Whether you are a seasoned finance professional, retired veteran, or first-time homebuyer, you may be surprised to learn that the Federal Reserve’s monetary policy affects you. As the central bank of the United States, the Federal Reserve System — called the Fed, for short — is responsible for maintaining price stability and optimizing employment.
The Fed has four main areas of operation: monetary policy, banking supervision, systemic risk mitigation, and financial services. Nearly all developed countries have central banking systems that conduct similar activities. Some, like France and Italy, participate in the European Central Bank (ECB) rather than maintain their own central banking system.
Federal Reserve Bank Structure
There are 12 Federal Reserve Banks that service different regions of the country, many with additional branches that service depository institutions and the public. Commercial banks, savings institutions and credit unions are the main types of depository institutions.
A critical area of responsibility for the Fed involves keeping tabs on the state of the economy and the drivers affecting it. This includes the continual evaluation of hundreds of statistics and trends. To stay abreast of any and all factors that could significantly affect the money supply or the economy, the Fed closely monitors housing sales, e-commerce activity, and interest rate fluctuations.
Central Banking Monetary Policy
The Federal Open Market Committee (FOMC) formulates the monetary policy of the U.S. The committee consists of seven governors and five Reserve Bank presidents. The system is designed to be apolitical to promote stability in the economy, as well as consistent policies.
Controlling the supply of money helps to re-balance the economies and encourage economic investment in the U.S. and foreign countries.
Three Financial Instruments
The Federal Reserve Education website describes central banking monetary policy as the Fed’s activities “to influence the amount of money and credit in the U.S. economy” through three financial instruments:
Open Market Operations
The Fed buys and sells government securities through open market operations (OMO), which, in turn, either expand or contract the amount of money available to primary lenders such as banks and credit institutions, affecting the interest rate charged for lending funds. Securities are sometimes put in a “buy-and-hold” portfolio where they stay until maturity. These funds create a permanent increase in the level of reserve balances until the securities mature.
The discount rate is the interest rate on short-term loans for depository institutions. When the Fed determines a need to inject more activity and more funds into the economy, it can lower the discount rate. Lenders with access to the discounted funds can then offer reduced rates to their clients. The lower cost of borrowing money encourages individuals and businesses to take out loans that inject additional money into the economy.
The Fed requires depository institutions to safeguard funds in client accounts by holding a percentage of the money in reserve. In the event of an economic crisis — real or presumed — funds held in reserve can return money to individual depositors.
The Fed’s impact on the economy is far-reaching. Its response to the housing market collapse in 2008 is a case in point. Home and building values for many families and businesses dropped dramatically at the same time that unemployment increased, causing borrowers to default on loans. The Fed used the above three instruments to respond to the financial crisis and mitigate its devastating effect on retirement accounts. It also used less common methods such as creating emergency lending programs, offering sweeping bank bailouts, and buying back both short- and long-term treasury securities.
An in-depth knowledge of central banking monetary policy forms the basis for a thorough understanding of financial markets. Texas A&M University-Corpus Christi offers “Financial Markets & Institutions” as a core course in its online MBA in Finance program to give graduates an understanding of monetary policy and its importance to the economy.
Learn more about the Texas A&M University-Corpus Christi online MBA in Finance program.
Federal Reserve 2008: A Timeline of Fed Actions and Financial Crisis Events
FederalReserveEducation.org: Monetary Policy Basics
Federal Reserve Bank of New York: Open Market Operations
European Central Bank: Participating Countries