Kocherlakota demystifies Federal Reserve basics for investors
Kocherlakota began his speech on April 8 at the Rochester Chamber of Commerce by informing his audience about the basic structure and function of the United States Federal Reserve system, which is the primary institution responsible for improving and maintaining the U.S. economy.
Kocherlakota stated that the Fed is a uniquely American institution. By this, he meant that the U.S. central bank is highly decentralized in terms of power relative to its counterparts around the world. He elaborated his point by taking the Federal Reserve Bank of Minneapolis as an example. The Minneapolis Fed is one of 12 regional Reserve Banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System.
The Federal Open Market Committee (or FOMC) meets eight times a year to decide the Fed funds rate for the next six to seven weeks. All 12 presidents of the various regional Federal Reserve Banks and the seven governors of the Federal Reserve Board contribute to these deliberations.
The Fed funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. The federal funds rate is one of the most influential interest rates in the U.S. economy, since it affects monetary and financial conditions, which in turn have a bearing on key aspects of the broad economy, including employment, growth, and inflation. The higher the federal funds rate, the more expensive it is to borrow money. Since this is only applicable to very creditworthy institutions for extremely short-term (overnight) loans, we can view the Fed funds rate as the base rate that determines the level of all other interest rates in the U.S. economy.
An increase in the Fed funds rate has a ripple effect throughout the economy. This generally sends bond prices lower, since the fixed coupon rate they offer becomes less attractive relative to new issues at higher rates. ETFs like the ProShares Short 20+ Year Treasury (TBF), the HOLDRS Merrill Lynch Pharmaceutical (PPH), and the Vanguard Information Tech ETF (VGT), which has its major holdings in information technology companies like Apple Inc. (AAPL) and Google, Inc. (GOOG), could help investors, as they generally do well during the early part of a tightening cycle.
Kocherlakota went on to talk about the FOMC and its structure. Find out more in the next part of this series.