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Tuesday, May 17, 2022

Everyday Economics: What is the Fed, and what role does it play in the US economy?

This is the first time since 2018 that the US central bank has raised borrowing costs. The Fed had kept interest rates near zero since March 2020 as the Covid-19 pandemic dealt blows to the US economy

By: Explained Desk | New Delhi |
Updated: March 18, 2022 12:08:35 pm
The Federal Reserve building. (Reuters Photo: Joshua Roberts)

The United States Federal Reserve raised its key interest rate by a quarter of a percentage point on Wednesday as the first decisive step to tame runaway inflation that has touched a 40-year high in that country.

This is the first time since 2018 that the US central bank has raised borrowing costs. The Fed had kept interest rates near zero since March 2020 as the Covid-19 pandemic dealt blows to the US economy. With the virus in retreat and prices raging, policymakers have signalled they are pulling support to the economy, and projected another six similar increases of rates over the rest of 2022.

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The US is the world’s biggest economy and the Fed the biggest central bank, and its decisions impact market behaviour around the world. The Fed’s decision to hike rates will also have a bearing on the Reserve Bank of India’s monetary policy review at the next meeting of the Monetary Policy Committee scheduled between April 6 and April 8.

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The US is the world’s biggest economy and the Fed the biggest central bank, and its decisions impact market behaviour around the world. (Reuters Photo)

The role of the Federal Reserve

The US central bank system performs five broad functions to promote the effective operation of the American economy. The Federal Reserve identifies these functions as follows:

  • conducting the US monetary policy to promote maximum employment and stable prices;
  • promoting the stability of the financial system and seeking to minimize and contain systemic risks through active monitoring and engagement in America and overseas;
  • promoting the safety and soundness of individual financial institutions and monitoring their impact on the financial system as a whole;
  • fostering safety and efficiency in the payment and settlement system through services to banks and the federal government that facilitate US-dollar transactions and payments;
  • promoting consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, and the administration of consumer laws and regulations.

Parts of the Fed

While the Federal Reserve has frequent communication with the executive branch and congressional officials, its decisions are made independently. The Federal Reserve System consists of three major entities:

  • The Federal Reserve Board of Governors (Board of Governors), the main governing body of the system. The chairman and governors of the Board are appointed by the President and confirmed by the Senate. The present chair of the Federal Reserve Board of Governors is Jerome H Powell, who was nominated to the board by President Barack Obama in 2012 and elevated to its 16th chair by President Donald Trump. The offices of the Board of Governors are headquartered in the Marriner S Eccles Federal Reserve Board Building in Washington DC.
  • The Federal Reserve Banks (Reserve Banks), are the regional operating arms of the Federal Reserve System, and are supervised by the Board of Governors. There are 12 Federal Reserve Banks (such as those of New York, Boston, Philadelphia, Atlanta, Chicago, San Francisco, etc.) corresponding to the 12 Federal Reserve Districts in the US.
  • The Federal Open Market Committee (FOMC) consists of the members of the Board of Governors and presidents of the Reserve Banks. The chair of the Board is the chair of the FOMC. The FOMC has 12 members at a time: seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four of the remaining 11 Reserve Bank presidents, who serve one-year terms on a rotating basis.
Federal Reserve Chair Jerome Powell. (Reuters Photo: Tom Brenner)

Monetary policy

Monetary policy refers to actions taken by the Fed to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve controls the three tools of monetary policy: open market operations, discount rate, and reserve requirements.

The Board of Governors is responsible for the discount rate and reserve requirements, and the FOMC is responsible for open market operations.

The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services, the Fed says on its website.

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