September 21, 2007

The Fed's Power

Ben Bernanke, the Chairman of the Federal Reserve, has more power over the economy than any other single person in the world. He has this power because as chairman, he sets the agenda for meetings of the Board of Governors of the Federal Reserve and the Federal Open Market Committee (FOMC). These two bodies are responsible for setting and carrying out (respectively) monetary policy. Monetary policy is basically the supply of money that is in the U.S. economy. You hear about the Fed raising or lowering interest rates, but there's only one that it sets, and that's not the important one. The one interest rate they set is the Discount Rate, which is the rate at which banks can borrow money from the Fed. The idea behind this is to prevent runs on banks by offering banks a guaranteed source of liquidity, which is a fancy word for the ability to get cash money.

Where does the Fed's true power lie? The answer is the money supply, which determines interest rates. Interest is the cost of money. A bank will give you money to buy that house, but you're going to have to pay interest for the privilege. If you call interest the price of money, and plot it against the quantity of money, then you have our old friends supply and demand. The price of money, interest rates, is determined by the demand and supply of money in the economy. The logic is straightforward, if the supply of money is decreased, then there is less to go around and lenders will charge a higher price, i.e., a higher interest rate.

The Fed controls the money supply not by printing money, which is the job of the Treasury department, but through the FOMC, which buys and sells government bonds in the open market, hence the name. When the FOMC buys bonds, money goes into the system. It's just like at the store: when you buy your candy bar, the store now has $1 more money than they had before. Conversely, when the FOMC sells bonds, cash comes out of the system, lowering the money supply which in turn increases the price of money: interest rates.

The Fed's actions affect all interest rates, but there is one in particular that it tries to keep at a certain level. This is the Federal Funds rate which is the rate at which banks lend to other banks to cover their reserve requirements. All banks are required to keep a certain percentage of deposits on hand at all times so that customers can get at their money whenever they want. During the course of the day, from deposits and withdrawals, the bank's reserves may have dropped below the required level. To meet the requirement, they will borrow from other banks with excess reserves. These loans are usually very short term, usually just overnight, and the interest rate they charge is the federal funds rate. About every six weeks, the Fed sets a target, recently dropped to 4.75% from 5.25%, and then the FOMC is constantly buying and selling bonds to keep the federal funds rate as close to the target as possible.

The federal funds rate is actually determined by the market for reserves among banks, just like most interest rates. The money supply affects all rates equally, increasing or decreasing the market price of a loan. The Fed watches the federal funds rate because it is probably the least risky loan in existence and shows the cost of the money itself without any other premiums added. Normally, the lender will add a premium to the loan for various reasons, such as the risk of the borrower defaulting on the loan or the risk of lending over different time periods.

Think of the implications of the Fed's power. Lowering the money supply too much will increase interest rates to the point that loans cost too much to be feasible, which will lock the economy up faster than just about anything. There's not a company out there that doesn't borrow money on a regular basis. On the other side, increasing the money supply too much will decrease the value of each dollar, which is the definition of inflation, which will wreck an economy as well. The practical trade off is a choice between helping the economy grow with lower interest rates, and keeping inflation in check with higher rates.

To summarize: The Fed controls the supply of money which determines interest rates. They have a target rate which they attempt to achieve by actively participating in the markets. This is the gist of how the Fed affects the economy. There are a lot of details that I left out, but this is the framework that gives the Fed the power.

Posted by chupathingy on September,21, 2007 at 1:50 PM | Comments (4)

It's not often that I see a blog post that doesn't really editorialize. A lot of good information about the Fed, but I'm curious as to what your opinion of it is.

Personally, I haven't made up my mind about the Fed, but I just wanna toss out this talking point:

In my experience, economists treat economics like a science, using all kinds of observed markers and tried methods of predicting what will happen with the economy. And in this sense, they are like meteorologists, economic weather men. As we all know from experience that there are far too many variables in the weather to truly accurately predict what will happen, and any prediction made more than a few days in advance is pretty unreliable (I planned this outdoor party a week ago when they said it would be clear and sunny! Why is it raining?). The same seems to go with economists, but unlike weather men there are more very different schools of thought in economics, causing a lot more disagreement in the field. And as to whether they are always right, there is a saying: "Economists have correctly predicted 8 of the past 3 recessions."

But there is no government sponsored weather machine that meteorologists can use to control the weather, and if there was, based on how I perceive their accuracy, I think it would be disastrous. But economists, with widely differing theories and even lower accuracy, have this power to control the economic weather though the Federal Reserve.

Is this really the right way to do things?

Comment by: mallio at 10:20 AM, September, 27, 2007

There was no editorializing because there's nothing to editorialize about. There's a misconception that there is a lot of disagreement among economists. 95% of economic theory is accepted all but universally. The parts that aren't are policy decisions, with the main disagreement being the magnitude of changes, not what changes will take place.

Economics is a science in so far as any social science is science. Remember, economies are made up of people. Economists are trying to predict how rational people will react to new events. The bedrock foundations of the economic theories involve assumptions about how people think and act. Unless we can perfectly describe how all people think, then economic forecasting can never be as precise as using physics to predict the location of a falling object. Your weather analogy is a very good one, except the comparison doesn't do justice to what economists are trying to predict. The natural world is governed by laws of physics that have been cataloged over the years. The economy is governed by the whims of individual people. There really aren't a set of proven, quantifiable laws that govern human thought. For that reason, economic forecasting can never be completely accurate.

That said, economists actually have done a very good job at predicting what will happen, but they are not good at predicting when. Its hard to say when enough people will realize that the price of candy bars is high enough to significantly decrease the quantity sold.

As far as the Federal Reserve goes (or central banks in general) they have to exist for an economy to function well. Believe it or not, the Fed has only existed since about 1911 (don't quote me on exact date). Imagine life without the Fed. There would be no common currency. Banks would have to be totally self-sufficient, meaning it is in danger of running out of cash at any time. The economy would also lose the stability of a controlled money supply. Before the Fed, the U.S. averaged major recessions every 10-20 years. I don't mean the 1-2 quarter recession we had in 2001 that everyone bitched about. I'm talking 3-5 years or more of steady economic decline. Think something comparable to the Great Depression (only a bit shorter) every 20 years.

Everyone complains about the Fed, but they're right a vast majority of the time, and they're crucial if a modern economy is going to prosper.

Comment by: Neil at 6:13 PM, September, 27, 2007

I'm sure 95% of economists agree on all things microeconomics because that's all simple, but on a macro scale, wouldn't you say that Keynesian and Supply-Side (Trickle Down) economists differ a lot? It's actually been like 5 years since I've taken an economics class, so I couldn't even tell you what those differences are, I just remember debating it way back when...

Comment by: mallio at 6:40 PM, October, 1, 2007

So-called "trickle-down" economics is a political construct as far as I'm concerned. The idea that you can make everyone better off by giving the upper 1% more money is ridiculous. The argument goes that they are likely to use the money for consumption (wrong, they save far more of their income than lower income households) and this will produce jobs. Why anyone could think that's a better idea than simply giving the money in some form or another to low-income households is beyond me. Supply-side economics is mostly just championing policies that give businesses more autonomy and fewer regulations.

I think the debate you're remembering is between Keynesians and Monetarists. That debate is whether the money supply affects interest rates (Monetarist) or whether interest rates are affected by real economic growth and determine the money supply (Keyensian). Its mostly a chicken and the egg type debate because both sides acknowledge the same relationship between the two, just a matter of which causes the other. In reality, they're both right in that either can affect the other. However, it's much easier to adjust the money supply than to "adjust" the rate of economic growth. This is why the government follows the "Monetarist" view.

This is how the debate frames up in terms of the Fed. It also clashes with the Classical school of economics in that the Keyensian model does not show changes in prices or wages as happening as fast as in the Classical models for various reasons, and also says that money is not neutral (has an effect on real economic growth) whereas the classical model says that money is neutral. Long story short, in the short term, elements of the Keyensian models are valid, but in the long term, the classical models seem to hold much better.

Comment by: Neil at 1:59 AM, October, 2, 2007