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The Federal Reserve and Inflation

President Woodrow Wilson signed into law the Federal Reserve Act in 1913, creating the Federal Reserve, the nation's central banking system. The Federal Reserve, or Fed, has also been called "the gatekeeper of the US economy" because of its unique power to influence US financial and credit markets.

Comprised of seven presidentially-appointed Board of Governors; the Federal Open Market Committee; 12 Federal Reserve Banks; and private U.S. banks and advisory councils, the Fed's mandate is "to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar, and moderate long-term interest rates." In other words, the Fed's job is to regulate the nation's financial institutions while simultaneously keeping inflation in check.

To accomplish this important yet difficult task, the Fed studies economic indicators, creates, and then implements monetary policy - its specific plan of action or "target" for the economy - based on its findings. And while there are many tools at its disposal, the Fed has three main instruments of monetary policy: open market operations, interest rates, and reserve requirements, all of which can impact the mortgage industry.

Open market operations, the principal tool used by the Fed in its monetary policy, consist of the buying and selling of U.S. government and mortgage-backed securities (treasury bonds, notes, and bills) on the "open market." Basically, the Fed buys when it wants to increase the flow of money and credit, and sells when it wants to reduce it.

The Fed also controls two important interest rates: the discount rate and the fed funds rate. The discount rate is the interest rate charged by Federal Reserve Banks to commercial banks and other eligible financial institutions on short-term loans. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. Experts say that changes in the discount rate can serve as a clear announcement of a change in the Fed's monetary policy. These changes are important because they can impact lending rates for banks and interest rates for the open market.

According to the Federal Reserve, the fed funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. Like the federal discount rate, the fed funds rate is another tool the Fed can use to control inflation and other interest rates. This interest rate is often a source of intense speculation whenever the Federal Open Market Committee meets, creating uncertainty that can move the financial markets as well.

Finally, think of reserve requirements, the last of the Fed's main monetary policy instruments, as the cash deposit requirement for a secured credit card. Reserve requirements represent the specific portion of deposits that banks are obligated by law to keep in non-interest-bearing funds at a Federal Reserve Bank, typically 10%. Consequently, as banks attempt to stay as near to the reserve limit as possible without dropping below, they constantly lend money back and forth to each other. The Fed, interpreting signs of inflation in its economic indicators, may choose to reduce the amount of reserves available to banks by slowing the selling of securities. Generally, this causes interest rates to rise, the economy to slow, and inflation to slow with it. The reverse is generally true when indicators suggest a slowing economy or deflation.

By Diane Tuman

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  • Last edited October 12 2012
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