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What is the Federal Reserve?
How do they influence mortgage rates?
The Federal Reserve is the central bank of the United
States. It is an independent agency of the Federal government,
but key positions are appointed by the President and confirmed by
Congress. The Federal Reserve is composed of twelve regional
banks and has a board of governors that oversees its activities.
The central bank provides liquidity to reserve member banks,
regulates bank holding companies and monitors growth of the U.S.
money supply. Over the years, the Feds have become the gate
keeper of domestic economic growth and the rate of inflation.
The Federal Reserve uses two methods to maintain modest economic
growth with low inflation. First, they implement a monetary
policy that assures a steady but modest growth of money. Second,
they establish the borrowing rate on two key financial
instruments: the Federal Funds Rate, the borrowing rate on loans
between commercial banks; and the Federal Reserve Discount Rate,
the rate of interest on funds borrowed by commercial banks from
the Federal Reserve. Both key rates help to control the growth of
money. In the past several years, the Federal Reserve has been
successful in maintaining modest economic growth, high employment
and low inflation through its monetary policy.
The central bank has a committee called the Federal Open Market
Committee (FOMC) that meets periodically during the year
(typically every five to eight weeks) to set the two key interest
rates and establish its monetary policy. The FOMC is comprised of
the seven members of the Board of Governors and five Reserve Bank
Presidents. The committee reviews the preceding months' economic
data for clues on the future and present health of the economy.
The committee will act preemptively after reviewing the economic
data. If they believe the economy is growing above their target
range and creating inflation pressures, the committee may elect
to raise interest rates to slow economic growth. Conversely, if
they believe the economy is heading into a recession, they may
lower rates to stimulate economic growth. Any time inflation is
growing faster
than their target rate, they will most likely raise interest
rates. Their other primary monetary policy tool is buying U.S
securities that add reserves to the commercial banking systems or
selling U.S. securities that withdraw reserves from the banking
system.
Investors, lenders and borrowers throughout the world keep a
watchful eye on the Federal Reserve's policy. As economic
indicators are released by the U.S. government and private
researchers, Fed watchers anxiously attempt to anticipate the
central banks next policy move.
The following are some more closely watched economic
indicators that give clues to the current and future domestic
economic growth and inflation:
Unemployment and Non-Farm Payroll
Reported by the Department of Labor:
An increase in employment and/or an increase in non-farm payroll
suggests a healthy or expanding economy. In this scenario, there
may be increased pressures on wages as
demand exceeds the supply of workers. An increase in wages has
wide spread ramifications on the cost of goods and services,
increasing inflationary pressures. Conversely, a decrease in
employment and/or a decrease in non-farm payroll suggests a
contracting economy, thereby reducing inflation.
Industrial Production
Reported by the Commerce Department:
The industrial production statistic reflects the output of the
countries' factories, mines and manufactures. An increase in
industrial production suggests demand for wholesale and retail
goods are expanding and the economy is growing. As demand
outstrips the supply of goods, prices may rise and inflation may
rise as well.
Housing Statistics
The government and housing trade associations release statistics
on the real estate activity in the country. The statistics cover
new home sales, existing home sales, housing starts, building
permits and new constructions. The housing sector and its many
support industries are a major, if not the largest, component of
the economy. An increase in housing activity can lead to
inflationary pressures.
Producer Price Index (PPI)
Reported by the Commerce Department:
The PPI shows the monthly changes in prices at the wholesale
level. An increase in prices at the wholesale level is often
passed on to consumers at the retail level, resulting in an
increase in the inflation rate.
Consumer Price Index (CPI)
Reported by the Commerce Department:
The CPI reflects the monthly changes in prices at the retail
level. An increase in prices at the retail level, is considered
inflationary. A decrease in prices is considered deflationary.
Consumer Credit
Reported by Commerce Department:
The monthly statistic on the growth of consumer credit is the
total aggregate amount of consumer debt, excluding housing. An
increase suggests consumers are confident about their jobs and
ability to repay debt over the ensuing months. Consumers use debt
to buy goods and services, stimulating economic growth.
Conversely, a decrease suggests consumers are scaling back debt
and may postpone the purchase of goods and services, inhibiting
economic growth.
Gross Domestic Product (GDP)
Reported by the Commerce Department:
The GDP reflects economic growth in the country. The report is
released each quarter, but is revised several times after new
economic data is released. A strong rise in economic growth
sometimes suggests there may be inflationary pressures on the
horizon. Conversely, a decline in economic growth is considered
deflationary.
In conclusion, the Federal Reserve monitors the economy to assure
there is full employment, low inflation and modest growth. Many
economic indicators, some of which are mentioned above, are used
by the Feds to gain clues on the future health of the economy.
When the Federal Reserve believes there are compelling economic
signals that may push the economy out of balance, they may raise
or lower interest rates and/or add or withdraw reserves from the
banking system as a preemptive corrective tool.
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Send e-mail to John Shea at: loan@mindspring.com
Last modified: December 04, 1997