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Federal Reserve (The Fed) RECOMMEND
Jay Mallin/Bloomberg News
Updated: June 21, 2011
The Federal Reserve, through its power to raise and lower interest rates,
has exercised more influence over economic growth and the level of
employment than any other government entity. That unusual role dates
from the 1970s, when the executive branch and Congress pulled back
from the use of fiscal tools — vast New Deal-style spending and targeted
tax cuts — as the primary means of regulating prosperity.
Instead, the Fed, as it is universally known, would pump up a sagging
economy by using interest rate cuts to in effect make money cheaper, or
slow a boom down by ratcheting rates up — a process described by one
Fed chairman as taking the punch bowl away just as the party's getting
going. That approach was credited with helping to moderate recessions.
Since the financial crisis began brewing in 2007, the Fed has been moving
into uncharted waters, aggressively intervening in deals to prop up or sell
of failing institutions, making loans available to banks in new ways and
buying vast amounts of assets to help keep the global economy afloat.
As the financial system moved to the brink of collapse in late 2008 and
early 2009, the Fed made up a whole new rule book, not only slashing
interest rates virtually to zero, but pumping well over a trillion dollars
into the economy through purchases of securities and the creation of new
lending platforms. Most economists credit those actions, known as
quantitative easing, along with the stimulus bill and the federal bank
bailout, with preventing a global depression. But they also made the Fed
the focus of unusual scrutiny and criticism, with critics pointing to its
failure to head off the real estate bubble and others denouncing what they
saw as unwarranted giveaways.
Despite its naysayers, the Fed emerged as a big winner in the bill
Congress passed in July 2010 to revamp the nation's financial regulatory
system. Despite widespread agreement, even within the Fed, that its
regulatory record leading up to the 2008 credit crisis was poor, it was
given oversight of large financial institutions that are not banks, and a
proposal to strip it of its oversight of the nation's small banks was
dropped. The bill also puts a new consumer protection agency under its
While the Fed generally won praise for its swift action at the depth of the
2008 crisis, in the run up it had consistently underestimated the depth of
the financial system's problems, and since then it has consistently
overestimated the strength of the recovery, as did many other
In the spring of 2010, Fed officials suggested that continued weakness in
the labor market would lead them to leave interest rates at very low levels
for an extended period. But they also brought to an end the single largest
intervention to prop up the American economy, its $1.25 trillion program
to buy mortgage-backed securities.
Yet by summer, a string of weak economic numbers altered the sentiment
within the central bank. In September, the Fed's policy making
committee hinted strongly that it might resume buying vast amounts of
government debt to spur the recovery. The day after the November
elections, it announced that it would buy $600 billion in government
debt, calling the recovery "disappointingly slow."
The effort, nicknamed QEII, drew fire from conservatives worried about
inflation and countries around the globe, who saw it driving up the price
of their exports by weakening the dollar. Six months later, a broad range
of economists described the results of the asset purchases as
disappointing. Stock prices have climbed. Corporations have rarely been
able to borrow money more cheaply. Mortgage loans have seldom been
available at such low interest rates. But companies are hiring few new
workers, and people are buying few new homes. Almost 25 million
Americans cannot find full-time work, a number that is rising again after
But as the asset buying program came to an end in June 2011, the leaders
of the central bank have shown little appetite for another intervention.
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The political backlash against the current round of asset purchases is one
reason for the Fed’s timidity. Some at the central bank also see evidence
of diminishing returns from additional spending. And the Fed has made
clear that it its primary focus is on the pace of inflation, in part because
the central bank regards slow, steady price increases as a prerequisite for
sustainable job creation.
The Fed is, however, expected to leave its $2 trillion in purchases on its
balance sheet for some time, rather than selling them off.
How the Federal Reserve Works
President Woodrow Wilson signed the Federal Reserve Act on Dec. 23,
1913, creating a seven-member board of governors, including the Fed
chairman, and 12 regional banks — a structure collectively known as the
Federal Reserve System. The governors are appointed by the president
and approved by Congress; the regional bank presidents are selected by
leaders of their communities, particularly bankers.
Private banks controlled the flow of credit and thus interest rates in the
late 19th and early 20th centuries, and farmers, the backbone of the
populist movement, complained that the big Eastern banks often starved
them of credit at critical moments. Populists called for direct access to
credit, without the banks as intermediaries. That did not happen.
The Federal Reserve System was a compromise. The banks would remain
the lenders to the public, but the Fed would control the supply of funds
on which the banks depended to make loans. Injecting more money into
the banking system put downward pressure on interest rates, while its
opposite, restricting the supply of potential credit, pushed up rates. The
regional banks were intended to help make the flow of credit even across
Through various refinements over the years, this “open market”
operation, as it was called, has been at the heart of the Fed’s power. The
interest rate that results is called the federal funds rate. In turn, the
interest that banks and other lenders charge for mortgages and for
various forms of commercial and consumer credit fluctuate with the
federal funds rate. As a supplement, to assure an even flow of available
credit, commercial banks in various parts of the country can borrow
directly from the Fed at the nearest regional bank, using the so-called
discount window. The discount rate is linked to the federal funds rate.
The federal funds rate is set by the Fed’s Open Market Committee,
composed of the chairman, the six other governors, and five of the 12
regional bank presidents, on a rotating basis. The committee meets at Fed
headquarters in Washington every six weeks or so.
The Fed’s chairman, currently Mr. Bernanke and before him Alan
Greenspan and Paul A. Volcker, dominates Open Market operations.
Their main thrust has been to limit inflation, even at the risk of a
recession — although they have cut rates when the nation seemed in
danger of one.
The Financial Crisis
With the American housing market on the verge of collapse, the Fed used
its standard tool of intervention. The central bank began an aggressive
series of interest rate cuts beginning in August 2007. The cuts were
intended to counteract the tightening credit market and spur growth. The
Fed has since lowered interest rates to nearly zero. Analysts expect the
central bank to leave the target rate unchanged at the range of 0 to 0.25
When such cuts lose their impact, central banks turn to what economists
call "quantitative easing'' -- unorthodox methods of pumping money into
an economy and working to lower interest rates that central bankers do
not usually control. Their effect is the same as printing money in vast
quantities, but without ever turning on the printing presses.
In November 2008, Mr. Bernanke, who has avoided the "quantitative
easing'' term, outlined a range of unorthodox new tools that the central
bank can use to keep stimulating the economy once the federal funds rate
effectively reaches zero. Those techniques include buying vast amounts of
longer-term Treasury bonds, mortgage-backed securities issued by
government-sponsored companies like Fannie Mae and Freddie Mac and
commercial debt issued by private companies and consumer lenders.
The Federal Reserve introduced a slew of lending programs in its effort to
revive corporate and consumer lending. It had a hand in JPMorgan
Chase's takeover of Bear Stearns, and the government bailouts of Freddie
Mac, Fannie Mae and American International Group.
Since September 2008, the Fed's balance sheet has ballooned from about
$900 billion to more than $2 trillion as the central bank has created new
money and lent it out through all its new programs. As soon as the Fed
completes its plans to buy up mortgage-backed debt and consumer debt,
the balance sheet will be up to about $3 trillion.
More Power, More Controversy
Fed policy makers have traditionally made their decisions about interest
rates behind closed doors, communicating those decisions primarily
through brief, cryptic statements that analysts busily decode in the days
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But that kind of distance has become impossible in the two years since
the American economy plunged into its worst financial crisis since the
Great Depression. These days, Mr. Bernanke and the Fed have been
bailing out financial institutions, printing money in unheard-of volumes
and stepping in to fill the lending gap left by the crippled capital markets.
The Fed has never wielded as much power as it does right now, but the
very expansion of its mission has exposed it to more second-guessing and
more challenges to its political independence than ever before.
Republican lawmakers now portray the Fed as the embodiment of heavy-
handed big government, and have called for scaling back the central
bank's regulatory powers. But liberal Democrats have accused the Federal
Reserve of caving in to demands by banks for huge bailouts, for failing to
protect consumers against dangerous financial products and for being too
secretive about its emergency rescue programs.
The ire at the central bank is sure to figure into the continuing debate
over how to reform financial regulations. The Obama administration has
proposed consolidating regulatory powers under the Fed, while some in
Congress want to strip away its oversight authority.
Taking a step to normalize lending after holding interest rates to
extraordinary lows for more than a year to prop up the financial system,
the Federal Reserve on Feb. 19, 2010, raised the interest rate it charges on
short-term loans to banks, to 0.75 percent from 0.50 percent.
The move was a clear sign to the markets, politicians in Washington and
the country as a whole that the era of extraordinarily cheap money
necessitated by the crisis was drawing to a close.
On March 31, the Fed announced the end of its giant program of
purchasing mortgage-backed securities. The program was initially for
$500 billion. The purchases began in January 2009, and in March, the
Fed raised the goal to $1.25 trillion. The purchases were to end by Dec.
31, but in September, the Fed said the purchases would taper off more
slowly, ending on March 31.
Reconsidering an Exit Strategy
Over the next few months, the Fed performed a turnabout. A series of
newly worrying economic indicators increased concern at the Fed about
the pace of the recovery. Officials there shifted from the more optimistic
assessment of the spring that economic growth was sufficiently strong to
begin thinking about how to gradually return to normal monetary policy.
In June, the Open Market Committee downgraded its outlook and openly
discussed the prospect of deflation — a declining spiral of demand, prices
and wages — but cautioned that it was only likely to act if the situation
took a serious turn for the worse. By August, the signs of a slowing
recovery were strong enough to lead the committee to announce that it
would use use the proceeds from its huge mortgage-bond portfolio to buy
long-term Treasury securities, rather than letting the bonds mature. The
effect of the step would be to keep the Fed's giant balance sheet from
The measure fell short of the additional stimulus that some economists
were hoping for, in the form of new largescale asset purchases, the central
bank left open the possibility that additional easing of monetary policy
could take place in the fall if the recovery were to continue to weaken.
The Fed bought $1.25 trillion in mortgage-backed securities, and another
$200 billion in debts owed by government-sponsored enterprises,
primarily Fannie Mae and Freddie Mac, and completed the purchases in
March. The Fed had planned to allow the size of that portfolio to shrink
gradually over time as the debts matured or were prepaid. Instead, the
Fed will reinvest the principal payments in longer-term Treasury
securities. The central bank said it would continue to roll over its holdings
of other Treasury securities as they mature.
By the fall the Fed's governors had reached a consensus that a new round
of purchases was needed to offset the drag on the economy caused by
persistently high unemployment. Some economists worried that big asset
purchases would sow the seeds of new inflation; others thought the $600
billion announced in November was not enough, or that pumping more
money into the system might have a limited effect when neither
businesses or consumers were in the mood for spending, no matter how
available money becomes.
By April 2011, the critics who worried about inflation were still worrying,
while those who warned of a limited impact could point to the pace of
economic recovery, which had slowed after the program began. Mr.
Bernanke and his supporters sayid in response that the purchases have
improved economic conditions, all but erasing fears of deflation, a
pattern of falling prices that can delay purchases and stall growth.
Inflation, which is beneficial in moderation, climbed closer to healthy
levels since the Fed started buying bonds.
Sitting Out a Slowdown
In June, Mr. Bernanke said that disappointing recent data showed that
growth remained slow and uneven, but he made no mention of the
possibility that the Fed would intervene, noting instead that “a healthy
economic future” required a plan to shrink the federal deficit. William C.
Dudley, one of Mr. Bernanke’s top lieutenants, expanded on the same
theme, saying that the government needed to balance its books, and that
the nation needed to reduce its dependence on borrowing and
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Mr. Bernanke made clear that recent data had shaken his confidence in
the strength of the recovery, which continues to depend on extensive
federal support. Mr. Bernanke has said he wants to see evidence of strong
and sustained hiring by private firms before deciding that the economy
can withstand the loss of that support.
The economy has expanded much more slowly this year than the Fed had
predicted. Last month private employers added only 83,000 jobs,
reducing the average so far this year to about 180,000 jobs a month —
barely enough to cut into the numbers of the jobless.
Mr. Bernanke noted that after two years of economic recovery, the net
decline in one important measure, aggregate hours worked, remained
greater than the peak decline in the same measure during the deep
recession in 1981-82.
The Fed has invested more than $2 trillion in a range of unprecedented
programs, first to restore the financial system and then to encourage
economic expansion. Mr. Bernanke has argued that the policies achieved
worthwhile but limited objectives. Internal and external critics, however,
describe the results as lackluster and warn that the policies could make it
more difficult for the Fed to control inflation.
Those critics have taken a toll. So has internal debate about the efficacy of
additional stimulus, which already seems to be yielding diminishing
returns. So the Fed’s focus has turned to advocating for broader solutions
to broader problems.
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