Federal Reserve and the Current

Federal Reserve and the Current Economy

Federal Reserve and Current Economy

The Federal Reserve is the central bank of U.S. And it has an important role in maintaining and stabilizing the banking system as well as the economy on the whole. It uses a variety of monetary policies and tools such as federal funds rates to keep the banking system stable, to provide financial services to the government, to handle the U.S. payments system, to stabilize the economy and to maintain the inflationary pressures. In the light of these powers, the role of the Federal Reserve has become central in the current financial crisis. Its actions are closely watched by economists, investors, the U.S. Congress, leaders of other countries, the IMF and World Bank and the public because what it does can influence each of these groups in a big way.

Role and effectiveness of Federal Reserve in stabilizing the economy

The main catalyst of the recent economic crisis was a banking system that was under-capitalized and still took a lot more risks than it could withstand. To prevent such a financial catastrophe again, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act was introduced and this gave wide powers to prevent the occurrence of such systemic risks and to maintain financial stability. As a result of this Act, the Federal Reserve established stricter standards for large BHCs and non-bank financial companies that had an asset of $50 billion or more and this included risk-based capital and leverage requirements, liquidity requirements, risk-management requirements, stress tests, single-counter party credit limits and early remediation regime (federalreserve.gov, 2012). These measures are expected to prevent systemic risks that come from the reckless actions of the banking system.

The Fed has taken many measures to provide a higher degree of liquidity in the market and this has helped to increase the availability of loans to qualified customers. It has also worked actively with the Congress to encourage mergers and acquisitions in the banking industry for better stability. The Fed has also injected more than $1 trillion into the financial system and this has also helped the economy to stabilize.

The Federal Reserve has another important role and that is to ensure that people of all ethnicity have access to credit and there is no discrimination by the lending agencies due to race and color. The Fed has a big role in the Community Reinvestment Act that was enacted to ensure that banks do not discriminate against certain communities or neighborhoods when it comes to lending. Anybody who meets the credit qualifications should have access to credit. It also sets regulations for the implementation of the Equal Credit Opportunity Act that is aimed at preventing any discrimination in the provision of credit. These two roles are a part of the civil rights implementation policies of the Federal Reserve and this has helped many neighborhoods to overcome their problems (Spriggs, 2006). Also, a balanced growth across communities and states has also been possible.

The actions taken by the Federal Reserve has been fairly effective and it has helped the economy to prevent a further slide into a depression. The economy is stable now and the employment numbers are inching higher. The primary fear that injection of money would lead to unmanageable levels of inflation has eased and the inflation rates are stable now after a period of deflation. The banking industry is back on its feet and credit is available for qualified individuals and businesses. Though the economy is not completely out of the woods yet, there are promising signs and all this has been due to the effective handling of this crisis by the Federal Reserve.

Economic indicators that have to be analyzed by the Federal Reserve

The Federal Reserve Committee (FOMC) takes into account many economic indicators that provide a better idea of the health of the economy so that they can take the right actions based on it. The current economic conditions are contained in a report popularly known as the Beige Book. It is published eight times every year and the Fed collects information about the economy from different banks, Federal branches and interviews with economists and business leaders.

Some of the indicators that this Beige book contains include the economic activity in different districts of the Federal Reserve. This gives the policy makers a fair idea of the regions that are growing as against those that are lagging behind so that they can look into the reasons behind this lop-sided development. Another indicator they look into is the growth of the manufacturing sector. The concerns of business leaders in this segment is taken into account for the next round of policy-making. Retail spending is another indicator of a strong economy as it reflects that people are in a better position to buy goods and this means, businesses are strong and stable. The retail numbers are paid close attention to by the Fed as it is a strong indicator of the overall strength of the economy. A related field is household spending that shows the percentage of money that people spend on goods and services.

Real-estate industry is also keenly watched by the Fed because this was at the heart of the economic recession. The number of new homes that are sold in a given period of time is analyzed by the Fed to see if this sector is picking up from the initiatives taken by the Congress and the Fed. The construction industry is also related to real-estate and the numbers from this sector are also analyzed.

Another major indicator of an economy's strength is the employment rate. Members of the Federal Reserve closely monitor the hiring rate of companies. They look at the number of jobs that were added to the economy each month and based on this vital information, they take steps to reduce unemployment rate and boost the hiring and confidence of companies. Price stability and inflation are the core functions of the Fed and so, the rates of inflation say a lot about the effectiveness of certain monetary policies and the overall health of the economy. Availability of credit and the stability of the banking sector are also taken into account. Activities in agriculture and mining sectors over a period of time are also watched by the Fed. These are the economic indicators that the Federal Reserve looks into before formulating its next set of policies or amending its existing ones.

Monetary Policies to influence money supply

The Federal Reserve has taken numerous monetary policies that are available at its disposal to increase money supply and the availability of credit in the economy. One of the most important tool available for the Fed is to purchase and sell U.S. Treasury securities. The short-term objective of this tool is to increase money supply in the economy so that banks have more money to lend to individuals and businesses. "To create additional money on the economy, the Fed buys Government securities from Wall street firms. In exchange for the securities, the Fed increases the number in its computer system that show how much the banks at which those Wall Street firms keep their accounts have on deposit at the Fed" (Croushore, 2006, p.10).

The Fed also increases money supply by altering the federal funds rate, the rate at which the financial institutions trade balances held by the Fed, to each other overnight without any collateral. The Fed has maintained this rate at 0-0.25% since the recession began to increase the flow of money between the different financial institutions. By doing so, the Fed bought securities in exchange for reserve and this led to an increased money supply in the market (Croushore, 2006).

Another rate that is controlled by the Fed is the discount rate. This is the rate that is charged by the Fed to financial institutions that borrow money from any of the regional facilities of the Federal Reserve. There are three kinds of discount rates and they are primary credit, secondary credit and seasonal credit. Primary credit is a short-term loan given to financial institutions that are sound while secondary credit is given to those institutions that do not qualify for primary credit. Seasonal credit is given to institutions that are involved in seasonal business such as agriculture to meet their intra-year fluctuations. The current primary rates are 0.75%, secondary credit rates are 1.25% and seasonal credit rates are 0.20% respectively (federalreserve.gov, 2012). These rates are at historic lows to give banks access to more credit so that they can lend more to induce more economic activity. The lower the rates, the higher is the money supply in the market. Moreover, these rates also provided credit easing to banks that were stuck with a vast number of mortgage-based securities (MBS).

The Fed also decreased the interest rates on bank reserves and the minimum balance of reserves so that banks have more money to lend. This has also led to an increase in the money supply and has encouraged the flow of money between different groups within the economy (Croushore, 2006).

The Federal reserve realized the big negative impact of MBS and announced a 600 billion program in November 2008 to purchase these securities and this helped to bring back some liquidity into the market. In March 2009, it added another $750 billion to bring the total to $1.25 trillion.

The Fed has the power to create or print more money to increase money supply in the market and this is exactly what it did. Though the downside of this measure is inflation and an increased balance sheet for the Fed, Ben Bernanke, the chairman of the Federal Reserve felt it was imperative to boost the economy. Through this tool, the Fed generated money and provided it to large corporations that depend on loans to ensure that their growth was not drastically affected. The Fed executed this policy through the lending institutions to increase economic activity and the dependent employment numbers.

It announced other monetary programs to increase money supply in the market. One such program was the Term Auction Loan Facility (TALF). This program aimed to provide short-term liquidity to banks so that they can lend to households and small businesses. In 2009, it increased the number of banks that can use this program and also expanded its list of collateral so that more financial institutions can participate in it. Another program is the dollar swap lines that made it possible for foreign central banks to prevent disruptions in the value of dollar abroad. The Federal Reserve also came up with another program called the Primary Dealer Credit Facility (PDCF) after the collapse of Bear Sterns to provide overnight loans in cash to primary dealers against some form of eligible security (federalreserve.gov, 2012).

Strengths and weaknesses of monetary policy over fiscal policy

Both monetary policy and fiscal policy are important for a strong economy. However, there are certain areas in which their effectiveness varies. Monetary policy provides a quick short-term solution to credit problems that can stagnate the economy. A good case in point is the current economic recession. The numerous monetary policies undertaken by the Federal Reserve eased the credit availability and helped the banks to increase their lending to individuals and businesses. On the other hand, extended monetary policies can have a negative impact. For example, the Japanese economy has a zero-interest rate for a long time and this has not helped to boost the economy in a big way. Monetary policies are not effective in increasing consumer spending, especially when the economy is facing a prolonged period of deflation. In such a case, only a fiscal policy will help to boost the economy and increase spending.

Fiscal policies have their share of weaknesses too. These policies mostly revolve around government spending and increased taxation and over a long period of time, it can be detrimental to the economy. Firstly, government spending can spiral out of proportion and it may not be matched by the growth of the economy. This is exactly what is happening in countries like Greece and Spain where the government debt is way more than what the economy can sustain. Another problem with extended fiscal policy is that people are likely to alter their behavior including their spending patterns in anticipation of the effects of the fiscal policy. For example, when the government borrows extensively, the public will expect the taxation rates to go up after a while and they will make provisions for it by decreasing their spending and increasing their saving potential. This results in overall sluggishness of the economy. Therefore, both the policies have to be used in tandem for best results because each has their share of strengths and weaknesses.

Effects of Federal Reserve's actions

The aggregate demand and supply model helps to analyze the conditions that affect the Gross Domestic Product (GDP) after adjusting it for inflation. The different monetary tools and programs undertaken by the Federal Reserve has produced moderate results. The good aspect is that it has prevented the country from a further economic decline and a possible depression. The easing of credit has helped to jump start the economy and it is on its way to a slow recovery. Moreover, the employment rates are ticking up as also the GDP and other sectors of the economy such as manufacturing and retail. All this is good news for investors and the American public.