What the Fed Does, and Can Do

Binyamin Appelbaum, 12/08/13

With the prospective nomination of Janet L. Yellen to head the Federal Reserve, here is a look at the fundamentals of the organization she would be taking over.

What does the Fed actually do?

The Federal Reserve is a government agency that regulates the American financial system and, by extension, the broader economy. Think of the financial system as an engine. The Fed controls the availability of fuel, basically by manipulating the price, and it dictates the permissible uses of fuel. It does these things with two goals in mind: preventing the economy from growing too quickly, and preventing the economy from shrinking.

How do interest rates work in this analogy?

The fuel, of course, is money. And the Fed manipulates the price of money by raising and lowering interest rates. When the Fed wants to slow down economic activity, it raises interest rates, increasing the cost of borrowing money. People and businesses borrow less and spend less, and growth slows down. When the Fed wants to stimulate the economy, it lowers interest rates. People borrow more, spend more — you get the drift.

So why hasn’t the Fed made larger cuts to consumer interest rates? The average rate on a 30-year mortgage is 4.6 percent. That’s low, but the economy is still terrible.

The Fed has cut the interest rate it directly controls all the way to zero, for the first time in history, and it has kept the cost at zero since December 2008. But you can get money at that rate – free – only if you’re a bank, and you are willing to pay the loan back the next day. Everyone else needs to pay more, for three reasons.

First, if you want to borrow money for more than one day, the lender will worry that interest rates may rise while the money is tied up. That would be a lost opportunity. So interest rates on longer-term loans reflect the expected level of short-term rates over the life of the loan. Since no one expects the Fed to keep short-term rates near zero for, say, 30 years, rates on 30-year mortgages remain higher than zero.

Second, lenders worry that borrowers won’t pay them back. The future is uncertain; the distant future is more uncertain. So even borrowers with excellent credit pay a premium to borrow for 30 years.

And of course, banks are businesses, so there’s a profit margin too.

Is the Fed powerless to reduce those consumer rates further?

The Fed has tried a pair of novel strategies to drag consumer rates – and for that matter, business rates – closer to zero.

The campaign that gets all the publicity is called quantitative easing. The Fed has purchased more than $4 trillion in Treasury securities and mortgage-backed securities since 2008, driving up prices as other investors compete for the diminished pool of available securities.

When investors pay a higher price for a bond, it means that they are accepting a lower interest rate from the borrower. So the Fed’s purchases have helped to reduce the interest rates paid by the government and by people buying homes. The Fed says the purchases also drive down other interest rates, but that is not yet widely accepted.

The quieter campaign, but probably a more important one, is called forward guidance. Recall from the last answer that one reason for higher interest rates on long-term loans is uncertainty about the future level of short-term rates. The Fed has sought to address this uncertainty by declaring its intention to keep short-term rates near zero at least as long as the unemployment rate remains above 6.5 percent.

Most experts agree these efforts have helped, at least a little.

Shouldn’t the Fed be worried about inflation?

Economists generally agree that the single most important thing the Fed can do for the economy is to maintain slow and steady inflation. Last year the Fed declared that it thinks 2 percent annual inflation is just right, meaning that on average, $1.02 will buy what $1 bought one year ago.

Historically, the Fed has focused mostly on preventing inflation from rising too quickly. But right now, the Fed has the opposite problem. The economy is so weak that inflation has sagged to the lowest pace on record.

Some economists worry that the Fed’s efforts to foster growth – particularly its huge asset purchases – will eventually cause faster inflation. The Fed pays for its purchases by creating money from nothing, and when the supply of money grows faster than the economy, inflation is the result.

Fed officials are more worried about giving a boost to the economy at the moment. But they also think they’ve got a clever new tool to prevent inflation. The money spent on bond purchases is credited to banks, but it is kept in accounts held by the Fed. The Fed recently started to pay interest on those accounts, giving banks an incentive to leave the money with the Fed. As the economy starts to grow, Fed officials say they can keep a lid on inflation by paying the banks higher interest rates to leave the money untouched.

President Obama has said he wants a Fed chief who will prevent asset bubbles like the housing bubble that caused the financial crisis. How does the Fed do that?

Bubbles happen when prices rise unsustainably. It’s a wonderful term because everyone can visualize what happens next.

In the years before the crisis, Fed officials were basically divided into two groups, neither of which paid much attention to bubbles. Some denied the existence of bubbles, on the grounds that the price of an open-market transaction is accurate by definition. Others simply denied that the Fed could identify or pop bubbles.

Since the crisis, the Fed has started taking this part of its job a lot more seriously. It is working to improve financial regulation to curtail excessive speculation — for example, by requiring banks to raise a larger portion of funding in the form of capital rather than debt, a bet on the future of the company rather than a low-risk loan.

It is also vastly increasing its oversight of financial markets, to look for evidence of emerging bubbles that can be constrained by regulation.

The outstanding question is whether the Fed should try to pop bubbles if those first lines of defense don’t work. The problem with popping bubbles is that the Fed really only has one way to do it: by raising interest rates for the entire economy, which is something like dropping bombs on cockroaches.

Still, some Fed officials think it’s worth a try. Jeremy Stein, a Fed governor, has compared it to unleashing a flood. In his view, that’s a good thing, because it gets into cracks you can’t even see.

Interest rates, bubbles – what else is on the Fed’s plate?

The overhaul of financial regulations that Congress passed in 2010 contained a long honey-do list for the Fed, and much of it remains undone. One of the most important items is defining new restrictions on the activities of the largest banks, which still benefit from the perception among investors that the federal government will not allow them to fail.

The Fed is under pressure from Democrats to speed up.

The Fed also is pushing for increased regulation of other kinds of financial companies, like money market mutual funds, and to improve the stability of trading in areas like the vast marketplace for derivatives.

The Federal Reserve system is also the nation’s largest employer of research economists. The staff at the Washington headquarters is widely regarded as the gold standard for economic forecasting – although it’s a pretty low standard. The Fed has almost never predicted recessions correctly.

Oh, and the Fed is also America’s most successful exporter. It just introduced a new version of its most popular product:The $100 bill.

http://economix.blogs.nytimes.com/2013/10/08/what-the-fed-does-and-can-do/