What is the Fed and What Does it Do?

The markets expected the Federal Reserve Open Market Committee to hold the line on interest rates and the nation’s bankers didn’t disappoint anyone.

The Fed held the key overnight rate at 5.25 per cent. The statement noted that while it was concerned about a credit crunch, it wasn't panicking.

Investors were hoping for some sign that the Fed may be ready to begin cutting rates, but that doesn’t appear likely at this point.

We hear a lot about the Fed as it is known, but what does it really do?

The Fed

The Federal Reserve Board is the nation’s bank. It is a federal agency charged with maintaining a stable economy and strong financial system.

The Fed operates 12 Federal Reserve Banks around the country that serve as banks to commercial banks, providing a variety of services and ensuring a stable financial system.

You can learn more about the Fed’s activities on their Web site.

The activity that has the most direct bearing on the stock market occurs eight times a year when the Federal Open Market Committee Meets.

Target Rate

It is at these meetings that the target for key fed funds rate is set. This interest rate is the basis for all other interest rates and when it moves, other interest rates move.

Banks are required to keep a certain level of cash reserves on hand, depending of the level of their deposits. During the daily course of business, it is not unusual for a bank to drop below their reserve level.

When that happens, the bank borrows overnight funds from another bank until its own reserves are replenished. The interest rate the lending bank charges for that often-overnight loan is the fed funds rate.

The actual rate is set by market conditions, so the Fed only suggests a target.

Prime Concern

The Fed’s primary concern is to prevent inflation from wrecking the economy, which can occur if the economy grows too fast. On the other hand, if the economy slows down too much, it will stall into a recession.

The way the Fed adjusts the speed of the economy is with interest rates. If the economy is growing too fast or inflation appears to be growing, the Fed will raise interest rates.

Higher interest rates tend to slow business growth and consumer spending.

If the economy is slowing too much, the Fed can lower interest rates, which makes it cheaper to borrow and that encourages businesses to expand and consumers to spend.

Conclusion

The Fed is the single most influential body in the U.S. when it comes to moving the markets. You should watch for their meeting announcements and pay attention to which way interest rates are headed.