Like the framers of our country’s Constitution, the founders of the Federal Reserve System rejected the notion of a single influential entity. Today’s system is established as three bodies with shared responsibilities: the Federal Reserve Banks, the Federal Open Market Committee (FOMC), and the Board of Governors (“About,” 2021).
The Federal Reserve plays a significant role in promoting the effective operation of the economy; it employs four primary tools by which it manages monetary policy. These include the discount rate, reserve requirement, federal funds rate, and open market operations. All four allow the Federal Reserve to impact the banks and stock market in terms of interest rates and the expansion/shrinkage of the money supply.
While these tools provide the Federal Reserve with consequential control—enough to argue that it is the most powerful financial institution in the world—it is still severely limited by several external factors (Hayes, 2021). By the time policy is debated, formed, and implemented, the data used to justify a Fed decision is already stale and out of-date. Other players in the financial market have differing incentives as well. From bankers to lobbyists to individual households, the Fed has to balance the interests of many only to encounter the result of rational expectations in the end. Furthermore, it has no ability to enforce its decisions, which significantly limits the extent of its power.
Historically, the Federal Reserve’s policies have been a point of contention according to many voices, especially during times of financial turmoil. Moving forward, the Fed needs to learn from its mistakes and adapt accordingly. But of course, we will by then be living under new circumstances with new data.
References
About the Federal Reserve System. (2021, September 10). Board of Governors of the Federal Reserve System. Retrieved from https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm.
Hayes, A. (2021, October 7). Understanding the Role of the Fed. Investopedia. Retrieved from https://www.investopedia.com/terms/f/federalreservebank.asp.
Moore,
I think you have an interesting post. One thing that you said really struck me. You mentioned that the Federal Reserve must balance many separate interests. I think a good example of this happened not too long ago, with the GameStop stock boom. Large investment firms had been shorting the stocks of declining companies for a quite a while (Fordea, Charles, & Talis, 2016). Shorting is when you make a contract to borrow stock from another party, and then sell it on the market (Fordea, Charles, & Talis, 2016). Once the contract expires, you are required to buy back the stock and give it back to the lenders. The hope is that the stock price will go down, so that you buy it for less then you sold it for. This is a risky investment, because if the stock prices rise dramatically, you are still required to buy the stocks back. In comparison, for normal stocks, you are never forced to sell your stocks at a loss. The only way for something equivalent to happen is if the company you invested in goes bankrupt. Since many of these investment companies were so large and well respected, when they shorted a stock, its price dropped dramatically. This is because many investors (seeing these companies short the stock) would start selling, thinking something bad was about to happen. This caused a self-fulfilling prophecy, so to speak. In the case of GameStop, many independent investors decided to buy stock in GameStop to drive up the price of their stock (Kerckhoven, & O’Dubhghaill, 2021; Anand & Pathak, 2022) The problem is that they did it far too well, and they nearly bankrupted several investment firms, and seriously harmed many others (Kerckhoven, & O’Dubhghaill, 2021). In this instance, the Federal Reserve stepped in and bailed them out, rather than letting these companies go bankrupt because they made a risky investment and failed. They did this to prevent a shockwave from traveling through the rest of the market, as was the case with Enron. What do you think about this case of government intervention?
References
Anand, A., & Pathak, J. (2022). The Role of Reddit in the GameStop Short Squeeze. Economics Letters, 211, pp. 1-4. https://doi.org/10.1016/j.econlet.2021.110249.
Fordea, C. C., Charles J. M., & Talis P. J. (2016). Shorting at Close Range: A Tale of Two Types. Journal Of Financial Economics, 121(3), pp. 546-568. https://doi.org/10.1016/j.jfineco.2016.05.002
Kerckhoven, S. V., & O’Dubhghaill, S. (2021). Gamestop: How Online ‘Degenerates’ Took on Hedge Funds. Exchanges, 8(3), pp. 45-54. https://doi.org/10.31273/eirj.v8i3.805