Understanding The Federal Reserve System

Operating Federal Reserve System through Stocks. The Federal Reserve System (Fed) is the principal monetary authority or the central bank of the United States of America. Its primary role is to conduct monetary policy, supervise federal and state banks and maintain stability in the system by providing payment services to depository institutions. It is made up of a seven member Board of Governors in Washington DC, 12 regional Federal Reserve Banks and their 25 branches. The Board is appointed by the President and approved by the Senate.

Federal Reserve issues monetary policy guidelines and carries out stabilization activities which are particularly important in times of financial crisis such as stock market decline in 1987, the international debt crisis of 1998 and the terrorist attacks in September 2001. The principal instruments at the disposal of the Federal Reserve for maintaining stability are interest rates for loans, reserve ratio stipulations for commercial banks thereby determining liquidity and regulating circulation of new currency.

The latter is carried out by the Federal Open Market Committee (FOMC) by buying securities in the open market thereby increasing money supply.

This will simultaneously decrease the federal funds rate, reducing interest on mortgages and loans and generating demand. The price of bonds and securities operate within a narrow margin as these are long term instruments pledged by the government. During such times, it would be seen that the price of stocks which are volatile instruments will undergo large fluctuations as opposed to bonds and securities.

Similarly an increase in money supply also results in people putting more money into the stock market.

In case the economy is growing too fast, Fed can sell Treasury securities and reduce the money supply, marking higher interest rates. Stocks construe ownership of shares in the assets of a company. The price of shares is determined by the market. The New York Stock Exchange provides a facility for trading shares. Stocks are guaranteed to the extent of the liquidity of assets of the company and unlike federal bonds are not direct instruments of liquidity.

There is a possibility of default in stocks unlike bonds. The US Fed will not be able to ensure stability through regulation of money supply by holding stocks. The aim is also to ensure sustained long term growth in the economy; this is achieved through investments in long term instruments as mortgages, insurance and loans. Stocks are relatively short term instruments which provide market marked returns and thus are not suitable as a policy instrument for the US Federal Reserve. Impact Open Market Purchase of Gold or Foreign Currency.

Purchase of gold or foreign currency by the Federal Reserve will increase money supply in the domestic market. Buying gold or foreign exchange is similar to outright purchase of government securities from the open market. In this case money supply is altered permanently rather than temporarily. The purchase of gold or foreign currency is carried out in very few cases merely to send an appropriate signal as the impact is considerable. Similarly theoretically speaking if the Fed sells gold and foreign currency it will be decreasing money supply in the domestic market.

The gold and foreign exchange markets are beyond the control of the Federal Reserve as there is no regulatory authority unlike the bond market. Thus fluctuations can be substantial and impact the domestic economy gravely. Instability in the Gold and Forex market has not been defined and can cause speculation which is related to fluctuations in the exchange rates as well as trader’s reluctance to buy and sell the commodity or foreign exchange. Maintenance of stability in the economy is the principal role of the Federal Reserve.

This has to be done through specific instruments which are provided for the same and the controlling organization for it, which is the Federal Open Market Committee, the federal and the state banks. The Federal Reserve has been intervening from time to time in a small way in the foreign exchange market merely to send an appropriate signal to the investors. In this case Federal Reserve sells dollars and buys foreign currency to exert downward pressure on the price of the dollar while it buys dollars and sells foreign currency to exert an upward pressure.