WEALTH

AVENTURIST

WEALTH The Role of the Federal Reserve

AMID AN UNCERTAIN ECONOMY, MONETARY POLICY TAKES CENTER STAGE

BY JUDY MARTEL

hen the economy gets out of whack, all eyes turn to the Federal Reserve. Officially, the Fed’s mission is to control monetary policy. But what does that mean and how effective is it?

“The Federal Reserve’s primary role is to manage the supply of money in order to meet two key objectives: keep prices stable and promote maximum employment,” says Sean Snaith, director of the Institute for Economic Forecasting at the University of Central Florida.

Composed of three entities, the Federal Reserve System is this country’s central bank. It includes the board of governors, the 12 regional Federal Reserve banks, and the Federal Open Market Committee. Located around the country, the regional banks clear checks and act as the eyes and ears for the board. Presidents of each bank cycle through the Federal Open Market Committee as voting members who decide whether or not to raise interest rates. The board of governors, chaired by Jerome Powell, is made up of seven members representing different sectors of the economy who are appointed by the president of the United States. Its role is to oversee the banks and implement monetary policy.

So just how does the Fed manage the supply and flow of money?

WOne of the most effective methods is to manipulate interest rates, says Snaith. When rates are lower, as they were for a decade leading up to 2022, it stimulates spending among consumers and businesses because the cost of borrowing money is less, especially on bigticket items such as cars, homes, commercial buildings, and large appliances, but also on credit card purchases. In turn, there is an increased need for businesses to hire because the items in demand have to be built, produced, and shipped. At the other end of the spectrum, higher rates make it more expensive to borrow money, and that’s where we find ourselves in 2022. “In our current inflationary environment, the economy has overheated because the government shut it down for two months in 2020 during the COVID-19 pandemic,” says Snaith. Once the shutdown lifted, pent-up demand overwhelmed the supply chain and put a strain on companies that were scrambling to get workers back. “We opened the birdcage and everyone came out flying and looking to spend. The economy just exploded.” In response to higher prices for nearly everything, the Fed began raising rates to try to bring inflation (the rate at which prices rise)

back to its target 2 percent annual average, rather than the 8 percent and more we reached during this past year. That helps slow spending, giving employment and the supply chain a chance to catch up to demand while prices stabilize or drop.

This strategy works well in this economic environment, says Snaith. “Monetary policy has a powerful effect over time because it impacts spending behavior,” he explains. “Especially when it comes to controlling infl ation, the Fed is the tip of the spear, if not the entire spear.”

When the Fed’s actions are not suffi cient, there are some additional tools to help stabilize the economy. During Congressional hearings this year, Federal Reserve Board Chair Powell has been asking the government to do more, but Snaith says there aren’t many options on the table.

“Congress can either cut government spending, raise taxes, or do both at the same time,” he notes. Higher taxes cut into consumers’ discretionary spending money, while a reduction in government spending translates into money that won’t be pumped into the economy, resulting in less demand. Heading into mid-term elections, Snaith doesn’t see the government taking any action. “I think the Fed will have to go it alone,” he says.

The fi nal thought on the current economy is a word people don’t like to utter: recession. It’s always a possibility in an infl ationary environment, Snaith says, but the silver lining is that it’s actually another tool to help the Fed in its mission, by bringing spending back in line and the economy back into balance. “Recession may be the bitter pill we have to swallow.” «

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