Marc Cuniberti: It’s the Fed’s foot on the gas pedal
Many Americans do not fully comprehend exactly what it is the Federal Reserve actually does (commonly referred to as the Fed).
From its own website, its function can be summed up as:
Conducting the nation’s monetary policy.
Supervising and regulating banks and other important financial institutions.
Maintaining the stability of the financial system.
And, providing certain financial services to the U.S. government, U.S. financial institutions, and foreign official institutions.
The Fed has three key entities, the 12 Regional Banks (12 districts that cover the U.S. and are the operating arms of the Fed) the Federal Reserve Governors (the governing body of the Fed that reports to Congress) and the Federal Open Market Committee (FOMC) which is responsible for what is called Open Market Operations (OMO).
OMO refers to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. It all sounds a bit technical, but think of it as a gas pedal for the economy, or at least one of the gas pedals possessed by the Fed. Press on the gas pedal and away you go, lift off the pedal and things slow down.
So how does OMO act like a throttle on an economy, allowing it to speed up (improve economic conditions) or slow down (cool off an overheating economy from inflation)?
It all has to do with how inflation works. Simply put, increase the amount of money in an economy, economic conditions generally improve and prices tend to rise. Withdraw (reduce) the amount of money, the economy slows and prices tend to fall. OMO plays to this mechanism.
In one instance, the Fed prints up some money and buy debt that large U.S. banks are required to hold which are called “bank reserves”. This debt may include U.S. Treasuries (Government IOU’s) or debt from Fannie Mae or Freddie Mac, which is basically government backed mortgages. Large banks always hold vast amounts of both of these types of IOUs and agree to let the Fed buy or sell these IOUs at any time as a part of the OMO program.
When buying, the Fed gives the banks money in exchange for its IOUs. The Fed can also order the banks to do the reverse and buy IOUs from the Fed.
This back and forth selling or buying between the banks and the Fed either funnels more cash into the banking system (when the Fed buys the debt) or takes money out of the system (when the Fed orders the bank to buy the IOUs from the Fed). Incidentally the banks make a profit every time a transaction takes place because the Fed pays them a little bit extra when they are on the buy side of the equation.
A buy and a sell of the same IOU can happen overnight, meaning the Fed sells the IOU one day then buys it back the next. These are called repurchase agreements or “overnight repos” for short. The repurchase agreements can also be much longer in duration.
When the Fed buys IOUs, more money goes into the banking system and the gas pedal is pressed down. When the Fed orders the banks to buy IOUs from the Fed, money is taken out of the system and the pedal is lifted.
By adding or subtracting money from the banking system, the Fed’s hope to control how much money is lent out to consumers and businesses thereby stimulating or slowing the economy.
Money is the fuel which drives the economy and by simply adding or subtracting vast amounts of it, the belief is it will act like an accelerator pedal and the economy will respond accordingly. Coupled with a variety of other tools at the Fed’s disposal, they hope to control the economy in the direction they want it to go and at the instant they want it to go there.
Given the history of market crashes, economic blow ups and the severity of such events since the Fed’s inception in 1913, I will leave it to the reader to decide whether they actually accomplish this task.
This article expresses the opinions of Marc Cuniberti and should not be construed or acted upon as individual investment advice. Mr. Cuniberti is an Investment Advisor Representative through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Marc can be contacted at MKB Financial Services 164 Maple St #1, Auburn, CA 95603 (530) 823-2792. MKB Financial Services and Cambridge are not affiliated. His website is http://www.moneymanagementradio.com.
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