The Fed 101: Part 1, What the Fed Does...

There is a lot of talk about what the Fed might do with the Fed Funds rate, so I thought a full explanation of the Fed's role might be in order. I'll start with an explanation of the Fed's basic objectives and operations (Part 1) and then will touch on more arcane topics like Fed Funds futures and "predicting" what the Fed will do (to come in Part 2).

The most basic objectives of the Fed, established by federal lesgislation, is to ensure both maximum employment and stable prices. Though originally established to be a "bank of last resort," the popularity and political implications of an exploitable Phillips Curve led to this more involved role for the Fed. In the most simple of terms, the Fed's job is to maintain a money supply level which isn't so high it causes inflation (or so low it causes deflation) while making sure that enough money is out there to ensure economic growth and full employment. But how does it do this?

The Fed has three basic tools for controlling the money supply in the economy. Because only two of the tools are ever used, we'll ignore the third (reserve requirement ratios). First, the Fed can set the "discount rate" which is simply the rate it charges all other banks who borrow from it. Why would other banks borrow from the Fed? Two obvious reasons: 1) They have to meet their reserve requirement levels to avoid paying a penalty fee, 2) They need extra bank reserves to loan out to prospective borrowers who will pay the banks more than the banks were charged to borrow from the Fed (profitable lending, "borrow short and lend long"). The second and the more talked about tool is referred to as the Fed's "open market operations (OMOs)." OMOs are essentially purchases or sales of securities, usually US treasury bonds, by the Fed. A purchase of bonds from the open market means that the Fed takes in bonds and sends out money to the seller. A sale of bonds means the Fed has taken money away from the market in exchange for bonds. The idea is that everyone who buys or sells bonds to the Fed has a bank account, and the Fed credits or debits that person's bank account depending on whether the OMO was a purchase or a sale. Thus, by buying or selling securities on the open market, the Fed ends up injecting or withdrawing bank reserves (what we call "high powered money") from the banking system (and the economy). With more (less) reserves, banks are more (less) able to loan to each other, individuals and businessess. More (less) lending means more (less) economic expansion, and by some measures, more (less) inflation.

Now, the key thing to understand is that the Fed targets the "Federal Funds" rate which is the rate at which banks are lending to each other in overnight transactions. Banks borrow from one another for the same reason they would borrow from the Fed (see above). Now, during August it became very apparent that a few banks had very bad (worthless) assets on their books which involved subprime mortgages. No bank wants to be the last one to loan to another bank before the borrowing bank fails (is unable to pay back the loan), so no lending was taking place between banks. From EC 101, if there is no lending, there is no supply of loanable funds, and if there is no supply of loanable funds, the interest rate increases. The interest rate, remember, is the Federal Funds rate (the rate at which banks lend to one another in overnight transactions). So to stop the Federal Funds rate from moving up any further, the Fed engaged in "defensive" OMOs by purchasing securities on the open market in exchange for money. This money was in the form of bank reserves which ended up at the bank of the sellers of the securities the Fed bought (the Fed credited the bank account of the sellers). As banks ended up with more and more of these reserves from the Fed they became more and more willing to lend to one another a fraction of the newly acquired reserves (fractional reserve banking). This pushed the Federal Funds rate back down (because of the increased supply of loanable funds) to where the Fed wanted it (the Federal Funds target rate).

I hope this makes it somewhat clearer what role the Fed plays and how it plays that role. Post any questions in the comments section and I'll try to get to them soon.

Next-
The Fed 101: Part 2, Fed Funds Futures and "Predicting" What the Fed Will Do