The Economy and The Fed

The stock market continued its volatile ways during the second quarter, finishing with small gains for the quarter. The bond market had a strong quarter as interest rates fell in response to slowing economic growth. It is also notable that the Federal Reserve cut the Fed Funds Rate during the third quarter for the first time in more than a decade. The U.S. economy is being impacted by slowing global growth and domestic trade policy.

There has been much discussion about interest rates lately and the Fed’s policies when it comes to making rate decisions, so we thought it might be a good idea to take a closer look at the Federal Reserve and what they do. The Federal Reserve is the central bank for the United States. They are charged with providing our country a safe, flexible, and stable monetary and financial system. That’s a pretty tall task. Through various mechanisms they attempt to keep the economy growing at a targeted rate while at the same time keeping growth from becoming overheated and causing inflation.

While the Fed Funds Rate, the interest rate banks charge other banks for overnight borrowing, and the Discount Rate, the rate banks are charged on loans from the Fed, get the most attention, the Fed has other important tools in their toolbox to affect the economy. Open market operations, the purchase and sale of securities in the open market by a central bank, are a key tool used by the Federal Reserve in the implementation of monetary policy. Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Fed’s Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks. The Federal Reserve Banks pay interest on required reserve balances and on excess reserve balances. The interest rate on required reserves is determined by the Board and is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions.

The Federal Reserve would like the Fed Funds Rate to be within a range of 2% to 5%. They would like our economy, as measured by the gross domestic product (GDP) to grow between 2% and 3% per year. The Fed’s target inflation rate is 2%. Deviations from these targets results in one or a combination of Fed actions, most of which are never seen by the public or talked about by politicians.

It is important to know that the Fed’s job is not to make the stock market rise or to keep politicians happy. Since the early 1980’s, the Fed’s overriding mandate has been price stability (low inflation) in the economy. When the economy grows and inflation remains low, the capital markets will be just fine. There will always be economic cycles, but they are less severe because of the actions of the Federal Reserve.

Wabash Capital