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Five Things You Must Know About the Fed

The Finance Professor explains what the Fed does and how it can affect you.

To the beginner investor and most noninvestors, it seems as though the Federal Reserve System acts in a cloak-and-dagger manner. Eight times a year, the Federal Open Market Committee issues its determination for policy on the federal funds rate, and this tends to be the most covered and visible action that comes out of the Fed. But as recent events show, there is more that the Fed can and will do to impact the markets and our lives.

In this installment of the Finance Professor, I will cover five things every investor must know about the Fed and why.

1. The Fed's Role

The Fed is responsible for much more than determining the fed funds rates. According to the Fed's own publication entitled

The Federal Reserve System Purposes & Functions, 9th Edition

(June 2005), the Fed "is the central bank of the United States" and was started by Congress "to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded."

This publication goes on to specify the Fed's four main duties:

  • "conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates"
  • "supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers"
  • "maintaining the stability of the financial system and containing systemic risk that may arise in financial markets"
  • "providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system"

I would like to add another critical role the Fed plays (which is not explicitly stated in this Fed brochure) that happens to impact all of us: the regulation of the extension of credit by banks, securities brokers and other financial institutions.

All of these functions help to determine interest rates and credit standards and ensure liquidity in the banking system. In turn, this impacts investors and consumers in very direct ways (like the interest paid on mortgages) and somewhat indirect ways (like creating or removing an economic stimulus and controlling

inflation).

2. How the Fed Is Organized

By understanding the structure of the Fed, you can ascertain which individuals hold the power in the body of the Fed, which controls each of the key banking rates, and how decisions are ultimately made.

So here is how the Fed is organized.

The Federal Reserve System is divided into 12 Federal Reserve Districts or Banks (Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco). Each district has its own president who heads up that district. Each of these banks has its own board of directors.

The Fed is headed up by a seven-member Board of Governors. The members of this board are appointed by the president of the U.S. and confirmed by the U.S. Senate. Each board member serves a 14-year term and can serve for onlya single term (in addition to completing the term of a vacant member). No more than one board member can be appointed from any single Fed district. The chairman (currently Ben Bernanke) and vice chairman (currently Donald Kohn) are appointed by the U.S. president and confirmed by the Senate to a four-year term.

The Federal Open Market Committee is a 12-member institution, which is responsible for monetary policy. The FOMC is composed of the seven-member Board of Governors plus five other Federal Reserve district presidents. One of these five "at-large" members must be the president of the New York Fed. The other four members are selected from among the other district presidents on a rotating basis to serve one-year terms.

The FOMC determines its own leadership. Traditionally, the chairman of the Fed Board of Governors is elected as FOMC chairman, and the New York Fed president is the vice chairman.

3. Key Rates That the Fed Controls

There are two important interest benchmark rates that the Fed controls: the discount rate and the federal funds rate.

Discount Rate

. The discount rate is often referred to as the Fed's "primary rate." That is the interest rate charged on loans made by the Federal Reserve banks to commercial banks, such as

Citibank

(C) - Get Citigroup Inc. Report

and

Bank of America

(BAC) - Get Bank of America Corp Report

, and other depository institutions (like certain governmental and quasigovernmental agencies). To get this "discount" from the Fed, these big borrowers must be financially sound and maintain sufficient

capital.

It's important to keep an eye on the discount rate because it will either provide or remove liquidity to or from banks for further lending activity downstream in the commercial and consumer credit system.

Federal Funds Rate

. This is the interest rate at which depository institutions can lend to one another via the Federal Reserve on an overnight basis. The FOMC will establish this fed funds rate as a target through

open-market operations.

The federal funds rate tends to be the key rate at which consumer-lending rates such as "

prime rates" are targeted.

4. How the Fed Achieves Its Monetary Policy

Both the discount rate and fed funds rate are determined by the Federal Reserve System. However, each of those rates is controlled by entirely different financial mechanisms.

The discount rate is controlled by the board of directors of each Federal Reserve District Bank and is further overseen by the Fed Board of Governors. These loans are made at a facility called the "discount window." Typically, these loans are made on an overnight basis. What made the Fed's recent move so extraordinary was the fact that the loans were made on a 30-day term basis.

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The fed funds rate is determined by the FOMC. The FOMC meets eight times each calendar year. At the conclusion of each meeting (which can last as long as two days), the FOMC will issue a press release stating its assessment of the economy and the "target" fed funds rate. In addition, a bias for future FOMC policy will be extracted from the statement.

Three weeks after the press release, the FOMC will release more detailed minutes (notes) of the committee's meeting.

It is important to note that the FOMC can and will meet from time to time in between meetings to take monetary action as is necessary to achieve its goals. Examples of this behavior include the extraordinary monetary actions that were taken after the 1987 stock market crash and the terrorist attacks of Sept. 11, 2001.

It is important to note that the FOMC controls the targeted fed funds rate but not the discount rate. In order to accomplish the FOMC's objectives, the FOMC will enter into "repos" (to tighten or remove liquidity) or "reverse repos" (to ease or increase liquidity).

A third way in which the Fed achieves its monetary policy is through setting the "reserve requirement." The reserve requirement is a percentage of liabilities that each depository institution must maintain in cash or on deposit with the Fed to satisfy Fed

Regulation D.

5. The Fed Influences the Extension of Credit

The Fed also controls the rules regarding the extension of credit by financial institutions to the public. A few of the more important credit-related Fed regulations that affect the individual (as a borrower or investor) are:

  • Regulation T
  • Regulation U
  • Regulation X
  • Regulation Z

Regulation T

. This covers the extension of credit by

brokers and

dealers. In a more general sense, this Fed regulation covers the rules for margin lending (see

margin account). I cover borrowing on margin in more depth in "

Understanding Leverage."

Regulation U

. This controls the extension of credit on margin-lending by banks and other financial institutions that are not registered

broker-dealers. For example,

Morgan Stanley

(MS) - Get Morgan Stanley (MS) Report

is a broker dealer so it is subject to Regulation T, but when a commercial bank like

SunTrust

(STI) - Get SunTrust Banks, Inc. Report

lends on margin outside of its broker-dealer division, then it is subject to Regulation U.

Regulation X

. This applies provisions of Regulations T and U to the extension of credit outside the U.S. for borrowers that are subject to regulation

within

the U.S. It is because of Regulation X that many

hedge funds establish

offshore funds for non-U.S. investors.

Regulation Z

. Commonly referred to as the "Truth in Lending Act," this regulation ensures uniformity for computing the cost of credit, disclosure of credit terms and for resolving errors on certain types of credit accounts.

Fed Homework

To strengthen your understanding of what the Fed does, how it works and its overall impact on the markets and

you

, I suggest the following homework:

  • Read several FOMC minutes at www.federalreserve.gov/FOMC/#calendars and start to form your take on what the FOMC said and how the markets interpreted its decisions.
  • Read related articles by the financial and business press. Then incorporate what you read into your new understanding of how the Fed works.
  • See if you can forecast the FOMC's next move. Why? This might help you determine your investing and borrowing strategies. How? To be a savvy investor you need to be able to somewhat anticipate earnings, the economy and interest rates. If you want to be ahead of the curve, then solely reacting to news is not sufficient.

At the time of publication, Rothbort was long C and MS, although positions can change at any time. Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities. Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University. For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.