What in the world is the Fed?
By Ed Roche • Bankrate.com

"Federal Reserve Board Chairman Alan Greenspan woke up this morning with a cough. Fed watchers believe an interest-rate hike is a definite maybe." OK, you've probably never heard your morning newscaster utter that sentence, but they've come pretty close. You know this Greenspan guy is important. You know he works at "The Fed." But what exactly does "The Fed" do? Where is it, for crying out loud? And what does Greenspan have to do with me?

A lot, actually. Made up of the Board of Governors (of which Alan is chairman) and 12 Federal Reserve Banks, the Federal Reserve System (a k a "The Fed") watches over the economy by regulating the amount of cash that's floating around. It can do this because (1) it's the independent central bank of the United States and the government has a lot of cash and (2) it's the banker for other "regular" banks -- the ones where you and I keep our paychecks.

The Federal Reserve Board is in Washington, D.C. (essentially, Fed headquarters) and the 12 Reserve Banks are centered in districts across the United States -- San Francisco, Minneapolis, Cleveland, Richmond, Boston, New York, Philadelphia, Atlanta, Chicago, St. Louis, Kansas City and Dallas.

The seven-member Board of Governors is appointed by the president and confirmed by the Senate. They serve 14-year terms and cannot be reappointed after their term ends, except for members who complete an unexpired portion of a term. Our friend, Mr. Greenspan, is a perfect example of this. He took office as chairman in August 1987, completing the unexpired term of Paul Volcker, who Reagan pink-slipped. Fret not -- Greenspan's not out next year. In 1992, he was re-appointed to a full 14-year term, so he'll be in and around D.C. until 2006 -- going to parties with his wife, TV journalist Andrea Mitchell, and frequenting the skyboxes of Redskins games. Having been reaffirmed as chairman by presidents Reagan, Bush and Clinton, he must be doing something right.

Now that you know where it is -- home office in D.C. and 12 branches around the country -- what does it do? Well, the Fed is akin to a watchful parent -- and the U.S. economy is one huge baby. The Fed stands on the sidelines, observing the economy as it goes about its day-to-day gyrations. Monetary policy is the primary tool the Fed has to scold or encourage the economy. The Fed implements monetary policy through its top policy-making group, the Federal Open Market Committee. The goal is to achieve economic growth not influenced by inflation.

If the Fed thinks the economy is overheating -- the child is getting really wound up and will soon crash -- then it takes a variety of actions. It may sell U.S. Treasury securities (bonds), which decreases the supply of money, making it scarcer and thereby increasing its value. At the same time, the Fed may charge banks a higher rate of interest to borrow short-term. The banks will in turn charge higher interest to borrowers who will think longer before borrowing to finance new homes, cars and refrigerators. When cash is scarce and the cost of borrowing has increased, the effect is a tightening of the economy -- a little monetary-policy Ritalin.

If the economy is listless, then the Fed will try to nudge it along by easing its monetary policy. Buying up Treasuries (infusing cash into the economy) and lowering the interest rate it charges banks gives people the incentive to spend rather than save. Of course, the question for the Fed, as for any concerned parent, is when to intervene. Jump in too soon, you might hobble the child unnecessarily. Wait too long and things could get out of hand.

Easing, tightening, Ritalin -- what's all this got to do with you? For one thing, the Fed's actions have an impact on stocks in your 401(k) and IRA. That's because companies rely on people having money to buy their products. With less money and higher borrowing costs, people buy fewer things, and companies earn lower profits. Stocks in young companies (such as a lot of Internet outfits), which tend to have high need for cheap capital are particularly vulnerable to interest-rate hikes.

The Fed's actions also impact you as a consumer, since the prices of everything you buy fluctuate along with the money supply. Sometimes, the inflation is pre-eminent on the Fed's collective mind. Inflation arises when too many dollars chase too few goods. Prices increase, reducing the purchasing power of money. When this happens, the Fed can step in by restricting the money supply and raising the costs of borrowing.

Inflation tends to hurt owners of capital, whose assets suddenly can purchase less. And since inflation can mean higher wages, some people benefit from it. To this point of view, inflation isn't necessarily the enemy -- high interest rates and high unemployment are. So the Fed's delicate balancing is to keep inflation low by letting steam out of the economy while making sure the economy chugs along well enough to provide jobs and growth.

-- Posted: June 14, 2000