WHAT THE FED CAN AND CAN'T DO

Welcome to The Wealth Span - if you want to join the growing list of folks learning about investing for longevity each week, subscribe below...

Feel free to read the most popular posts and connect with me on LinkedIn!

Now - today's post...

___________________________________

You don’t have to be an economist to see that the Federal Reserve has an increasing portion of the media’s and population’s mind share. The infamous institution has been in the headlines quite a bit in recent months.

After all of the coverage, you might believe that the Fed essentially controls every aspect of the financial system from the banking system and stock market to even your personal finances.

Fortunately, that is not the case.

___________________________________

What is the Federal Reserve?

The Federal Reserve, commonly called the Fed, is one of the most important institutions in the United States, yet many people know little or nothing about it.

The Fed is the central bank of the United States, formulating and administering credit and monetary policy.

1 - Credit Policy

The Federal Reserve will lend money on a short-term basis (often overnight) to large, institutional banks which allows the banks to maintain their overall liquidity.

2 - Monetary Policy

The Federal Reserve partakes in a number of actions to accomplish three goals: promote maximum employment, foster stable prices, and moderate long-term interest rates.

The Federal Reserve’s duties are very technical and complex in nature. In the most basic sense, they attempt to promote safety and stability in the financial system through a number of ways.

What the Fed Can Do

When Congress created the Fed, the mandate was simple. The Fed’s role in the financial system and overall economy has slowly spread over time. Now, as you have probably noticed, they have significant authority and ability. Some of the tools in the Federal Reserve’s tool belt include those listed below.

1 - Reserve Requirements

This is the amount of cash the Fed requires member banks to keep in vaults or hold at an actual Federal Reserve bank. The higher the reserve requirement, the less money that can be lent to corporations/consumers.

Reducing the reserve requirement is considered to be expansionary (more money in the market) monetary policy and raising the reserve requirement is contractionary (less money in the market) monetary policy. These corresponding actions are meant to control overall liquidity and assist in warming up or cooling down the economy.

2 - Open Market Operations

The Fed can buy or sell US Treasuries (a type of government bond) in the open market in an attempt to affect interest rates. Buying is expansionary, and selling is contractionary.

Once again, the Fed takes this action to cool down a hot economy or attempt to add fuel to the economy. This can indirectly affect credit markets, overall output, and unemployment. If you have heard of quantitative easing or tightening, then you are familiar with open market operations. Both terms refer to the same actions by the Fed.

3 - The Discount Rate

“The Fed is raising rates” is something you may have heard/seen in the news. It has been a common refrain in recent months. When this happens, the discount rate is the “rate” the Fed is able to change directly.

When the Fed lends money to commercial banks, it does so at the discount rate. Because of this, it is the basis of nearly all other interest rates. Raising the discount rate is contractionary and lowering the discount rate is expansionary.

What the Fed Can’t Do

Although the headlines attribute many outcomes to the Fed, the truth is that they do not have as much control over our lives as we would be led to believe. The list of things the Fed is unable to do is much longer than the tools/capabilities they have at their disposal.

1 - Force you to stay in a certain job

The Fed may be able to impact the job market at large in some ways, but it doesn’t directly control you or your decision making process when it comes to transitioning careers. Despite concerns about other components of the economy, the job market has proved to be resilient.

Highly talented and motivated individuals always have options. You shouldn't allow the Fed’s attempt to crush the job market to keep you in a job you don’t even like.

2 - Keep you from buying a home

As mortgage rates have risen significantly in recent months, it is clear that the Fed raising rates has had some amount of impact on the overall housing market. The 30-year fixed mortgage rate has risen to above 7% from right around 3.20% in June of 2021.

Buying a home is an intensely personal decision. The financial benefits are not as significant as you might have been led to believe, but the home purchase has more gravity than other financial decisions. The Fed may have changed your budget for a mortgage payment because of the higher interest rates.

If you want to buy a home, the largest considerations are personal not financial.

3 - Start or stop a recession

The Fed is only inspecting backward-looking data which makes it difficult (nearly impossible) to solve any potential problems in the future. The data is suspect at best, possibly out-dated and irrelevant at worst.

It is hard to make economically efficient or optimal decisions under any circumstances, but when the information available is as good as a year-old frozen dinner - it’s essentially impossible.

The Fed may attempt to slow down the economy to curb inflation (what is happening now) or try to accelerate growth in the economy during a recession. Despite their honest effort, the Fed alone cannot stop inflation or a recession.

4 - Manage all of the market’s complexities

Ultimately, the Fed and its employees are in a difficult position. They have blunt tools and must solve complex problems with no easy solutions. It’s no wonder that the Fed has had more than its share of blunders.

The unforeseen events and unexpected results aside, the Fed is just one player in a complex game. There is not much it can do to keep everyone and everything else in line.

Even though the Fed has made an effort to “cool down” the economy, the number of factors outside their control is endless.

You are outside of the Fed’s control. Really, it is for the best.

___________________________________

TL;DR

The Federal Reserve is important. It helps the financial system to function properly, providing regulation for the banking industry and guardrails for the economy as a whole.

Don’t give it too much credit though. Your financial situation and life generally is more dependent on you and your decisions than those of the Fed.

It is best to stay focused on what you can control rather than what the Federal Reserve can’t control.

___________________________________

Hopefully you know more about the Federal Reserve, its duties, and its impact on your life.

Share your new knowledge with a friend - and make sure to tell them you received it from The Wealth Span!