Monday, June 25, 2007

Why the Federal Reserve Matters

If you are nothing more than a casual observer of the financial markets, you are well aware of the markets' obsession with the intentions of the Federal Reserve Board. Just from reading a newspaper or financial website, you'll learn that the Fed influences the direction of interest rates. The prices of stocks, bonds and other investments will change, sometimes rapidly, as a result of what Fed does, says or even doesn't do or say, with respect to interest rates. Perhaps you've wondered what gives with the Fed, and why it has so much influence and power. Here's a brief overview, something to keep in mind when you're reading about this coming week's Fed meeting.

The Federal Reserve System is America's central bank. It doesn't offer consumer checking accounts or credit cards. Rather, it is the bank for other banks. When other banks need a loan, they can borrow from the Fed. Why would a bank need a loan? Because banks sometimes don't have enough cash on hand--their customers may demand more cash than the bank has available (remember Jimmy Stewart in "It's a Wonderful Life"?). Normally, banks borrow from other banks (with the interest rate on these interbank loans called the "federal funds rate").

The Fed can influence the federal funds rate (also called the "fed funds rate") by buying and selling bonds through a trading operation at the Federal Reserve Bank of New York. But the Fed generally needs only announce a target for the fed funds rate and the market will listen. Interest rates across the nation and around the world will react almost instantaneously. Prices of stocks, precious metals and other investments will also react to changes in the Fed's target for the fed funds rate, since all investments have both an absolute price (the price in dollars) and a comparative price (their value in comparison to alternative investments).

Why do interest rates matter so much to the Fed? Because its job is to try to control inflation, and it can influence the rate of inflation by changing interest rates. Inflation--in the sense of a general rise in prices overall--is, in part, the product of the availability of money. The more money there is, the greater the risk that prices will rise.

Where does money come from? Mostly from lending activity. For example, when a bank takes money a customer has deposited and lends it out (which is what banks do), the borrower has acquired buying power he or she didn't previously have. That effectively increases the money supply.

The lower interest rates are, the more people will borrow. (Remember your Econ 101: if something is cheap, people buy more of it; and credit is no exception.) The more they borrow, the larger the money supply and the greater the potential for inflation. So when the Fed sees inflationary storm clouds on the horizon, it will raise its target for the fed funds rate. Other times, when the Fed is nervous but not entirely sure inflation threatens, it will hold rates steady but issue a statement indicating its concern. That statement tends to keep interest rates from falling and therefore helps to control the amount of credit available.

What will the Fed do at this coming week's meeting? Darned if we know. But keep in mind the Fed's ultimate goal.

Controlling inflation is a very important job. Inflation erodes hard earned wealth and undermines public confidence. In extreme situations (like Germany of the 1920's or China of the 1920's and 30's), high levels of inflation contributed to social unrest that paved the way for extremist regimes (remember that guy, Adolf, and that fellow, Mao?). Even though the Fed's interest rate policy may cause gastronomic distress for stock market speculators, if the Fed succeeds in holding the line on inflation, it will pave the way for long term prosperity.

To protect your retirement plan from inflation, increase the amount you save each year by the rate of inflation. See our earlier blog at

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