A visit to the San Francisco Federal Reserve Bank yesterday prompted a lot of questions. One of which is whether the US Federal bank structure is sustainable, and whether our wealth is protected. First, a little background on how the Fed works. It is fascinating how the whole US banking industry works, and the Federal Reserve Bank (FSB) is central to it all because it is the bank for all the other banks. By manipulating the Fed Rate, Discount Rate and Reserve Limits, the FSB stimulates lending and limits inflation. Fed rate is the lending rate set by the Federal Open Market Committee (FOMC). Discount Rate is a special lending rate to member banks of the FSB. Reserve Limits are federally mandated minimum liquidity that a bank must maintain. Your local corporate bank, like B of A, or Chase, are required to maintain federally mandated reserve limits.
For safeguarding, your corporate bank keeps a lot of money at the FSB because they can then count the cash sitting there as part of their reserve. Ever heard of the Automatic Clearing House (ACH)? That's actually a service provided by the FSB. Since all banks have deposits at the FSB, when you deposit a from bank A to bank B, the receiving bank B simply forwards the check to the ACH, which is the FSB, who then moves money from bank A's pile to bank B's pile.
So is the Fed sustainable? Is the wealth of the US protected? The US dollar used to be backed by gold and silver, referred to as the gold standard. Since gold is now traded separately, backing the dollar with gold will limit growth to our economy and cause unnecessary fluctuations. The gold standard practice has been long abandoned. Now the US dollar's value is based on faith of the American people, faith of the world, and the Fed's ability to curb inflation and keep our dollar steady. So can the Fed keep our dollar steady?
So far, so good. The primary tools used to stimulate the economy and curb inflation, namely the Fed Rate, Discount Rate and Reserve Limits, have proved useful so far. The question is whether this can continue indefinitely. And during this recession, we have discovered the limits of these tools.
To curb fears of bank bankruptcy during the recession, the Reserve Limit has been increased. However, to stimulate investment, we had to decrease the Fed Rate, and therein lies the culprit. You see, there is a lower limit of zero for the Fed Rate. If we cannot bounce the economy back by lowering the Fed Rate all the way down the zero, which is what we have done so far, then we are out of tools for manipulating the economy from the Fed's perspective. At that point we have to turn to other stimulants, those which require increasing the deficit. Luckily, it seems the Fed is raising their rates again in anticipation of the economic upswing. This story: Feds to lift discount rate as "exit" begins was covered in today's Financial Times.
So it seems for now the Fed and the Fed policies live on. But until we figure out other methods for the Fed to stimulate the economy, we are always in danger of hitting this lower bound.