The Federal Reserve System is the central bank of the United States. It was created via the Federal Reserve Act of 1913. It includes a federal government agency, the Board of Governors, in Washington D.C., and 12 regional Federal Reserve Banks. The purpose of the establishment of the 12 regional Reserve Banks is to balance the centralization with regional presence.
The seven members of the Board of Governors are appointed by the President and confirmed by the Senate. The Board sets monetary policy. The Federal Reserve Banks provides a supply of currency by distributing Federal Reserve Notes to the banking institutions. The Board and Federal Reserve Banks have three monetary policy tools to control the flow of money through the economy.
1. Regulatory and supervisory responsibility
Federal Reserve makes changes in the required reserve ratio. It regulates and supervises banks that are members of the System, bank holding companies, international banking facilities in the United States, foreign activities of member banks, and the U.S. activities of foreign-owned banks.
2. Open market operations
Federal Reserve purchases and sells government securities. The Federal Reserve can cut the federal fund rate by open market operations and by changing the required reserve of the banks. Federal fund rate is the rate on short-term loans among commercial banks for overnight use.
3. Discount rate change
The discount rate is what the Federal Reserve charges on short-term loans to member banks. Federal Reserve can change the discount rate at its discretion.
The mortgage woes have been going on this year. Quite a few mortgage and banking institutions have been urging Federal Reserve to cut the discount rate or fund rate to prevent the continued downturn in the housing market and the credit crunch from worsening the economy. What are the effects of cutting the discount rate or fund rate?
1. If the Fed Reserve cuts the discount rate, banks will get cheaper loans from the Fed Reserve. If it cuts the fund rate, banks will get cheaper short-term loans from other banks. Banks are likely to start passing on the cheaper rate by lowering their prime rate. Prime rate is the rate banks charge their best customers for short-term loans. Prime rate is bellwether rate in that it is a sign of rising or falling loan demand and economic activity. When the prime rate is lower, businesses are more likely to borrow. Consumers are more likely to spend because of lower credit card rates, which are tied to the prime rate. The subprime rate will be likely to be lower. The subprime rate is the rate offered above prime rate on traditional loans. It will start a chain reaction. Rates on mortgage, auto and construction loans will be lower. The lower the interest rates drop, the more investors will move their investments to stock. It will stimulate businesses to grow. If lower interest rates cause businesses to start growing and investors to increase investing, unemployed workers will get jobs, consumers will increase spending, housing market will start growing, and the economy will start to move again.
2. The size of the discount rate cut or fund rate is important. A half-point cut is not good enough to get the economy moving fast. Can Federal Reserve cut more than that? External conditions such as the ongoing war in Iraq, the federal deficit, both of which make the money supply out of balance, and problems in the banking industry will sure make businesses and consumers nervous. Federal Reserve plays a major role in alleviating recession and inflation. It has to strike a balance between increasing and decreasing rates to alleviate recession or inflation. In other words, the hands of the Fed Reserve are tight.
It is clear that the mortgage market crisis came about as a result of some bad lending practices and housing speculation. It may take a while for the housing market to recover with a discount rate cut or fund rate cut from the Federal Reserve. Even with some help from Fannie Mae and Freddie Mac, it will most likely take 18 to 24 months for a full recovery.