Rafi Mohammed

What Exactly Does Ben Bernake & "The Fed" Do?

Posted on August 21st, 2007 (3 Comments)

We all know that Ben Bernake and the Federal Reserve are machers in the economy. But exactly why is Wall Street (and the media) so infatuated with Bernake & Company? Remember the days when CNBC would broadcast the size of Alan Greenspan’s briefcase as some hint about the Fed’s future actions? You’d think the rock band The Police had written their greatest hits “Every Breath You Take” or “Everything (S)he Does is Magic” about the Fed! I thought it’d be fun to discuss what the Fed does and why it is so influential to the economy.

To understand the essence of the Fed, you have to understand its principle mantra: “interest rates control the economy.” Lower interest rates spur the economy, higher ones slow it down. It’s really that simple.

So how do lower interest rates stimulate the economy? The theory goes that since it’s cheaper to borrow money, businesses will borrow to expand and consumers will buy more – thus enhancing the economy. Psychologically, lowering interest rates is a signal that the Fed is working to grow the economy (and profits) – it inspires confidence. For example, between 2001 and 2003, the Fed lowered the interest rate 13 times (from 6.25% to 1%) to keep the U.S. economy from falling into a recession.

On the converse, the Fed increases interest rates to slow down the economy. Why would the economy ever need to be slowed down? When an economy grows fast – key input resources such as labor or materials become scarce. Because of this scarcity, input prices increase – and all companies raise their prices. These spiraling price increases lead to the dreaded “I” word…inflation. To combat inflation, the Fed hikes interest rates. Higher rates rein in business expansion and consumer purchases (it’s more expensive to borrow money). A weakened economy will lower price increases, thus reduce inflation.

So how can the Fed control interest rates? Through price of course! Interest rates are the result of supply and demand conditions in the securities (government bonds, corporate bonds, etc) market. When there are many securities buyers, interest rates decrease – securities don’t have to pay buyers as much interest to entice purchases. Conversely, when there are many securities on the market (excess supply), interest rates increase – securities issuers have to pay buyers more to lure them to purchase.

The Fed primarily controls interest rates through open market operations. When it wants to lower interest rates, it buys securities. Since the Fed is adding demand to the securities market, interest rates decrease (securities don’t have to pay as much interest to sell). When the Fed wants to increase rates, it sells securities that it owns – since more securities are on the market – interest rates increase to attract buyers.

I hope this blog helps clarify who the Fed is and what it does. In a future blog, I’ll write about why I think Bernake erred last week in his monetary policy actions to calm the stock market.

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Readers' Comments on This Blog Entry

From West Coast Steve on August 24th, 2007
I actually printed this out for my wife. Just yesterday she was asking this exact question. You answered it better than I did.
From Roberto on August 24th, 2007
Interesting post Rafi; and connected with this, I wonder what is the influence of our profession on these movements - if we have any influence at all, and if this gets to a size, which can be measurable at macro-economic level -. I think in both cases, the answer is yes. To make it clear: we pricers work to make everyone pay the right amount of money. It's no secret that, if and whenever possible, that amount is the highest possible one. And we work against all price leakages, against all possible sources of price deteriorations: we want to translate as much as possible a list price increase into a pocket price increase. At the end of the day, all this often translates into *faster + stronger* price increases than in the past. So... are we creators of inflation, are we making inflation a faster or more realistic possibility? I think yes. And I think this is good for the economy. The best example is possibly the airline industry (or hotel, or car rental industries). Years ago (10? 20?), prices were not adapting as today, and I bet leakages were happening. Today, in these industries prices adapt by the minute, both up- and downwards. Is there a spike in oil prices? It immediatly translates into a price increase (ok, they call it fuel tax). Demand falls? Prices go down to fill up planes + less planes are in the air. So: the impact of raw materials inflation goes immediately to the end consumer - there is some less absorption from companies -. My guess is that we pricers make the process smoother, faster and more effective.
From Rafi on August 24th, 2007
Roberto, thanks for your comment. I'm not quite sure I can agree that inflation is good - and welcome hearing more as to why it would be. I also don't think that the fact that pricing strategists are pushing for companies to attain their highest prices leads to inflation. Inflation is a case when the economy overheats and the resulting scarcity of resources causes systematic price increases. Pricing strategists are not causing market scarcity of resources. I'd even argue that my notion of offering early bird, regular, and chef's table options gives consumers options to in fact get a lower price. Happy to hear more comments on this topic.