Federal Reserve; Money and Banking

1. Introduction

1.1 Background to the study

The Federal Reserve System in the United States was established in 1913 by the Congress through the Federal Reserve Act. The objective of its establishment was to prevent the country from experiencing banking crises similar to the ones that it had experienced earlier. The economic crises adversely affected the country’s economy (Burton & Brown, 2009, p.46).

Initially, the core purpose of forming the Federal Reserve was to establish a Central Bank which would lend funds to other commercial banks and other depository institutions in the event of emergencies. Burton and Brown (2009, p.46) assert that the Federal Reserve was able to avoid occurrence of bankruptcies and insolvencies.

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Over the past decades, the role of the Federal Reserve has undergone a significant transformation. The transformation in its responsibilities was motivated by the Great Depression that occurred from 1930 to 1933. The Federal Reserve no longer acted as a bank for other banks anymore; however, it was transformed into an institution charged with the responsibility of ensuring that the country attains its financial and economic goals (Croushore, 2007, p. 424).

According to Burton and Brown (2009, p.46), one of the Federal Reserve’s core responsibilities entails controlling and regulating the country’s financial system. The resultant effect is that the country will be able to develop a smooth-running, competitive and an efficient financial system.

The Federal Reserve is also charged with the responsibility of promoting a healthy and stable economy. This is achieved through the institution’s capacity to influence the amount of credit in the economy and its cost. In addition to controlling economic activities and financial markets, the Federal Reserve is also charged with the responsibility of ensuring that the country has a low rate of inflation and to maintain price stability (Labonte, 2011, p.1).

1.2 Aim

The objective of this report is to analyze the current Federal Reserve (hereby referred to as Fed) assessment of the country’s economic activity and financial markets. The report also analyzes the opinion of Federal Reserves towards inflation. Additionally, the report analyzes the various monetary policy tools which have been incorporated by Federal Reserve in an effort to ensure economic and price stability.

1.3 Scope

The report is organized into a number of sections. The first section entails an analysis of the US current economic activity and financial markets according to Fed. The 2nd section, the report illustrates Fed’s analysis of the rate of inflation in the US. The third part illustrates the various monetary policy tools used by Fed. The fourth section entails a projection of US economic outlook for the next twelve to eighteen months. In the fifth section a conclusion is illustrated while the sixth section outlines a number of recommendations.

2. Analysis

2.1 Describe the Federal Reserve’s assessment of the current economic activity and financial markets.

Currently, the US is experiencing phenomenal budgetary and economic challenges. For example, the country is facing a numerous public debt. Since the occurrence of the 2007to 2008 economic recession which emanated from a significant decline in prices within the housing industry, the country has been under intense pressure to recover from the effects of the recession (Congressional Budget Office, 2011, p. 1).

The US rate of recovery from the recession has been slow thus affecting its economic growth. The resultant effect is that the rate of unemployment has remained relatively high (Marcello & Tsounta, 2011, p.1). From November 2006 to November 2009, the rate of unemployment in the US has been on an upward trajectory.

The unemployment rate increased from 4.5% to 9.9% (US Bureau of Labor Statistics, 2011, p. 1). In an effort to stimulate its economic recovery, the US government through the Fed incorporated a stimulus package which entailed purchasing bonds worth $ 600 billion. The objective of the stimulus package was to stimulate the rate of economic activity thus reducing unemployment (Aversa, 2010, para. 1).

The stimulus package led into a significant reduction in the rate of unemployment to 8.8% by March 2011. However, from March the US has experienced an increment in the rate of unemployment. Currently, the rate of unemployment stands at 9.1%. The graph below illustrates the changes in the rate of unemployment from 2006 to 2011.

Figure 1; Graph showing the rate of inflation in the US

Source: US Bureau of Labor Statistics

The current slowdown in the rate of economic growth is limiting the rate at which new jobs are being created. During 2011, approximately 1.5 million new jobs will be created compared to the projected 2 million jobs. Over the first 7 months of 2011, approximately 1 million jobs have been created. Different economic sectors such as the hotel industry, health care, retailing and manufacturing have increased their hiring (Federal Reserve, 2011, para. 2).

In addition to rise in the rate unemployment, the US is also experiencing a decline in rate of its Gross Domestic Product (GDP) growth. Currently, GDP growth rate has slowed to approximately 2%. The slowdown in GDP growth has arisen from a decline in the rate of economic activity in different sectors.

For example, the US economy is experiencing more shocks arising from an increment in price of commodities such as energy and food. These shocks have arisen from a disruption of the supply side of the economy due to a number of reasons. For example, the recent earthquake and tsunami in Japan negatively affected the US motor vehicle industry through a decline in its market.

The decline in GDP growth rate has led to a significant decline in the consumers’ purchasing power. This has affected economic activity in different economic sectors. For example, the construction industry is at its lowest level due to a decline in demand for homes (Federal Reserve, 2011, para. 9).

However, Fed projects that as the price of commodities and energy stabilize, there is a high probability that the pressure on household budgets will decline. In a meeting conducted in June 2011, Fed projected that the US economy will improve in the coming quarters (Federal Reserve, 2011, para. 4). The rate of GDP growth is expected to range between 2.7 % and 2.9%.

According to Fed, the prevailing rate of interest in the US is 3.25% and it is expected to remain low. Fed’s decision to maintain the rate of interest at new zero over the next 2 years was informed by the risk of another recession. As a result, commercial banks in the US will be expected lend at a prime rate of 3.25%.

This shows that the Fed is pessimistic regarding the country’s current economic outlook. Additionally, the decision to maintain the rate of interest at a relatively low point was also informed by the need to restore confidence within financial markets. Financial markets in the US have experienced a sharp decline. The only option to spur growth in the economy is by maintaining low rate of interest.

The low rate of interest has greatly stimulated business investment. During 2011, the US businesses have experienced an improvement in their borrowing conditions from the financial institutions. For example, businesses can be able to access financial capital at a lower cost (Federal Reserve, 2011, para. 7).

In addition, there has been an increment in demand for US exports especially with regard to capital goods. According to Federal Reserve (2011, para. 7), this trend is expected to persist into the coming months. This has played a critical role in the economy’s recovery efforts.

2.2 Explain the Federal Reserve’s current view about inflation

Inflation refers to the general increment in the price of commodities against the consumer’s purchasing power. According to Federal Reserve (2011), the US has experienced an increment in the rate of inflation. According to an analysis conducted in June 2011, the prevailing rate of interest in the US was 3.6% as illustrated in the graph below. This is a significant increment in the rate of inflation. From 1914 to 1920, the Fed has managed to maintain inflation at an average level of 3.38%.

This is depicted by the high prices of commodities in addition to disruptions in various supply chains. Additionally, inflation is also illustrated using the Consumer Price Index (CPI) which is used to measure consumer prices (Trading Economics, 2011, para. 1). Over the first 5 months of 2011, the Personal Consumption Index (PCE) increased with more than 4%. The increment in price index is as a result of the high commodity prices especially oil and other imports.

Figure 2; Graph showing changes in the rate of inflation in US

Source: Trading Economics; Bureau of Labor Statistics

The recent earthquake and tsunami in Japan led to a significant increment in the price of motor vehicles. This is due to the fact that the tragedy led into a shortage of supplies. However, Fed considers the recent rise in the rate of inflation to be temporary. The Federal Open Market Committee (FOMC) expects the rate of inflation to subside over the next few months to a low of 2%. As a result, the country will attain high price stability and maximize on employment creation (Federal Reserve, 2011, para. 9).

According to Fed, there has been a rise in the rate of PCE price index in 2011 from 2.3% to 2.5%. This is an indication of a decline in the rate of inflation during the 2nd half of 2011. The Federal Reserve forecasts that the rate of inflation will stabilize during 2012 and 2013 to approximately 1.5% to 2%. This decline is expected to arise from stabilization of commodity prices (Federal Reserve, 2011, para. 9).

2.3 Describe the monetary policy tools the Federal Reserve uses to stabilize the economy and to maintain price stability

The Federal Reserve uses different monetary policy tools to stabilize the economy and to attain price stability. According to Johnson (2000, p.253), monetary policy refers to the various strategies implemented to control the amount of money supply in the economy. The following are the main monetary policy tools used by Fed.

Open Market Operation (OMO)
Discount rate
Reserve requirement

2.3.1 Open Market Operation

One the other hand, OMO entails either buying or selling government securities such as bonds in the stock market. Through OMO, the Fed is able to regulate the amount of money supply thus influencing the rate of interest.

For example, by buying bonds from the public, Fed increases the money supply which leads into an increment in prices of commodities while the rate of interest declines. On the other hand, selling the bonds leads into a reduction in the money supply. The resultant effect is decline in price of commodities and an increment in the rate of interest.

2.3.2 The discount rate

This refers to the cost of finance that depository institutions such as commercial and savings banks incur by borrowing from Fed. The Federal Reserve can either increase or decrease the discount rate. By lowering the discount rate, banks are able to borrow from Fed at a minimal cost. The resultant effect is an increment in money supply hence stimulating the country’s rate of economic activity (Croushore, 2007, p. 424).

2.3.3 Reserve requirement

The reserve requirement refers to the amount of money that depository institutions such as commercial banks should hold at any given time (Croushore, 2007, p. 426). The reserve requirement is expressed as a proportion of a particular banks relevant bank deposits. Using the reserve requirement, Fed can either increase or decrease the size of deposit by rising or lowering the reserve requirement rate. As a result, the institutions lending capacity is controlled hence regulating money supply within the economy. The resultant effect is that price stability is attained.

2.4 Based on the information you researched from the Federal Reserve publications, present and justify your economic outlook for the next twelve to eighteen months

From the analysis, it is likely that the US will experience a significant recovery in its economy over the next twelve to eighteen months. For example, reduction in government spending is will enable the US government to reduce its debt. As a result, the government will be able to invest in other economic sectors hence leading into economic expansion.

The resultant effect is that the country’s rate of GDP growth will increase. In an effort to ensure that the financial institutions do not lend to individuals whose creditworthiness is low, Fed has instituted monetary policies aimed at controlling lending by financial institution.

This is likely to stabilize prices within the housing industry over the next one and a half years. The monetary policies implemented by Fed are also likely to reduce the rate of inflation in the country. The resultant effect is that the consumers’ purchasing power will be increased thus stimulating growth in GDP. Economic growth will also be stimulated by the low rate of interest at 3.25%.

3. Conclusion

The Federal Reserve plays a vital role within the US economy. As a constitutional institution, Fed is able to influence economic activities and financial markets within the US. The resultant effect is that it is able to control the country’s economic growth.

Some of the Federal Reserves core responsibilities entail ensuring stability of prices and interest rates. In addition, Fed is also charged with the responsibility of ensuring that the rate of inflation is maintained at a minimal point. To achieve this, Fed uses monetary policy as one of the control instruments.Some of the monetary policy tools used include OMO, reserve requirement and discount rate.

4. Recommendations

In order to attain its financial and economic goals, the Federal Reserve should consider the following.

Conducting frequent economic analysis in order to determine the health of the economy.
The Federal Reserve should evaluate the effectiveness of the monetary policy tools implemented.

Reference List

Aversa, J. (2010). Bernanke says bond buying plan necessary to reduce unemployment, boost economy. New York: CNSNEWS.com. Retrieved August 15, 2011 from http://www.cnsnews.com/news/article/bernanke-hits-back-critics-bond-buying-p

Burton, M. & Brown, B. (2009). The financial system and the economy. New York: M.E Sharpe.

Congressional Budget Office. (2011). The budget and economic outlook; fiscal years 2011 to 2021. Retrieved August 15, 2011 from http://www.cbo.gov/ftpdocs/120xx/doc12039/SummaryforWeb.pdf

Croushore, D. (2007). Money and banking; a policy oriented approach. Boston, MA: Houghton Mifflin Co.

Federal Reserve. (2011). Federal Reserve chairman Ben Bernanke; the US economic outlook. New York: The Wall Street.

Johnson, H. (2000). Global financial institutions and markets. Malden, Mass: Blackwell.

Labonte, M. (2011). Changing the Federal Reserve’s mandate; an economic analysis. Washington: Congressional Research Service.

Marcello, E. & Tsounta, E. (2011). Has the great recession raised US structural unemployment? New York: International Monetary Fund.

Trading Economics. (2011). United States inflation rate; US annual inflation rate unchanged at 3.6% in June. Retrieved August 15, 2011 from http://www.tradingeconomics.com/united-states/inflation-cpi

US Bureau of Labor Statistics. (2011). Unemployment rate; seasonally adjusted. Retrieved

August 15, 2011 from http://www.google.com/publicdata/explore?ds=z1ebjpgk2654c1_&met_y=unemployment_rate&tdim=true&fdim_y=seasonality:S&dl=en&hl=en&q=current+rate+of+unemployment+in+us#ctype=l&strail=false&nselm=h&met_y=unemployment_rate&fdim_y=seasonality:S&scale_y=lin&ind_y=false&rdim=state&ifdim=state&tdim=true&hl=en&dl=en