Federal Open Market Committee

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Federal Open Market Committee

What It Means

The Federal Open Market Committee (FOMC) is a committee within the central bank of the United States, the Federal Reserve System (commonly called the Fed). The Fed is responsible for regulating the U.S. money supply (the amount of money in circulation at any given time), and the FOMC is responsible for making the most important decisions about the money supply.

Changes in the money supply have a profound effect on the overall economy. When the money supply increases, the economy tends to grow, and prices tend to rise. When the money supply decreases, the economy tends to stop growing, and prices tend to fall. Economic growth is generally desirable, but if it gets out of control, prices may rise too quickly and undermine the value of the dollar, causing a wide range of economic problems. When the economy is growing quickly, then, the Fed may try to keep this growth in check by decreasing the money supply. Alternately, during times of economic stagnation, the Fed may increase the money supply in the hope of stimulating growth. Though it is normal for the economy to go through periods of slow growth, the Fed tries to minimize the hardship caused to businesses and individuals during these downturns.

The FOMC, which consists of 12 of the Fed’s most important leaders, meets eight times a year in Washington, D.C., to decide whether or not the money supply should be increased, decreased, or kept constant, depending on economic conditions at the time. The FOMC’s means of controlling the money supply is the manipulation of a basic interest rate (interest is a fee charged to those who borrow money) that affects the entire economy.

When Did It Begin

The Federal Reserve System was created in 1913 to regulate the U.S. banking system. The Fed is composed not only of the central leadership in Washington but of 12 regional banks, each of which is identified by the city in which it is headquartered. The cities are New York, Boston, Philadelphia, Richmond, Cleveland, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. At the time of its creation, the Fed was intended to be a decentralized system, in which the regional banks made their own policies based on regional economic conditions. This arrangement proved to be ineffective as the U.S. economy became more integrated across regions, and in the 1920s the Fed began eliminating the regional policy differences in favor of a more standardized approach to the money supply. A forerunner to the FOMC was organized on an informal basis during this time by Benjamin Strong, head of the Federal Reserve Bank of New York.

The Great Depression (the severe crisis that afflicted the world economy in the 1930s) led to further regulation and centralization of the U.S. economy, meant to prevent future crises. The Banking Act of 1935, pushed through Congress under President Franklin D. Roosevelt, restructured the Fed and formalized the FOMC’s role as a central player in the crafting of monetary policy (government actions affecting the money supply).

More Detailed Information

The FOMC meets eight times a year in Washington, D.C., to review current economic conditions and come to an agreement about the appropriate measures to be taken in regard to the money supply. Of the 12 FOMC members, the seven members of the Board of Governors of the Federal Reserve System (the Fed’s governing body) form the majority contingent and therefore have the power to enforce their will. The president of the Federal Reserve Bank of New York is also a member of the FOMC, since New York City is the nation’s financial capital. The final four seats on the FOMC are split among the remaining eleven regional heads. The Federal Reserve Banks of Boston, Philadelphia, and Richmond share one voting membership; those of Cleveland and Chicago share another; Atlanta, St. Louis, and Dallas another; and Minneapolis, Kansas City, and San Francisco another.

The FOMC regulates the money supply primarily by affecting the interest rates that banks charge to borrowers. The money supply consists not simply of the bills and coins minted by the government but also of bank-account balances. When you deposit a paycheck in the bank, you own a quantity of money even though you do not physically possess currency; your money exists simply as a number within a bank’s computer system. Likewise, when banks loan money to individuals and companies, they do not hand over the money in cash; they give borrowers an account balance. In other words, when banks lend money, they increase the U.S. money supply simply by changing some figures in their computer systems. But banks are not free to create unlimited amounts of money. Their lending behavior is subject to the direct influence of the Fed.

The Fed requires banks to keep a small proportion of its overall balances on hand (or in an account with the Fed) in the form of hard currency. This is to ensure that banks will be able to give account-holders money when they want to withdraw it. The larger a bank’s reserves are, the more money it can lend out. Therefore, when the Fed wants to regulate the money supply, it changes the levels of bank reserves.

The Fed, through the FOMC, imposes changes on bank reserves by changing an interest rate called the federal funds rate: the price that banks charge one another to borrow money. Banks generally borrow money from one another in order to maintain their required reserves. When the federal funds rate is low, banks are able to obtain reserves for a low price. Therefore, banks have a greater ability to make loans, and this results in lower interest rates for the individuals and businesses who borrow money from them. Individuals borrow money from banks to make large purchases. This stimulates the economy, of course, but it is the borrowing of businesses that has the power to trigger exponential economic growth.

Businesses commonly borrow money to start or expand their operations. A business may invest this money in equipment that will bring long-term profits, it may use the money to hire new workers, or it may use the money to fund research into new technology. In other words, businesses put the dollars they borrow to work in a variety of ways, so that every dollar borrowed is ultimately multiplied many times over throughout the economy.

Though it has other ways of changing interest rates and altering the money supply, the Fed, through the FOMC, primarily relies on open market operations: the buying or selling of government securities (a security is a form of investment, such as a bond, which can be assigned value and exchanged among investors). When the Fed sells government bonds, they take in money from the buyer and give out a piece of paper (the bond) that the buyer cannot spend. Because the Fed holds on to the money, the amount of money in bank reserves decreases, and the federal funds rate rises. When the Fed buys government bonds, they credit the seller’s bank account, the amount of money in bank reserves increases, and the federal funds rate falls.

Because of the ripple effects caused by changing interest rates, the FOMC changes the federal funds rate with the intent of adjusting a wide range of economic variables in addition to the money supply. Chief among these variables are employment levels (the number of people who want jobs and can find them) and prices. The Fed’s overall goal is a healthy level of economic growth. Growth of around 3 to 5 percent per year is usually considered healthy.

Recent Trends

Prior to 1994 the FOMC did not inform the public about the actions it meant to take regarding the federal funds rate and the money supply. Economists would study changes in interest rates and open market operations to determine the Fed’s stance on the federal funds rate and then relay the news to the general public. In 1994 the FOMC began issuing news releases at meetings that resulted in a change in the federal funds rate, and in 1999 it began issuing a statement about each of its eight yearly meetings.

Since the mid-1990s, the announcement of the FOMC’s eight yearly decisions about the federal funds rate has become one of the most anticipated events in the financial world. Because the federal funds rate has such a broad effect on the economy, investors in the stock market (the stock market is a system for buying shares of company ownership; these shares gain value when companies grow and prosper, and lose value when companies struggle).often alter their behavior significantly in response to rate changes. When the federal funds rate is lowered, the stock market tends to gain value immediately as people rush to buy stocks in anticipation of future economic growth. When the rate is raised, investors tend to sell of shares of stock in anticipation of an economic downturn.

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Federal Open Market Committee

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Federal Open Market Committee