The United States Federal Reserve has committed to do everything it can to save the financial system and the American economy from collapse.
Most recently, it began an unprecedented effort to ensure banks, companies and now households have all the money they need by offering to buy unlimited amounts of securities.
Here’s a quick primer on the U.S. central bank, how the Fed works and what it’s doing to keep the economy from sinking into depression.
Before Congress created the Federal Reserve System, the safety and soundness of U.S. banks was hardly a sure thing. Bank runs were common.
Without a central bank, it fell to private financiers such as John Pierpont Morgan to avert financial crises by infusing their own capital into the economy. That led more people to believe that monetary policy and banking should be centralized, culminating in the 1913 Federal Reserve Act.
The act said the Fed would handle monetary policy and stimulus, keep banks safe and sound, and make sure the amount of money circulating was appropriate.
The most well-known tool is the Fed’s ability to set short-term interest rates.
While initially limiting bank runs, the Fed failed to prevent the speculative bubble that preceded the Great Depression – and the bankruptcy of nearly 10,000 banks. This led to the Glass-Steagall Act in 1933, which separated commercial and investment banking and created federal deposit insurance to prevent bank runs.
In 1977, Congress passed the Federal Reserve Reform Act and established what became known as the “dual mandate” of maximum employment and stable prices.
The Fed consists of a group of seven economists – collectively known as the Board of Governors – who have two key tools to affect monetary policy. The Board of Governors uses 12 regional Federal Reserve banks to perform banking services.
The most well-known tool is the Fed’s ability to set short-term interest rates. When it lowers rates, the Fed aims to reduce borrowing costs for companies and consumers to encourage more lending and investment, thus stimulating the economy. It raises rates primarily when the economy is strong, when it wants to keep a lid on inflation.
The other key tool is its ability to buy and sell debt securities in open-market operations.
By buying Treasury securities from private sellers, it is able to pump more money into the banking system, ensuring there was enough cheap credit for borrowers.
The Fed reimagined this powerful tool during the 2008 financial crisis, when it began a program of “quantitative easing” to buy longer-term, riskier debt.
Financial markets have been in a panic since late February, when they began to reflect anxiety about the economic impact of the new coronavirus.
Since then, the Fed has engaged in a variety of actions to keep financial markets working and calm investors, including backstopping the commercial paper market and supporting money market funds.
It has also been using its two tools in more traditional ways.
The Fed used its first tool in dramatic fashion recently when it cut rates twice, first by half a percentage point and then by a full point, bringing its target rate to basically zero.
So it turned to its second tool and committed to essentially buy as many securities as necessary to stave off mass layoffs, debt defaults, bankruptcies and depression. This includes buying bundles of investment-grade corporate bonds, student loans and credit-card debt for the first time.
As a result, the Fed’s balance sheet, which had fallen below $4 trillion last year, has now swelled to a new record of $4.7 trillion – and could double in size before it’s done.
Ryan Matthew Brewer is an associate professor of finance at Indiana University. Distributed by The Associated Press.
