You may hear about the Federal Reserve (the Fed) often in the financial news. But how much do you know about the roles of the Fed and how its actions affect the economy and investment markets? Let's take a look:

The Fed and its many roles
The Fed is a system of 12 district banks and 25 regional branches located across the United States. Its chairman is appointed by the president. The current chairman, Alan Greenspan, was first appointed in 1987 by President Reagan and reappointed by Presidents Bush and Clinton.

The Fed oversees the operations of its member banks, including all national commercial banks and many state-chartered banks. One of its roles is striving to keep the economy running smoothly.

Navigating the economic cycle
To stimulate a sluggish economy or thwart a recession, the Fed can add new money to the economy by two methods. First, it can buy U.S. government securities from banks and brokerage houses. When the money supply is increased (an “easy monetary policy”), more money is available for banks to lend to businesses and consumers, and the economy tends to grow. Companies tend to hire more workers, and consumers typically spend more freely. Second, the Fed can lower the discount rate, which is the rate of interest the Federal Reserve banks charge commercial banks to borrow funds.

If left unchecked, substantial economic growth can lead to high inflation. Why? Because as the economy picks up and demand for products and services increases, sellers tend to raise prices. To slow down economic growth and thus combat inflation, the Fed can reduce the amount of money in circulation by two methods: first, by selling U.S. government securities to banks, forcing the banks to use their funds to pay for the securities, thus reducing the amount of money banks have available to lend (a “tight monetary policy”). A second method is to raise the discount rate.

If a tight monetary policy goes too far, it can lead to a recession like the one we experienced in the early 1990s — or worse, a depression. To help avoid this, the Fed may revert to an easy monetary policy to stimulate the economy. And the economic cycle continues. Overall, however, the Fed seeks moderation both in economic growth and monetary policy management. It attempts to avoid extremes.

The discount rate actually is the only interest rate that the Fed directly controls. The Fed indirectly influences the highly publicized federal funds (or fed funds rate) through its control of the money supply. Commercial banks are required by the Fed to keep on deposit an amount of cash equal to a certain percentage of their depositors' money (called the reserve requirement). The term fed funds is commonly used to describe all money deposited by commercial banks at a Federal Reserve bank, including any money in excess of the reserve requirement. When a bank receives deposits or sells securities, that money increases the bank's store of federal funds. When a bank makes loans or buys securities, its store of federal funds decreases. When a bank falls short of its reserve requirement, it may borrow the excess reserves of another member bank, normally as an overnight loan. Interest on these unsecured, overnight loans is computed at an annualized rate and paid by the borrower to the lender daily. The fed funds rate, effective rate of interest, is the daily average rate of interest costs as negotiated between the commercial banks through the Federal Reserve System.

The fed funds rate fluctuates hourly and is one of this country's most volatile rates. Changes in the fed funds rate have a significant impact on other interest rates in the financial system and, consequently, on securities prices.

How the Fed's policy can affect investments
Previously purchased bonds generally are resold at a discount or premium, their prices moving in the opposite direction of moves in interest rates. Why? Because coupon (interest) rates on newly issued bonds tend to reflect prevailing interest rates. If investors can earn a return of 6 percent on a newly issued bond, with 20 years to maturity, selling at a face value of $1,000, they won't pay $1,000 for a previously issued bond of similar maturity returning only 5 percent. The 5 percent bond must be “discounted” to a price of $884 to compete with the 6 percent bonds. A previously issued bond of similar maturity that is returning 7 percent in an environment of 6 percent interest rates would sell at a “premium” — $1,116.

The stock market, which competes with the bond market for investor dollars, is also affected by interest rate changes. Here again, it is usually an inverse relationship. When investors sell stocks to move into bonds, stock prices in general tend to fall. Also, an increase in interest rates makes it more expensive (and less attractive) for consumers and businesses to borrow money to buy goods and services. That, in turn, can hurt corporate profits. Stock prices tend to decrease when investors anticipate that corporate profits will fall. Of course, as interest rates fall, stocks become relatively more attractive.

The Fed also performs these other roles:

• Handling the daily banking business of the U.S. government. This includes holding deposits for corporate taxes (such as unemployment and income withholding), authorizing payments of Social Security and Medicare benefits, and interest payments on U.S. Treasury securities. The Fed also stores gold kept in the U.S. by foreign governments (it is held at the Federal Reserve Bank of New York) and administers the exchange of gold bullion between countries.
  
  

• Supervising its member banks. The Fed monitors and audits all member banks to ensure compliance with federal banking regulations.

You should understand how economic conditions such as changes in interest rates may affect your investments. However, it is generally advisable to focus on the long term and make investment decisions based primarily on your individual objectives — and not on short-term economic events.

The above article is for general information only and is not intended to provide specific advice or recommendations for any individual. Consult your attorney, accountant, or financial or tax advisor with regard to your individual situation.