Big Ben and The Federal Reserve

This is a long overdue post that I promised a friend. So here it is. You know who you are. I'll try to make it more understandable since you're a med student.. By the way, you should be studying whatever you should be studying instead of watching CNBC. Please don't end up killing your patients!

What is the US Federal Reserve all about?

Long before our time, the US banking system was in a mess (not like it isn't now) but we had banks popping up like pimples on a pubescent teen. Unregulated lending led to a whole host of crises that basically screwed many people over. So, the Yanks decided to install a Central Bank, known as the Federal Reserve to reign in these cheeky monkeys.

The Federal Reserve is headed out Washington by the Board of Governors of the Federal Reserve and is currently led by Ben Bernanke. It basically acts as a banker to banks, a banker to the US government, a regulator of financial institutions and the nation's money manager. Their main role, however, is to implement monetary policy with the end goals of sustainable economic growth, full employment and stable prices. Through monetary policy, therefore, the Fed attempts to tweak the economy to the right levels.

The Fed's Magic

So how does the Fed work its magic? Well, it has three main tools in its "toolbox". They are, Open Market Operations, Discount Rate and Reserve Requirements.

Open market operations refer to the Fed's buying and selling of US government securities in financial markets. Assume Daniel owns some US government securities. If the Fed decides to buy all these securities, I get money in my pocket (which I can then go and spend on liposuction). With this increase in money supply, interest rates will then be lowered (my econs friends: please correct me if I am wrong). The converse would be true, and I won't be needing new pants.

The discount rate is the rate banks pay on short term loans from a federal reserve bank. This rate is set directly by the Fed Reserve. Don't confuse the discount rate with the Fed Funds Rate. They are not the same thing. The higher discount rate, the more expensive to borrow, less people will borrow and consequently, less money will be flowing around (decrease in money supply) and vice versa. What we saw was both the lowering of the discount rate and Fed Fund Target Rate to "promote liquidity" in the markets - AKA increase money supply.

Reserve requirements refers to the amount of physical funds that a depository institution (think DBS, POSB, UOB) needs to hold in reserve against deposits. If the Fed increases this requirement, then more money will be held in the bank's vault, and there's less money going around. Makes sense?

You asked what "injecting money into the markets mean". Well, there you have it, that's how the Fed "injects" money into the system and that's how I can get my money for lipo and hopefully a nice pair of slim fit jeans.

Why is it before this whole crisis, there was talk of inflation, then now, they're just injecting money into the market?

Like I said earlier, Fed Reserve needs to tweak the economy. Pre-subprime, what happened was that borrowing costs were so low and everyone was spending money like mad (people with annual incomes of $40,000 were buying $1million homes!). This led to demand pull inflation, where we saw the increased demand for goods and services pulling up the prices all around. Inflation's bad because it reduces our spending power. Think about it, we earn the same each month, but everything's getting more and more expensive! It's like, instead of getting that plate of Char Kway Teow (more hum and tau gey) for $3, we now need to pay $5 for a plate of CKT! Less Hum and Tau Gey somemoreeeee!!! Criminal!

What happened post-subprime was that the credit markets tightened up. That is, nobody wanted to be lending to nobody cause every lender was afraid of not getting their money back. This created a whole host of problems. Without this liquidity, people get desperate and start hawking off their assets at firesale prices. This causes deleveraging and its shitload of ill-effects which I blogged about sometime earlier. On the macroeconomic front, without liquidity in the markets to help right this financial crisis, there could be a decrease in overall consumer confidence which could result in decreased consumer spending. In addition, there could be a decrease in investments made by corporations on new capital items since it is now harder for them to obtain loans at affordable rates to make such investments! These factors could adversely affect the country's Gross Domestic Product, which could subsequently send the US into a recession - something the Fed is trying very hard to avoid.

At the end of the day, it's all a big trade off - and it's not an easy job trying to "tweak the economy". =) That's it in a nutshell and I hope it helps.