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Not a day goes by that one doesn't hear or read something about the Federal Reserve
Board or its Chairman, Alan Greenspan. Intuitively we think that since we hear so much
abut it, it must be important. That is correct. But the average investor may know little
about the Federal Reserve System and even less about how it has an impact on their
pocketbook.
What is the Federal Reserve System?
The Federal Reserve System (or Fed) is the central bank of the United States. Central
banks regulate the supply of money and provide a positive monetary climate for the
country's entire economy. The Bank of Japan, The Bundesbank (Germany), and the Bank of
England are central banks for their respective countries.
The policies of the Federal Reserve System are determined by a board of governors (the
board). The board is made up of seven individuals, each appointed to staggered 14-year
terms by the President of the United States and subject to approval by the Senate. A new
member is appointed only every other year. This tends to limit political influence over
the Fed. The Chairman of the Fed is appointed by the President and confirmed by the
Senate.
There are 12 Federal Reserve District Banks controlled by the Board of Governors,
located in 12 cities around the country: Boston, New York, Philadelphia, Cleveland,
Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San
Francisco.
These banks differ from commercial banks in three ways:
| 1. |
They are not profit-making
institutions since they are an arm of the U.S. Treasury. |
| 2. |
They can issue money (commercial
banks cannot issue money.) |
| 3. |
They act as the banker's bank.
(Individuals and corporations do not bank with Federal Reserve Banks.) |
The Fed and the executive branch of our government are independent. However, the
Chairman of the Fed and executive branch officials (the Secretary of the Treasury and the
Chairman of the President's Council on Economic Advisors) meet weekly to discuss and plan
macro-economic policy. The Fed and the legislative branch are also independent. The Fed
Chairman makes a semi-annual appearance before the Senate banking committee. During these
mid-January and mid-July hearings, the Chairman talks and answers questions about current
Fed policy and his outlook for the economy.
The Treasury and the fed have different functions.
The Treasury
The treasury is concerned with receipts and expenditures of the government. The
Treasury issues government securities to cover the shortfall between receipts and
expenditures.
The Fed
The Fed does not issue government securities. It buys and sells government securities
as a way to control the money supply.
How the Fed Controls the Money Supply
The Fed controls the money supply in three ways:
| 1. |
Changing reserve requirements |
| 2. |
Buying and selling government
securities |
| 3. |
Changing the discount rate |
Changing reserve requirements
Most commercial banks, like the ones in which many people have their checking and
savings accounts, are members of the Federal Reserve System. These banks are known as
"member banks." All member banks are required to maintain a certain percent of
deposits on reserve with the Fed. As the percent reserve requirement is raised, the
overall money supply contracts; and as the percent is lowered the money supply increases.
Buying and selling government securities
This activity is also known as Open Market Operations. When the Fed buys U.S. Treasury
securities, it does so from member banks thus increasing the level of funds held by the
banks. When it sells U.S. Treasury securities to the member banks, the action drains funds
from the banking system and thus reduces the money supply.
Changing the discount rate
The discount rate is the interest rate at which member banks may borrow from the Fed.
As the discount rate increases banks are less likely to borrow and thus less likely to
lend to businesses and individuals. As the Fed lowers the discount rate, the opposite is
true: banks are more likely to borrow and more likely to lend to businesses and
individuals. More lending introduces more money into the system; less lending causes less
money to be in the system.
The Fed is a powerful organization with the ability to influence markets not only in
the U.S. but globally. That's why , at Lyon Capital Management, we remember the words of
Martin Zweig, "Don't fight the Fed."
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