Commentary: Understand the Fed system to understand the economy

The Federal Reserve System, commonly know as the Fed, is simply an independent central bank established by Congress in 1913 that steers the economy by periodically raising and lowering federal fund rates.

Perhaps no institution has more power to affect the nation's economy than the Fed. The Federal Reserve System has a structure designed by Congress to give it a broad perspective on the economy. It is a federal system, composed basically of a central, governmental agency - the Board of Governors - in Washington and twelve regional Federal Reserve Banks located in major cities throughout the nation.

While the Fed is under the leadership of its influential chairman, Alan Greenspan, decisions are actually made by the 12-member Federal Open Market Committee (FOMC), which has eight scheduled meetings per year. The Board of Governors is comprised of seven Fed governors, including Alan Greenspan, who are appointed by the president for 14- year terms. All are permanent members of the FOMC.

Most developed countries have a central bank whose functions are broadly similar to those of the Federal Reserve. The U.S. Federal Reserve states that it has four main objectives.

First, it conducts the nation's monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices.

Secondly, it supervises and regulates banking institutions to ensure the safety and soundness of the nation's banking and financial system and protect the credit rights of consumers.

Third, it maintains the stability of the financial system and contains systemic risks that may arise in financial markets.

Finally, the Federal Reserve provides financial services to the U.S. government, the public, financial institutions and to foreign official institutions, including playing a major role in operating the nation's payments system.

Basically, the central bank generally raises rates to prevent the economy from overheating and to keep inflation in check. In June 2004, the Fed raised rates for the first time in four years, ending a long cycle of rate cuts.

Higher interest rates on credit cards and mortgages can cool consumer spending, which accounts for about two-thirds of economic activity. Higher interest rates tend to attract investment into bonds and other fixed-income investments, pushing down stock prices. Furthermore, higher interest rates can also make it more difficult for businesses to get loans to expand. Unemployment tends to rise, which eases wage inflation.

On the flip side, the Fed generally cuts rates when inflation is subdued and the economy needs a boost. Lower interest rates can create economic activity by inducing consumer spending. For example, lower mortgage rates can spark home sales and mortgage financing. Lower interest rates can also tend to boost stock prices because bonds and other fixed income investments are no longer so attractive. Furthermore, lower interest rates cut costs for companies, boosting profit and encouraging expansion.

Of course, monetary policy does not always work exactly as described above. For example, the Fed has raised short-term interest rates three times since June 30 for a cumulative increase of 75 basis points, or three-quarters of a percentage point, yet longer-term interest rates have fallen over the same period. On June 29, the yield on the 10-year Treasury note was 4.7 percent. Now it is hovering around 4.0 percent.

This is contrary to what typically happens. It also questions just how much of a drag a less accommodative monetary policy stance by the Fed will have on the economy. After all, longer-term interest rates, including mortgage and corporate bond rates, tend to have more influence on the pace of economic activity than short-term interest rates.

Hence, either longer-term interest rates will head higher or the Fed will stop raising short-term interest rates soon. The outcome depends on whether the expansion can be sustained at a solid pace in the wake of higher oil prices. At the moment, bond investors appear to be more concerned about higher oil prices and the pace of the expansion than the Fed.

Remember to seek the help of a qualified personal financial advisor to further understand rates and rate fluctuation, and how they may affect your goals and financial plans.

Gary S. Williams is a Certified Financial Planner practitioner, Chartered Retirement Planning Counselor and a Senior Financial Advisor with Williams & Associates, a financial advisory practice of American Express Financial Advisors. He can be reached at (410) 740- 5885 or toll-free at (888) 833-9335.

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