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The United States’ current economic expansion is about to enter its seventh straight year, making it the second longest period of economic growth in peacetime history. Policymakers vested with the responsibility of monitoring the state of the economy now have two concerns: whether the economy will stall abruptly and head into a recession, and whether growth will accelerate so swiftly that inflation will be ignited.
The responsibility for making sure the economy negotiates this delicate balance lies with the seven-member Board of Governors of the Federal Reserve System and five-regional Federal Reserve Bank presidents. Recently, President Clinton nominated Roger W. Ferguson Jr. to fill a vacancy on the Federal Reserve Board. Ferguson’s appointment would make it third time an African American has sat on the board, following BEBE member Andrew grimmer and Emmett Rice. The actions taken by the Fed every six weeks are so closely watched by money managers, investors, businesses and consumers that they are usually front page news around the world. And when Chairman Alan Greenspan speaks, the financial world listens. Mere off-the-cuff remarks from Greenspan concerning the state of the economy can send the stock market reeling or propel it toward record highs.
Yet while Ferguson’s appointment to this board would be significant, most people really have no idea what the Fed is and why it is so critical.
The Fed supervises the nation’s 10,000 commercial banks, 2,000 savings and loans associations and 12,000 credit unions. It also regulates the money supply, holds the deposits of commercial banks, and lends money to banks that run short of reserves.
The role of the Fed becomes defined when you think of a growing economy as consisting of two component parts suspended on either side of a balanced scale. One component is made up of the markets where goods and services such as automobiles, houses and Internet access are bought and sold. The other component consists of the markets where assets such as stocks and bonds are traded and where money is deposited in checking accounts or held as cash.
Money is the lubricant that facilitates trading on both sides of the scale. But interest rates not only link the two sides together, they determine just how much trading will take place. For example, if interest rates are high, auto and home purchases will decline. Likewise, stock and bond prices will fall. Eventually, the entire economy could tumble into a recession.
By contrast, if interest rates are too low, consumers will be encouraged to spend too much and businesses will be tempted to engage in more capital investment than is desirable. Too much spending will result in inflation, which can distort the economy by making it difficult for businesses and investors to plan for the future. This uncertainty can also cause a recession, making interest rates key to a stable economy.
By changing the discount rate and by expanding and contracting the amount of money circulating in the economy, the Fed can control interest rates. This is why its actions are so closely scrutinized.