The US Federal Reserve System, also known as the Fed, is the central bank of the United States and is in charge of conducting monetary policy. It also supervises and regulates financial institutions like large banks and helps maintain the stability of the financial system. It was established in 1913 with the Federal Reserve Act signed by President Woodrow Wilson. It was given three main objectives: maximum stable unemployment, stable prices, and moderate long-term interest rates. Unlike other central banks like the Bank of Canada, the US Federal Reserve is not in charge of issuing or printing currency.
The US Federal Reserve is a special combination of government and private groups that aims to be non-partisan. The Federal Open Market Committee (FOMC), the main decision-making body of the Federal Reserve, consists of 12 voting members: seven from the Board of Governors and five regional Reserve Bank presidents. While the Board of Governors are appointed by the President and the Senate, they are appointed for 14-year terms and can only serve a single term, giving them freedom from the political cycle or worry about re-appointment. The private sector also has significant input into the FOMC as commercial banks play a large role in deciding the presidents of the regional Reserve Banks. This combination of private and public allows the US Federal Reserve to remain non-partisan and make its decisions independently of the federal government.
The US Federal Reserve interest rate, or the Fed Funds Rate, is the rate at which commercial banks in the US lend to each other overnight. Every commercial bank has a reserve that is required to be kept at Federal Reserve Banks - if a bank has more deposits than it needs, it can lend to another bank that has a shortfall.
The US Federal Reserve, as part of its monetary policy operations, aims to keep the Fed Funds Rate within a certain range. The FOMC meets eight times a year to set this range and can use the tools of the Federal Reserve System to make sure that the actual rate, the Effective Fed Funds Rate, is kept within their desired range.
In response to the outbreak of COVID-19 and economic shutdowns in the US, the US Federal Reserve moved rapidly to cut their target Fed Funds rate range. In an emergency meeting on March 4th, the Fed lowered their target range by 50 basis points from 1.5% - 1.75% to 1.0% - 1.25%. Only two weeks later, another emergency meeting was held on March 15th to drop the Fed Funds rate down to the zero lower bound with a 100 basis point cut. Their final target range of 0% - 0.25% has not been changed since and is likely to remain at the zero lower bound until at least 2021.
In a speech on August 27th, Fed Chair Jerome Powell announced that the US Federal Reserve System was adopting average inflation targeting as well as a more relaxed interpretation of the Phillips Curve and the relationship between employment and inflation. Both of these measures allow the Fed to continue quantitative easing and loose monetary policy for the foreseeable future without restrictions from concerns about rising inflation.
Given the continued dovish approach by the Fed, we do not expect the Fed to reduce its quantitative easing measures or increase its target Fed Funds rate range until at minimum 2021.
|Date||Fed Funds Target Range||Change|
|December 15th||To Be Decided||--|
|November 4th||To Be Decided||--|
|September 15th||0% - 0.25%||--|
|July 28th||0% - 0.25%||--|
|June 10th||0% - 0.25%||--|
|April 29th||0% - 0.25%||--|
|March 23rd||0% - 0.25%||--|
|March 15th||0% - 0.25%||-1|
|March 3rd||1% - 1.25%||-0.5|
|January 28th||1.5% - 1.75%||--|
Prior to the Great Financial Crisis, the US Federal Reserve used a target rate rather than a range. This became problematic when they lowered the rate to zero during the GFC. As a result, the US Federal Reserve changed their targeting system to a range-based system rather than a specific rate after the GFC.
The US Federal Reserve is made up of three main bodies:
The FOMC is responsible for making decisions on monetary policy for the US Federal Reserve. It is made up of 12 voting members: the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four of the remaining 11 Reserve Bank presidents rotated on an annual basis. Traditionally, the chair of the Federal Reserve Board also acts as the chair of the FOMC and the president of the Federal Reserve Bank of New York acts as its vice-chair.
As part of its role in directing monetary policy, the FOMC is also in charge of executing monetary policy through "open market operations", foreign exchange interactions, and currency swap programs with foreign central banks.
The Board of Governors, or the Federal Reserve Board, oversees and governs the operations of the US Federal Reserve and its 12 Federal Reserve Banks. It is made up of seven members that are nominated by the President and confirmed by the Senate for 14-year terms. They can cannot be re-appointed. The Chair and Vice Chair of the Board of Governors are also nominated by the President and confirmed by the Senate and serve for 4-year terms, and may be reappointed.
The US Federal Reserve conducts its operations primarily through 12 Federal Reserve Banks. Each bank is responsible for a specific region of the United States and acts as a "bank of banks" to local financial institutions. They provide financial and lending/depository services, collect economic information, and help to regulate and supervise local financial institutions. The president of a Reserve Bank is responsible for the day-to-day operations of the Reserve Bank and also serve on rotated appointments on the FOMC.
A Federal Reserve Bank is a special combination of private and public interests. They are owned by commercial banks who elect six of the nine members of the board of directors. The other three members are appointed by the Board of Governors. While a Federal Reserve Bank can make money from its operations and the services it provides to local financial institutions, all its net profits are given to the US Treasury and are not distributed amongst its shareholders.
The 12 Federal Reserve Banks are:
* For mortgages of at least $500,000 with down payment under 20%.
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† For mortgages of at least $500,000 over a 25-year amortization period.
The Federal Reserve Act of 1913 gives the US Federal Reserve three main goals:
To understand these better, we can examine them one by one.
The level of unemployment in an economy is an important factor in determining its productivity and the happiness of its citizens. Every economy has a natural rate of unemployment, which is defined by economists as the rate of unemployment that is compatible with a steady inflation rateor the rate of unemployment of an economy at full capacity. While a low unemployment rate is good, an unemployment rate below the natural rate of employment for an economy can lead to competition for workers and excess demand that can signify an overheated economy and bring inflation. An unemployment rate higher than the natural rate of unemployment means that the economy is not at full capacity and could be more productive. The Federal Reserve's job is to try to keep unemployment near its natural rate, which is estimated to be around 3% to 5% for the US economy.
The Phillips Curve is an economic model named that describes the relationship between employment and inflation. The model suggests that there is an inverse relationship between the unemployment rate and inflation: if unemployment goes down, inflation goes up; if unemployment goes up, inflation goes down.
The slope of this inverse relationship changes based on where you are on the curve. If you already have a low unemployment rate and hot labour market, any further decreases in unemployment is likely to lead to a larger increase in inflation compared to if you started out with high unemployment. In addition, if you have high unemployment, going even higher will have less and less effect on inflation.
Stable prices, or stable inflation, is usually one of the most important goals of any country's central bank, including the US Federal Reserve. By keeping inflation, or the growth of prices over time, in check, the US Federal Reserve can maintain confidence in the US Dollar and minimize the costs associated with unstable inflation. For example, with stable inflation, a grocer can predict how expensive goods will be in the future and sign long-term contracts for workers and goods. However, if prices change dramatically from day to day, he cannot plan ahead and has to change prices day by day or risk losing money.
Although deflation, or decreasing prices, can seem like a positive for consumers, it can have a devastating impact on the economy. If you knew that prices were going to drop in the future, you wouldn't spend any money now. If everybody followed this principle, then consumption would stop and the economy would ground to a halt as nobody purchased any new goods or services. In addition, once you are used to deflation and flat or decreasing prices, it can be hard to get back to inflation or increased prices. This is one of the reasons why central banks aim to keep inflation above zero rather than at zero.
The Federal Reserve aims to keep annual inflation at around 2%, similar to the Bank of Canada and the central banks of other developed economies. The rate of inflation most commonly used by the Fed is the Personal Consumption Expenditures (PCE) price index, which takes into account a wide range of household spending but does not consider asset prices.
Average inflation targeting is a new approach by the US Federal Reserve System that uses the 2% inflation target as an average rather than a target. This means that the Fed is willing to build inflation above 2% to make up for previous periods of lower inflation, and vice-versa. In contrast, their previous target approach used by most central banks would not take historical inflation into account and would always try to keep inflation as close to 2% as possible.
Given the previous decade of lower than 2% inflation and the deflationary impacts of COVID-19 on household spending, this gives the Fed more room to conduct quantitative easing and loose monetary policy without pressure from a possible rebound in inflation beyond 2%.
One of the less well-known mandates of the US Federal Reserve is its goal to maintain moderate long-term interest rates. This means to keep the interest rate of borrowings by businesses and governments (including cities and state governments) within a moderate range so that it remains affordable to borrow money and invest. While the definition of "moderate" is not clear, it can be taken to mean a rate at which enough investment is made to keep the economy running at its natural rate of unemployment and with stable prices.
All three objectives of the US Federal Reserve are connected. By maintaining a moderate long-term interest rate, the US Federal Bank can encourage (or discourage) investment in the economy, which affects the unemployment rate. If the unemployment rate remains stable at the economy's natural rate, prices and inflation are likely to remain stable. There are, of course, many other factors that can affect any of these three goals, but it goes to show that how by achieving one of its goals, the US Federal Reserve is likely to achieve the rest.