Q: I heard the Fed Chairman Ben Bernanke’s press conference last week. Does Fed policy directly affect me?
A: Yes indeed. The interest rates on a host of transactions like investing in CDs, taking out a mortgage, or obtaining a business loan depend directly upon policy decisions by the Fed. It is therefore important to understand the role the Federal Reserve System plays in stabilizing the U.S. economy.
Most countries have some form of central bank that exercises control over the supply of money and credit within their borders.
This sphere of influence is referred to as monetary policy, and is typically the explicit purview of the central bank (as opposed to fiscal or budgetary policy, which in the United States belongs to Congress).
It is imperative that the central bank maintain a high level of independence from the legislature to insulate decision making from political pressure. The U.S. central bank is comprised of 12 regional
Fed banks and controlled by a board of governors of which Bernanke is chairman.
The primary responsibility of a well-designed central bank is to maintain price stability, avoiding prolonged bouts of inflation or deflation.
Inflation is a monetary phenomenon and is best influenced through decisive and independent control of the money supply and interest rates.
The Fed exercises this influence primarily by altering the rate that large banks charge each other for short-term loans. This rate (the Fed funds rate) stands at zero, which is why 30-year mortgages can be had below 5 percent, and why your six-month CD yields only 1 percent.
Unfortunately, the Federal Reserve serves two masters. In 1977, Congress added a second — contradictory — mandate to the Fed’s portfolio: maximizing employment.
While sound monetary policy is supportive of employment growth in the long run, job creation is primarily a fiscal policy responsibility — Congress’ job. The tool kit of the central bank is not much help in reducing unemployment.
Nevertheless, by law they must try. With interest rates already at zero, they embarked upon a massive purchase of government bonds in an effort to stimulate lending, and ultimately, hiring. This so-called “quantitative easing” is also suppressing interest rates (good for borrowers, bad for savers).
The program is scheduled to expire in June, but don’t expect juicier CD rates until sometime next year when the original mandate regains precedence.
Chris Hopkins is a certified financial analyst and vice president of investments at Barnett & Co. Inc. His personal finance column appears every other Wednesday.