My September column, “America’s Money,” explained the basic structure of the Federal Reserve, including the 12 Federal Reserve Banks, Board of Governors and Federal Open Market Committee (FOMC). All checks are cleared through this system. The interest rates charged for overnight borrowing and lending by the banks—to ensure they maintain the reserve levels required by law—produce a ripple effect on other short- and long-term interest rates, foreign exchange rates, available credit, and the money supply. In turn, those factors affect economic indicators, such as employment levels, production output, and the prices of goods and services.
Monetary policy allows for manipulation of the cost and availability of money and credit, and businesses are affected by the Fed’s decisions on interest rates and money supply. Why should the government want to manipulate the free market? Ideally, to create stability, balance the effects of a financial crisis and prevent future occurrences of disasters such as the 1929 stock market collapse.
After the bank failures that followed the 1929 debacle, safeguards were put in place to reduce the risk that depositors would lose the funds they entrusted to their local banks. Today, banks must retain about one-tenth of depositors’ funds, either as cash in the vault or on deposit in a Federal Reserve Bank. The Federal Reserve also evaluates the largest banks (more than $10 billion in assets) regularly, using the Comprehensive Capital Analysis and Review (CCAR) or Dodd-Frank Stress Testing (DFAST).
The annual CCAR assesses whether the largest U.S. bank holding companies have enough capital to operate during times of financial and economic stress and have processes in place to reduce risk in how they plan for future capital needs and acquisition. The assessment includes evaluations of whether there is enough capital to support operations and what procedures are in place to plan for capital needs. To repurchase stock or pay dividends, the institution also must have appropriate procedures for how capital is distributed.
DFAST is a complementary process performed either directly by the Fed or financial companies it hires, concentrating on whether sufficient capital is maintained to cover losses and continue operations during economic downturns.
Capital, by definition, includes a variety of assets that support bank operations. Cash and other liquid assets pay for the labor and materials to produce the goods and services that are sold to customers. However, capital also includes assets that are not liquid, such as equipment, vehicles and offices necessary to support operations.
While keeping banks open and healthy is an important consideration for business owners and individual depositors, the Federal Reserve also implements monetary policy to control the cost and availability of money and credit. The 1913 Federal Reserve Act established objectives that still drive the decisions of the Fed’s Board of Governors and the FOMC—the board plus district bank representatives. By law, these objectives are maximum employment, stable prices and moderate long-term interest rates.
Setting interest rates
After the 2007 global financial crisis, the Fed lowered short-term interest rates to nearly zero. The Fed hoped to help stabilize prices and spur a return to maximum employment. It also put downward pressure on long-term interest rates. In January 2012, the FOMC took the long-term view that a 2-percent rate of inflation would contribute to price stability and keep interest rates at a moderate level. That rate was established based on the annual change in the price index for personal consumption, and the FOMC issued a public statement to clarify its decision and explain that keeping long-term inflation in check would stabilize prices and promote maximum employment levels.
At its December 2015 meeting, the FOMC decided on a modest raise in its federal funds rate, which is the interest rate banks use to borrow from, or lend to, other banks. The goal was “normalization” of monetary policy, which refers to plans to return short-term interest rates and the level of securities held within the Federal Reserve system back to more normal levels.
In its June 2016 Summary of Economic Projections, the FOMC acknowledged that employment levels depend on nonmonetary factors that may not be directly measurable, and it did not specify a goal for maximum employment. Instead, it predicted unemployment rates over the long-term would range between 4.6 and 5.0 percent.
Regardless of policy decisions, the actions of consumers and businesses will determine whether the objectives are met. Individuals still decide whether to purchase a new building and when to request a larger line of credit to grow revenue. More important, if a business has a reputation for quality and service, there will be customers willing to finance their projects.
No matter what monetary policies are in place, businesses will still have customers to work with if their own objectives are being met.