Interpreting the News: The Fed, why should we care?

The Federal Reserve System (The Fed) of the United States is responsible for overseeing the economic condition of the US and money flows of the public. They are to maintain price stability and maximum employment. Part of the Fed’s role includes supervising and regulating financial institutions and their activities because they will work with the public to adjust the money supply.

Most people are familiar with the Fed’s Federal Open Market Committee (FOMC) who will determine what actions should be taken during different economic environments. The infographic below will help explain the economic environments that will cause actions by the Fed.

(click on the graphic to make it bigger)

EXPANSION:
During economic expansion, or economic recovery, businesses are growing and people are spending because they are fully employed and maybe have even gotten a raise. The value of US goods and services rise, measured by GDP. As people buy goods and services the supply of those items decreases and that ultimately drives up prices. Money can no longer buy as much as it used to, inflation is happening.

The Fed attempts to control the rise in prices for goods and services by raising interest rates, which decrease borrowing and slow spending. They will also increase the reserve requirements for banks, or the cash banks must have on hand. This contributes to a decreased supply of money available for the public to borrow. As the news has reported recently, another way to remove money from the system is for the Fed to sell their stash of Treasury bonds. Bond dealers buy those bonds and give their cash to the Fed. This process happens slowly over time. As money leaves the system, business profits will decrease and therefore the stock price of those companies will begin to fall. Investors should monitor signals when these events begin happening because you want to sell stock at the high price and not the low.

To stay viable, businesses will be forced to reduce their costs. They may even decide to lay off workers, which will cause a rise in the unemployment rate. Expansion has stopped and a new phase of the economy begins.

CONTRACTION:
When the economy has slowed and unemployment is high, we may hear the news talk about a recession. Business revenues have fallen and people are not spending money. Stock prices will be falling and reaching a bottom during this period. This is a time when having a savings account pays off because investors can take advantage of low stock prices and buy while they are “on sale.” When prices of goods and services decrease the US GDP decreases too. This is considered a deflationary period.

The Fed will decide to intervene when they feel the economy has slowed far enough. They will lower interest rates to stimulate borrowing and spending again. The banks will also have a decreased reserve requirement so that they can lend more to the public. Another way to add money to the system is to buy Treasury bonds from bond dealers, adding cash to the public sector. As spending slowly increases, businesses can begin profiting, spending more, and employing more people. This will cause the economy to recover and repeat through an expansionary period.

Natural disasters, wars, and other unexpected world events may disrupt these different economic environments and lengthen or shorten them depending on how the government and the public react. No one really knows how long any phase of the economy may last, but it is important for economists to study how best to respond to unexpected events and economic phases. The Fed must be able to protect the public during periods of financial crisis. This means being able to offer relief or a bailout to entities that could cause a serious economic event. Ideally, the Fed should avoid repeating history and learning from any crisis that occurs. (I am sure we could debate if they are actually doing that, right!? 😊)

Hopefully, the above will help you understand why the news has been talking about the President’s decision in November to fill 4 positions out of 12 that sit on the FOMC, one of which is the Chairman. Four out of 12 is a big deal. While the FOMC has a big job, no one specific individual on that committee will not likely matter to the American public. It is more important that the committee appears effective and cohesive. If the public can trust the FOMC sentiment will improve, or remain high as it is today, and there will be a calmer sense from investors. Knowledge is key and your choices to spend, save, be productive at work, and own businesses can give you the power to control the economy, not just the FED! Think about it…

 

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