Federal Reserve System (FED)
The central bank of the United States is the FED. FED stands for Federal Reserve System but this is also referred to as the Federal Reserve for short. Although the FED is an independent government institution, the American central bank is owned by a number of large banks and therefore not by the state. The main governing body of the FED is the Board of Governors which consists of 7 members who are appointed by the President of the United States. In addition to the national FED there are 12 regional Reserve Banks. 5 representatives of these regional reserve banks together with the 7 members of the board of governors make up the FOMC (Federal Open Market Committee). The primary responsibility of the FOMC is to supervise open market operations through monetary policy. One important responsibility of the Federal Reserve is to safeguard the stability of the United States’ financial system. The FED also has various other functions, including:
- ‘managing’ the national money supply by means of monetary policy with the aim of:
- preventing or limiting inflation and deflation (price stability). For an overview of current inflation in the United States, click here;
- maximizing employment;
- stable long-term interest rates.
- supervision and regulation of the private banks;
- preventing or resolving banking panics.
What is discount rate ?
The interest rate at which an eligible financial institution may borrow funds directly from a Federal Reserve bank. Banks whose reserves dip below the reserve requirement set by the Federal Reserve’s board of governors use that money to correct their shortage. The board of directors of each reserve bank sets the discount rate every 14 days. It’s considered the last resort for banks, which usually borrow from each other.
How it’s used: The Fed uses the discount rate to control the supply of available funds, which in turn influences inflation and overall interest rates. The more money available, the more likely inflation will occur. Raising the rate makes it more expensive to borrow from the Fed. That lowers the supply of available money, which increases the short-term interest rates. Lowering the rate has the opposite effect, bringing short-term interest rates down
Discount rate over the last 10 years
The Federal Reserve raised the Fed funds rate 1/4 point at the December 14, 2016, FOMC meeting. Most FOMC members think conditions are robust enough to warrant it. Members are pleased with recent strong jobs reports. The Fed funds rate is now 0.75 percent. For details, see Current Fed Funds Rate.
Fed Chair Janet Yellen explained at the November 17, 2016, Congressional meeting why the Fed isn’t affected by the election outcome.
Fed Board Members look at economic data, which won’t register the effects of a Donald Trump Presidency until he implements policies in 2017. Since he has promised expansionary fiscal policies, the Fed will probably follow contractionary monetary policy to prevent inflation. That’s because the economy is growing at a healthy rate. Tax cuts and increased spending in 2017 will overheat the economy, causing inflation. For more, see Which Phase of the Business Cycle Are We Currently In?
The Fed last raised its benchmark rate to 0.5 percent at its December 2015 meeting. That was the first rate increase since June 29, 2006. The rate had been at virtually zero (between 0 to 0.25 percent) since December 16, 2008. The Fed lowered it to combat the Great Recession.
It indirectly affects long-term rates, such as mortgages, corporate bonds, and ten-year Treasury notes. The Fed will raise those rates when it sells its holdings of Treasury notes and bonds. The Fed acquired $4 trillion of those through its Quantitative Easing program. Find out When Will Interest Rates Be Raised?
Why the Fed Is Raising Rates Now
The Fed is anxious to return rates to the healthy 2 percent level. It wants to get the economy out of a possible liquidity trap. That’s when families and businesses hoard cash instead of spending it. Low interest rates don’t give them much incentive to invest. The only way out of a liquidity trap is to raise interest rates.
The Fed also wants to raise rates because it’s been talking about it for more than a year. In response, forex traders expected the dollar’s value to rise. To take advantage of that, they shorted the euro. That strengthened the dollar 25 percent in 2014 and 2015. The strong dollar hurt exports and slowed economic growth. It also created lower import prices. That reduced the chance of inflation. If people expect prices to stay the same or drop, they have less incentive to spend now. They know their purchase might cost less in the future.
How It Affects You
Once the Fed raises the Fed funds rate, how high will it go?
Probably another .25 percent at first, as the Fed likes to take gradual steps whenever possible. The Fed expects to raise it to 1.5 percent in 2017. It will increase it to 2 percent in 2018 and 3 percent in 2019. The Fed forecasts inflation to remain around 2 percent until 2022. That’s because it will make sure that inflation is no worse than that. Here are 5 Steps to Take Now to Protect Yourself from Fed Rate Hikes.
Historically, the Fed funds rate remains between 2-5 percent. The highest it’s ever been was 20 percent in 1981 to combat stagflation and an inflation rate of 12.9 percent. That was an unusual circumstance caused by wage-price controls, stop-go monetary policy, and taking the dollar off of the gold standard. For more, see U.S. Inflation Rate: Current Rate, History, and Forecast
Former Federal Reserve Chairman Ben Bernanke has said that the most important role of the Fed is to maintain consumer and investor confidence in the Fed’s ability to control inflation. That means the Fed is more likely to raise rates than lower them.
Find out what Wall Street traders think the Fed will do with the Fed Funds Futures as a Predictive Tool.
|DATE||Fed Funds Rate||EVENT|
|2005: GDP = 3.3%, Unemployment = 6%, Inflation = 3.4%|
|Feb 2||2.5%||Subprime borrowers could not afford mortgages when rates reset, typically in 3rd year.|
|Fed Chair Ben Bernanke (February 2006 – January 2014)|
|2006: GDP = 2.7%, Unemployment = 6%, Inflation = 2.5%|
|Jan 31||4.5%||Raised to cool housing market bubble. More homeowners default.|
|2007: GDP = 1.8%, Unemployment = 6%, Inflation = 4.1%|
|2008: GDP = -0.3%, Unemployment = 6%, Inflation = 0.1%|
|Apr 30||2.0%||LIBOR began rising.|
|Dec 16||0.25%||Effectively zero. The lowest fed funds rate possible.|
|Fed Chair Janet Yellen (February 2014 – January 2018).|
|2015: GDP = 2.6%, Unemployment = 6%, Inflation = 0.7%|
|2016: GDP = 3.2%, Unemployment = 4.6%, Inflation = 0.4% (as of December, 19 2016.)|
Discount rate over the last 10 years