What does the Fed actually do? | NevadaAppeal.com
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What does the Fed actually do?

Carol Perry
For the Appeal

As some of you may have noticed this week, Bear Sterns was the newest casualty of the subprime market bloodbath. You also may have noticed that the Federal Reserve stepped in as the lender of last resort to avoid what some speculated would have been a major bank failure. But what does the Fed actually do and how were they involved in the Bear Sterns situation?

The Federal Reserve, often referred to as the Fed is actually the central bank of the U.S. In addition to being the lender of last resort, there are other roles the Fed plays in our economy.

The most important role is regulating the money supply. This includes currency in circulation, the reserves held in banks, and the amount of money being deposited and redeposited in bank accounts.

The money supply is important to both individuals and businesses because the more money that is available, the easier and cheaper it is to borrow. The opposite is that less money in circulation means more expensive borrowing.

The Fed controls the money supply through its open market operations. The meeting occurred this week and was also in the news with a 3/4 percent reduction in a key interest rate. By buying and selling securities, the Fed influences the health of the economy.

If it believes the pace of growth in our economy is too rapid, it reduces or tightens the money supply. Conversely, if growth slows or a recession seems possible, the Fed increase or loosens the money supply.

This week, in addition to its open market meeting, the Fed was also used in their role as the lender of last resort with Bear Sterns. How this works is that the Fed allows banks to borrow money from what is known as the discount window at a discount rate.

While borrowing from the Fed is cheap, banks usually avoid it if they can because it signals that they are in financial difficulty that is serious enough that other bank would not lend to them.

This “last ditch” borrowing may prevent bankruptcy or keep depositors from running to the bank to withdraw their deposits. In the Bear Sterns case, the Fed engineered a rescue through another bank, allowing continued operations.

There are those out there that criticize the Fed being available to bail out banks as it encourages risky behavior. That was definitely the case in Bear Sterns with risky hedge-fund lending against already risky subprime bonds.

As for my opinion, I was glad to see the Fed step in here as the result in the already shaky financial markets would have been quite serious.

• Carol Perry has been a resident of Northern Nevada since 1983.