify him of required transaction, and he will carry it out immediately.

When the FOMC decides to buy or sell securities, it needs the president of the Federal Reserve of New York, whose region houses Wall Street, in order to immediately carry out the necessary transaction.

FOMC is responsible for the third means of forming the monetary policy. With 12 members, 7 of whom are on the Board of Governors, FOMC is in charge of open market operations, which refers to the buying and selling of securities. Since this is accomplished exclusively on Wall Street, it makes logical sense why the president of the Federal Reserve of New York is a permanent member. The other members are 4 of the other 11 regional Fed presidents; with 1-year terms, the positions rotate on a yearly basis. Legally, FOMC must meet at least 4 times a year in Washington, D.C., where it prepares written reports on various financial developments. Most importantly, though, is their ability to immediately buy and sell securities based on their assessment of the current status of the economy.

The Federal Reserve Banks, which are regional, function as the operating arm of the Fed. They “provide services to the depository institutions”. Simply put, they dish out the dough to banks. Federal Reserve banks are just like the regular banks we frequent, except that they exclusively serve banks as customers. They are the source of the money that you borrow from the bank, albeit which you borrowed at a higher interest rate than the bank originally did.

The last group is the Board of Directors. There is a 9-person committee for each of the 12 regional banks; the respective regional banks appoint 6 of the members, while the Board of Governors appoints the other 3. This group is characterized by its responsibility to supervise the reserve banks. Directors are the link between the Fed and the public, a crucial element to ensure that all decisions are ultimately for our benefit.

Now that you know all the parts of the Fed and how it functions, you can see why it is so important. It has the ability to impact interest rates and the amount of money in the economy, both of which affect consumer spending and saving habits. Since the global economy bases many of its decisions on what happens in America, the consequences of any decision by the Fed can be, and often are, broad in both nature and scope.

The most talked about action of the Fed lately has been its policy on quantitative easing. Since the recession, the Fed has been making interest rates shockingly low, hovering around 0%. It accomplished this through quantitative easing, in which it purchased government securities from the market in order to reduce interest rates and increase money supply. Here is what this means in basic terms: by buying a lot of securities, the Fed is inundating the market with more money; with more money in the market, the interest rates go down. After all, with so much money, banks cannot loan it all out a high rate-so the rate must go down.

Critics of quantitative easing say flooding the market with cash is not the solution to our economic woes. It might even lead to more problems-with some claiming it will cause inflation.

Critics of quantitative easing say flooding the market with cash is not the solution to our economic woes. It might even lead to more problems-with some claiming it will cause inflation.

When there was a recession, the Fed deemed it necessary to reduce interest rates in order to persuade people to borrow money. Now, after so many years, and with America in a healthier state, the Fed is considering tapering the quantitative easing, meaning that it wants to scale back on the buying of billions of dollars worth of securities. To put the matter in perspective, the Fed has been buying $85 billion worth of bonds each month. Some people think it is time to finally stop quantitative easing and allow for higher interest rates since the economy is doing better; others believe the economy is still too vulnerable and the Fed must buttress the tepid, but rising, growth in the economy by maintaining the quantitative easing.

This is Janet Yellen. Become familiar with this face, as it will be in the news very often from here on out.

This is Janet Yellen. Become familiar with her face, as it will be in the news very often from here on out.

Janet Yellen is the first female to serve as chairwoman of the Fed in its 100 years in existence. The fact that both Republican and Democrats were able to approve of her is quite noteworthy, considering the schism that existed between the two parties barely 2 months ago during the Government Shutdown. With a new person in charge, there are bound to be changes. Will the reserve ratio stay the same? What will the discount rate be? What will be the fate of quantitative easing? All of these issues came to the forefront recently, as well as the candidates’ respective positions. For example, Janet Yellen believes in continuing quantitative easing. Whatever the case may be, it is important to know that new monetary policies will definitely be coming, so watch out.

Published in: on January 28, 2014 at 12:35 am Comments (0)

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