Written by: Daniel Calugar
The Federal Reserve has been getting a lot of attention recently as it attempts to stamp out inflation by instituting historic increases in the benchmark interest rate. But, while most people have heard of the Fed before, investor Daniel Calugar says some may need help understanding what the Fed is and its role in fiscal policy.
These are essential topics to understand, as actions the Fed takes can have significant consequences on various financial matters -- as anyone who's tried to obtain a new loan such as a mortgage has found out recently.
Below, investor Dan Calugar explains in depth what the Federal Reserve is, what it does and what happens when it makes a mistake.
What is the Federal Reserve?
The Federal Reserve System serves as the central bank of the United States. In essence, it's a financial institution that controls how and when money is printed and produced, as well as the system of credit within the U.S.
The Fed has only been around for a little more than 100 years, as it was established in 1913 by then-President Woodrow Wilson following financial panic in 1907. Until then, America was the world's sole financial power that didn't have a central bank.
Because of multiple financial panics leading up to the early 1900s, the U.S. economy suffered a few severe disruptions when banks failed, and businesses went bankrupt. The Fed was established in large part to prevent future disruptions and panics.
The Fed has what's known as a dual mandate, which is set by Congress. It must work to ensure that prices remain stable in all parts of the economy, and it must work to support employment at maximum levels.
Under that umbrella, the Fed does so by setting the overall monetary policy for the U.S. as well as regulating all of its member banks.
This is quite a big job, of course, which is why The Fed is split into 12 different Federal Reserve Banks, each responsible for a particular geographic region.
To prevent panics, the Fed is given rather broad powers to take actions they feel are necessary to ensure the country's financial stability.
Daniel Calugar explains that this can be seen in how the Fed is currently acting. With inflation above 7% for each of the last ten months as of September 2022 -- and above 8.2% for each of the last seven months -- the Fed has stepped in to take action by increasing its benchmark interest rate.
In doing so, they are walking a tightrope trying to bring down inflation while not causing a full-blown recession.
What is the Federal Funds Rate?
The Fed has a few primary tools at its disposal to guide monetary policy in the U.S., and the Federal Funds Rate is one of them. This rate affects all financial products that include an interest rate -- everything from debtor accounts such as personal loans and credit cards to savings accounts.
Because of this, the Federal Funds Rate, in essence, dictates how much money actually costs in practice in our economy.
This rate is set by the FOMC, or the Federal Open Markets Committee, at its eight meetings during the year. In doing so, the FOMC sets both an upper and a lower limit. The rate is determined based on several economic indicators, including the durable goods orders report and the core inflation rate, which provide general insights into the country's economic health.
The Federal Funds Rate is used by the Fed's member banks to determine how much interest they should charge -- or how much they should be expected to pay -- if they lend or borrow from other Fed financial institutions.
What are Federal Funds?
Federal Funds encompass any excess cash reserves that financial institutions and commercial banks deposit at their regional Fed bank. These funds are used to ensure that banks don't fail and have sufficient funds to meet customer demand on any given day.
Dan Calugar explains that each Fed member financial institution is required to have a certain amount of reserves on hand to meet customer demand. Any money they have in excess of that amount is considered Federal Funds.
These funds can be used to give loans to other member financial institutions that may not have enough cash in reserve to meet what the Fed requires or lend as much as it wants.
These loans are made between financial institutions with relatively low-interest rates to make borrowing more affordable for everyday consumers. Effectively, the rate that is used in these instances is the Federal Funds Rate.
What are Open Market Operations?
To affect the Federal Funds Rate, the Fed must take clear action. It cannot simply state that the rate has changed, for instance.
The way that it does this is through what is known as OMO, or Open Market Operations. Through OMO, the Fed will either purchase or sell securities on the open market. This helps the central bank regulate how much money is kept on reserve at its member banks.
If it feels as though the money supply needs to be increased, the Fed will purchase Treasury Securities. If it feels as though the opposite is necessary, it will sell these securities.
Investor Daniel Calugar explains that through OMO, the Fed will be attempting to affect how much credit and money is available in the U.S. economy. In theory, when interest rates are higher, there will be less money in the economy and less borrowing. This is what the Fed has attempted to do throughout 2022 to stamp out inflation.
When the Fed adjusts the Federal Funds Rate, its effects can also be felt in output, unemployment, and the overall costs of services and goods.
What are Treasury Securities?
Treasury securities are considered the safest of all investments in the U.S. The Fed and everyday investors have used them for years to bring financial stability and security, especially in turbulent economic markets.
The reason they are so safe is that the federal government backs them completely. The yields on these investments are typically low, especially compared to other investment vehicles, but there is next to no risk of losing the principal amount that is invested.
There are three types of Treasury securities, based on the maturity length.
The first type is T-Bills, which have the shortest maturity range of any government bond. T-Bills are the only treasury security found in money and capital markets. The T-Bills that mature regularly do so either over four, eight, 13, 26, or 52 weeks.
T-Notes are the mid-range for Treasury securities in terms of maturity date. The terms offered are two, three, five, seven, and ten years. Interest is paid on a semi-annual basis.
T-Bonds are the third type of Treasury security and are referred to as the long bond because of the longer maturity length of 30 years. These are, as a result, seen as long-term investment vehicles, often a part of a diverse investment portfolio. Interest is paid semi-annually, and the bonds are auctioned monthly.
What is the Discount Rate?
U.S. banks have two ways that they can borrow money -- either from other member banks or directly from the Fed. Again, banks can take these loans for various reasons, to cover any shortfall in reserve cash, to address any problems they have with liquidity, or to prevent its ultimate failure.
These loans are taken on a very short-term basis, usually for 24 hours or even less. When the Fed loans money to member banks, it does through its lending facility, which is called the discount window.
The Fed will charge the standard discount rate as interest to the banks taking the loan, and that rate is, again, set by Fed.
In most situations, commercial banks will only borrow from the Fed for emergency purposes when they cannot find another institution willing to lend them the money. In addition, the discount rates offered by the Fed have interest rates that are commonly much higher than the rates other banks offer.
When banks must borrow from the Fed, it may signal to investors and other participants in financial markets that the bank is weak.
What are Reserve Requirements?
Fed member banks can loan their customers based on just a fraction of the total cash they have on hand at their facilities. The federal government gives them the ability to do so with only one requirement -- they have to keep a set amount of money on hand so they can cover withdrawals customers may request.
The Fed sets this requirement because they don't want customers to be denied the ability to withdraw money they have deposited in the banks, according to investor Dan Calugar. If this were to happen, consumers would lose confidence in that bank -- and potentially the U.S. financial system as a whole.
The amount the banks must keep on hand is referred to as its reserve requirement. In addition to setting the interest rates on excess reserves, the Fed also sets the reserve requirements.
The Fed will use the reserve requirement to control the liquidity in the U.S. financial system. When they lower this reserve requirement, they are instituting expansionary monetary policy. This is because banks aren't required to keep as much money on hand, which gives them the ability to lend more.
When the Fed increases the reserve requirement, it's instituting monetary policy that's contractionary. By being required to hold more money on hand, banks won't be able to lend as much. However, it does provide these banks extra protection against potential failures during economic downturns.
How Does the Federal Funds Rate Affect Interest Rates?
When the Fed adjusts the Federal Funds Rate, it doesn't just affect inter-bank loans; it also affects the economy as a whole. One of the most direct ways it does through is how it affects general interest rates offered to businesses and everyday consumers.
When the Fed adjusts its funds rate, it immediately changes the prime rate. This is the rate financial institutions will offer their customers with the best credit scores.
The prime rate also serves as the basis for interest rates offered to all other consumers. When the Federal Funds Rate increases, the prime rate increases as well, and so, too, does the interest rate charged on most consumer lending products.
This directly affects credit, such as business loans, personal loans, credit cards, auto loans, and adjustable-rate mortgages. It also indirectly affects fixed-rate mortgages.
Of course, the prime rate can decrease and increase just as the Federal Funds Rate can.
What are the Implications of Higher Interest Rates?
When interest rates are higher, money is generally considered more expensive. This is because it costs more for businesses and individuals to borrow money -- whether it be for everyday purchases on credit cards or larger, longer-term investments such as homes.
Even slight increases in interest rates can cause things such as minimum monthly payments to go up substantially. In addition, for loans with adjustable rates, such as most credit cards, the same amount of outstanding principal may cost more to pay off after interest rates increase.
As such, consumers will typically make significant purchasing decisions based on interest rates. For example, the average benchmark 30-year fixed-rate mortgage had an interest rate of 7.32% as of November 3, 2022. That's a significant increase over what it was just a year ago, making homes much less affordable in late 2022 than they were at the same time in 2021.
Consumers will generally spend less money when interest rates are higher. As a result, the demand for various services and goods will also drop, which can cause inflation to decrease. This is what the Fed is attempting to do now.
On the other hand, higher interest rates mean better returns on deposit accounts such as savings accounts and Certificates of Deposit.
What are the Implications of Lower Interest Rates?
Lower interest rates will typically result in the exact opposite scenario. Daniel Calugar says when interest rates are low, borrowing money becomes significantly less expensive, which leads to expansionary actions by consumers and businesses alike.
Businesses may take out more loans to fund investments in their business. This can lead to higher output and the need for more employees, which can lower unemployment rates.
Consumers may similarly make larger purchases, such as cars and homes. They also may be more willing to make discretionary purchases since the interest they are charged on purchases is relatively low.
When the Fed lowers interest rates, it does so to encourage people to spend money. It's typically done during recessions or challenging economic times, such as during the height of the COVID-19 pandemic, when the Fed's rate was near zero. This essentially made borrowing money "free," or at least close to it.
That helped spur economic growth in the U.S. after the economy came to a grinding halt due to lockdown orders and massive restrictions on everyday life.
Lower interest rates also result in lower returns on deposit accounts such as savings accounts and CDs.
What Happens When the Fed Gets It Wrong?
Since the Fed has such immense powers over monetary policy in the U.S. -- and since those powers are largely unchecked -- it can be disastrous when they get it wrong. Many economists believe that the Fed completely missed the boat with inflation in late 2021 and 2022, and the country is paying for it now.
In the spring of 2020, the federal government took decisive action by passing a $2.2 trillion stimulus bill at the height of the pandemic. That helped to stabilize bond markets, recover stocks, and give households extra support they needed through expanded unemployment payments and direct checks.
Two more "rescue" packages followed that, spending about $5 trillion to stimulate the economy.
The Fed also played a direct part in the effort, increasing its purchases of short-term bonds by adding $3 trillion to the balance sheet.
The result was too much money being spent, and the economy performed too well.
With all that money in the economy, prices started rising rapidly. By August 2022, year-over-year inflation had increased 8.3%. In April 2021, that number was 4.2%.
As nearly everyone in the U.S. knows, inflation has dramatically affected various aspects of life, from higher prices of gas and food to considerable dips in the stock market.
How Can You Protect Yourself When the Fed Gets It Wrong?
When the Fed gets it wrong, there are some tactics consumers can take to protect themselves. But, first, Dan Calugar says it's essential to understand the effect of the Fed's misjudgment, as that will determine the tactics to take.
When the Fed increases interest rates, investors will typically start stocking up on short- or medium-term bonds. The yields on these will typically increase as interest rates rise. Series I Savings Bonds, for example, hit historic highs of 9.62% for most of 2022.
Another tactic is to invest in companies that consume a lot of raw materials. The thinking here is that the cost of raw materials will either decline or stay the same when interest rates increase. That, then, results in these companies experiencing a higher profit margin. Many investors consider these types of companies to be solid hedges against inflation.
On the other end of the spectrum, when rates drop due to a Fed mistake, consumers can take advantage of lower borrowing costs by refinancing their mortgage to a lower fixed rate.
You can even take the savings you are realizing from your new mortgage and invest it in solid options during deflationary times.
The Fed occasionally gets it wrong, but consumers don't have to be victims in the mess. Daniel Calugar says there are many things consumers can take to protect themselves when the Fed gets it wrong.
About Daniel Calugar
Daniel Calugar is a versatile and experienced investor with a background in computer science, business, and law. He developed a passion for investing while working as a pension lawyer and leveraged his technical capabilities to write computer programs that helped him identify more profitable investment strategies. When Dan Calugar is not working, he enjoys spending time working out and being with friends and family, and volunteering with Angel Flight.