Zaks Investment Advisory Service

The Federal Reserve, Money and Interest Rates (part 3 -- Rates and the Fed's Influence)

Today, we will conclude our excursion into the theory of money, interest rates and the role of the Federal Reserve. Our programs are fairly brief, which is why I had to split one subject into three installments. I would like to remind our listeners what we talked about in the previous two. We began by trying to understand how our central bank, the Federal Reserve, affects interest rates. Along the way, we determined what money is, and how banks in the course of their lending activity create new money. We also had time to learn that the Federal Reserve, by buying and selling securities, increases or reduces reserve funds of commercial banks, i.e. funds that banks by law must keep with the Federal Reserve. These additional reserves may potentially let banks issue new loans – thus increasing the amount of money in the economy.

We stopped during a discussion of the following example: the Federal Reserve bought Treasury bonds from a dealer and transferred the money into a bank (for example, J.P. Morgan Chase), which from this simple transaction received extra money on its Federal Reserve account (we have already mentioned that this money is called “federal funds”). And, as we learned, the bank thus gained an opportunity to issue new loans. Morgan Chase now has a chance to earn some money, but in practice this will take time: it still has to find a client. In the meantime it has, so to speak, “extra cash” that it would like to somehow employ instead of have sitting on central bank accounts without earning interest. On the other hand, imagine some other bank, say Citibank, was working all day, making payment transactions, opening credit accounts, and at the end of business hours discovering it was short of federal funds. Citibank knows it has to do something; otherwise, the Federal Reserve will fine it. What can it do? Very simple: it turns to Morgan Chase and borrows its extra federal funds: obviously, it borrows at a certain rate, which is called the “federal funds rate.” It borrows the money for just one day since its knows that by tomorrow, it will be able to correct its imbalance and be back within limits set by the central bank – or, if worst comes to worst, to borrow money for one more day. And thus, as a result of this transaction, Morgan Chase earns money while Citibank observes the rules prescribed by the Federal Reserve. These types of transactions are very frequent: the federal funds interbank trade is an enormous market whose daily volume stands at tens of billions of dollars.

So what follows from this? The federal funds rate is linked to other short-term rates. By manipulating the federal funds rate, our central bank affects practically every short-term rate. At the same time, it also affects the dollar’s exchange rate (we will definitely figure out how in one of our future programs). So, in this respect, the Federal Reserve’s influence is enormous. But long-term rates depend on numerous other factors: what the inflation expectations are, on the economic growth rate, and, accordingly, on the supply and demand of long-term credit. The Federal Reserve of course affects all these factors, but its influence here is indirect. One does not have to search far for an example: over the past four years, the Federal Reserve has raised its federal fund rates from one percent to 5.25 percent, but the long-term rates on its three-year Treasury bonds changed very little over this time. In exactly the same manner, mortgage rates recently went up, but only slightly. The relationship between short-term and long-term rates is a fairly curious subject called the “term structure of interest rates.” We might talk about it some other time. But what is important for us now is that the Federal Reserve may only directly affect the short-term interest rates, while its influence over long-term rates is indirect. The Federal Reserve must follow a particular course for a long time, for example by raising the short-term federal fund rates, before the long-term rates eventually follow in the same direction. You know that the Federal Reserve board periodically adopts a decision to change its interest rate, say from three percent to 3.25 percent. And so – the interest rates changed by the Federal Reserve are called the “federal fund rates,” which we just described. Now you know which interest rates they are talking about.

This aspect of the Federal Reserve’s work is called “monetary policy.” By manipulating the amount of money in the economy along with the short-term interest rates, the Federal Reserve tries to fight inflation, or, if the economy is in a decline, use these measures to try and accelerate growth and reduce unemployment.

Our Federal Reserve is a remarkably powerful and independent institution. Many believe that the chairman of the Federal Reserve is a more influential figure than the president of the United States. This, of course, is a slight exaggeration, but the central bank does often have a greater effect on our lives than the federal government. Nonetheless, within the confines the market economy, the central bank’s influence is limited: it cannot “appoint” interest rates, but can only influence the short-term portion of their spectrum. And it does so not through decrees, but by taking part in market transactions.

Why have we been talking about this for such a long time? Well, for starters, it never hurts to know how our financial system works. But besides, it is also interesting because despite all its limitations, the Federal Reserve has a tremendous effect on our economy (many, for example, believe that the central bank’s firm monetary policies of the early 1930s, when the Federal Reserve limited the amount of money in the economy, led to the Great Depression). At least now we know what people are talking about and have a general idea about the central bank’s means and limitations, placed on it by the very nature of this country’s market economy. The central bank’s chairman is appointed by the US president with agreement from Congress, and is not an elected position. This post is incredibly independent (and here the United States differs from almost all other countries on earth), which is why it is always good to know what it is that the Federal Reserve actually does.

But with this, we will have to draw our program to a close. This was Sergey Zaks. Thank you for your attention and until next time.