Meltdown 101: Why is there a Federal Reserve?

[October 30, 2008]  NEW YORK (AP) -- The Federal Reserve System, the nation's central bank, was created in 1913 with two specific charges: promoting maximum sustainable employment and keeping inflation low.

To the extent that the nation's economy can be heated up or cooled down, the Fed is the institution with its fingers on the thermostat.

Teams of economists parse reams of statistics to take the economy's temperature and try, using some powerful tools, to ensure the economy is not running so hot that prices soar and not running so cold that thousands of people lose their jobs.

Of course, there's plenty that's outside the Fed's control, from bank blowups to stock swings. But it still has more power over the economy than any other institution. That's why Fed actions make headlines even before they happen -- think of stocks gaining $1 trillion in total value Tuesday, rallying on the hope that the Fed would cut its short-term interest rate target. It did just that Wednesday, cutting the key rate to 1 percent.

Here are some questions and answers about the Fed and what it does.

Q: Why was the Federal Reserve created?

A: Just as the recent economic crisis has shaped national policy, so did the crises of the past. The legislation that created the modern Federal Reserve system came after a bank run in 1907 that followed a period of Wall Street speculation. (Sound familiar?)

Congress first passed an act providing for emergency currency infusions during a crisis. When the Fed was created in 1913, Congress hoped it would serve as a bulwark against future panics.

There had been two previous attempts to create a central bank in the U.S. during the 19th Century, but neither worked.

Q: What does the Federal Reserve do?

A: The Fed sets monetary policy, making decisions about the total amount of money in the economy -- also known as the money supply.

To loosen the money supply, the Fed can make loans itself, either to banks, foreign countries or businesses. That's something it's been doing increasingly over the last two months. Besides those loans, one of the Fed's primary ways of controlling the money supply is buying and selling Treasury securities -- U.S. government debt -- on the open market.

To loosen monetary policy when lending is tight and the economy is shrinking (as it is now), the Fed buys Treasury securities from banks. To pay the banks, it credits their reserves -- the cash banks keep on hand to cover loans they've made.

When those reserves rise, banks can, theoretically, make more loans. (Though there's no guarantee they'll do this -- like if they're too terrified to lend anything to anybody, as many seem to be now.)

To tighten monetary policy when the economy is growing and inflation is climbing, the Fed sells Treasuries to banks. The banks pay for them in cash, leaving them less money to lend. That should tighten lending, slowing the economy as loans get less common and more expensive, causing inflation to decline.

Another of the Fed's tools is its control over the Federal funds rate, the rate banks charge each other for overnight loans.

The Fed is currently cutting the rate, as it did Wednesday, to free up money for loans in the hopes the economy will grow. Lower interest rates should mean it's easier for businesses to get loans to buy new factory equipment or hire more workers and for individuals to borrow money to buy a home or a new car.

The last time the Fed tightened rates was during the economic expansion from 2004 to 2006. The Fed has been in loosening mode since September 2007.

Q: What's the difference between monetary policy and fiscal policy?

A: Monetary policy refers to the Fed's stance on the money supply and whether it's tightening or loosening access. Fiscal policy covers all the federal government's spending and taxation policies.

Q: Does the Fed set targets for unemployment and inflation?

A: The Fed does set unofficial targets for inflation; it does not set targets for employment.

The Fed targets a "nominal" level of inflation -- usually somewhere around 2 percent annually. When inflation gets much higher, as it did when it hit an annual rate of 5.6 percent in July, people struggle to buy necessities. When inflation gets much lower, as it did in 2003 when it hit 1 percent annually, the Fed acts to stimulate the economy.

Outside "supply shocks," such as last summer's soaring gas prices, inflation is something the Fed can influence. Creating a sustainable level of employment, on the other hand, is something no central bank can control.

Let's say the Fed were to keep interest rates low even as the economy was growing furiously. While that might cause employment to balloon, which would be a good thing, it would also cause inflation to spike, for a couple of reasons: Cheap loans make people and institutions more willing to spend money, which pushes prices up; and when nearly everyone has a job, employers are forced to raise wages to keep their workers.

Higher prices lead to spending cuts by individuals and businesses, which in turn lead to job cuts.

Even if the Fed could directly control the unemployment rate, there's no agreement on what the maximum sustainable level of employment should be, in part because the structure of the economy keeps changing: For better or for worse, the steel mill and auto factory jobs of the 1970s had become security guard and call center jobs by the 1990s. No amount of monetary policy can influence those broad economic shifts.

[Associated Press; By ELLEN SIMON]

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