Briefing: The Power of the Fed

With the economy teetering on recession, the nation’s central bank recently took the unprecedented step of lowering interest rates twice in three weeks. How does the Fed influence interest rates, the economy—and your life?

The Week Daily reports:

What exactly does the Fed do?

It operates like a big dam, regulating the flow of money into the economy. The Fed’s goal is to prevent both “droughts’’—recessions—and “floods’’—inflation. Congress created the Federal Reserve System in 1913, after a string of bank collapses battered the economy and stripped millions of people of their life savings. Today the Fed—a network of 12 government banks spread across the country—is responsible for keeping prices stable and long-term interest rates moderate. That may sound arcane, but the Fed’s machinations affect everything from the price of home loans to whether the economy is adding jobs or losing them. When the Fed manages the economy well, said former Fed official Robert McTeer, “fewer people go to prison, more are healthier because they can afford to take better care of themselves, even the environment gets better taken care of.”

How does the Fed have such a huge impact?

It all stems from its ability to manipulate how much money is available to businesses and individuals seeking loans. When the Fed wants to lower rates, it buys billions of dollars worth of government-backed bonds, thereby pumping money into the banking system. The increased availability of money reduces its cost—that is, the rate of interest. To raise rates, the Fed sells securities, which drains money from the system. By tinkering with rates, the Fed can tighten or loosen the amount of money coursing through the economy. Last August, when bond and stock markets were on the brink of a meltdown, the Fed cut the Fed funds rate by a quarter-point, which pumped $38 billion into the banking system. That reassured investors, who sent the stock indexes soaring, which calmed consumer jitters—at least for a while. “The Fed’s control over the money supply,” said Gregory Mankiw, a former economic advisor to President Bush, “is a powerful lever to move overall demand for goods and services.”

How does the Fed set its rates?

It’s a murky process mostly done in private. The decision to raise or lower rates is made by the Federal Open Market Committee, which includes the Fed chairman, Ben Bernanke, and five regional Fed officials. The panel makes an assessment of the economy, weighing everything from unemployment levels and retail sales to housing starts and manufacturing output. If the economy seems to be slowing, it can cut rates to encourage borrowing and spending. If the economy is overheating, it can raise rates to reduce the risk of inflation. It’s an inexact science. “Policy makers must rely on estimates,” says a Fed publication, “aware that they could act on the basis of misleading information.” The Fed rarely reveals what specific data guided a particular decision, which bothers critics. “The nation pays a terrible price for allowing this cloistered governing institution to evade serious public scrutiny,” said William Greider, author of a critical book on the Fed.

Whom does the Fed answer to?

Pretty much nobody. By design, the Fed is insulated from politics. Its top officials are presidential appointees, but they have staggered terms, so no one president can pack the bank with loyalists. The Fed is funded with interest on the accounts it controls, so Congress can’t use the budget to punish it. But this doesn’t mean the Fed is apolitical. In early 1972, a presidential election year, inflation was accelerating, usually a signal for the Fed to raise rates. Instead, then—Fed Chairman Arthur Burns, formerly a top aide to President Richard Nixon, kept rates low. “The policy helped re-elect the president,” said historian Allen Matusow, “but also assured the next cycle of boom and bust.” In 2001, then–Fed Chairman Alan Greenspan was roundly criticized by Democrats when he said that he did not believe President Bush’s proposed tax cuts would lead to a budget deficit. He turned out to be wrong, but not before he swayed many wavering lawmakers to support Bush’s plan.

Do rate cuts always have their intended effect?

Hardly, and the current financial situation may be a case in point. Banks seldom hesitate to pass on their higher borrowing costs to customers. But they’re not always so quick to share lower costs. Since the Fed’s most recent cuts, corporate loan rates have actually increased, by about 1.25 points, and banks and credit card companies have on average raised, not lowered, the rates they charge consumers. That’s probably because banks are trying to make up for the massive losses they’ve incurred in the mortgage crisis, by borrowing at low rates from the Fed and lending at higher rates to businesses and consumers.

Is there anything the Fed can do about that?

No. The Fed can’t order banks to make loans or lower rates. The Fed, in fact, may be quietly encouraging banks to raise their rates, some analysts say, hoping that this strategy will help banks shore up their mortgage-battered finances. But banks can’t make money on high-priced loans that no one wants. With the economy slowing, consumers are spending and borrowing much less. Businesses, in turn, have less motivation to build new stores and plants and stock up on inventory. When rate cuts fail to stimulate demand for new loans, as is currently the case, the Fed is said to be “pushing on a string.” Given the economy’s rapid deterioration, the Fed may be pushing for some time.