The Federal Reserve. Arguably the most influential institution in the world when it comes to financial markets. A slight misstep in its policies led to the worst global economic depression of the 20th century. Its stimulus packages fueled a bull market in the U.S. stock market for over a decade. A slight lapse in its regulatory oversight led to multiple financial tsunamis.
The decisions made by this group of twelve individuals during their meetings can impact the global economy. And for such an important institution, it even has shareholders and pays annual dividends.
My Experience with the Fed
Speaking of the Federal Reserve, I do have some experience with it. During my time working on Wall Street, a large part of my job was to keep track of the Fed's decisions and to understand the thought processes of those old professors on the Federal Open Market Committee (FOMC).
So today, we're not just talking about the Federal Reserve. I also want to take this opportunity to discuss the operating mechanism of central banks, the trade-offs they make when formulating monetary policies, and some of my own thoughts on the Fed.
The Structure of the Federal Reserve
The Federal Reserve, often shortened to "Fed" (note: no "s." Adding an "s" to make it "Feds" turns it into FBI slang for "police," so be careful not to mix them up), is the central bank of the United States. It manages U.S. monetary policy, including printing money, setting short-term interest rate policies, and so on. If you look closely at the U.S. dollar bill, you'll see "Federal Reserve note" printed in large font. This signifies that it's a liability of the Federal Reserve, and it's what we use as money.
You might think that central banks are a standard feature of every country and a common government department. However, that's not the case in the U.S. Since its founding in 1776, for more than half of its roughly 250-year history, the United States did not have a central bank.
Americans, by nature, distrust the central government and the concept of centralized power. They were even reluctant to establish a central bank for the seemingly simple task of printing money.
There were two instances when, due to wars and a lack of funds, a temporary central bank was jointly established – the First Bank of the United States and the Second Bank of the United States. Both these so-called central banks were closed down twenty years after helping the states overcome their difficulties.
You might be wondering, without a central bank, who printed the money? It might surprise you, but anyone could. In the 19th century, many private banks could issue their own notes, which were essentially equivalent to money. The United States at the time embraced free competition, even when it came to currency.
Of course, this didn't mean you could just grab a piece of green paper, draw a stick figure on it, write "100" and start spending it. Money could be printed by anyone, but for it to circulate, it had to be backed by collateral – for example, gold, silver, or U.S. government bonds.
Towards the end of the 19th century, a series of systemic banking crises hit. At the slightest hint of trouble, people would rush to banks to withdraw their money. The most severe of these crises occurred in 1907. The U.S. government had no choice but to turn to private banker J.P. Morgan for help. He used his personal prestige and funds to help the market weather the storm.
After this turmoil, people finally realized that unchecked free competition was terrifying and that a central bank was necessary. At the very least, a central bank was needed to provide a safety net when commercial banks faced bank runs. Thus, the federal government began drafting the Federal Reserve Act, and in 1913, the Federal Reserve was formally established.
A Delicate Balance: The Design of the Federal Reserve System
The design of the Federal Reserve System is ingenious. The reason the United States struggled to establish a central bank was public distrust of the central government and unwillingness to cede control. However, the government wouldn't accept an institution entirely free from its control.
Therefore, when discussing the operating mechanism of the Federal Reserve, the government and private bankers engaged in intense negotiations. After three to four years of debate, they found a balance acceptable to all parties.
Let's see how they achieved it.
The full name is the "Federal Reserve System", not the "Federal Reserve Bank." Therefore, it's not a single bank but a system composed of twelve regional Federal Reserve Banks. Each regional bank has its own jurisdiction, responsible for managing all commercial banks within that region.
Each Reserve Bank is held by thousands of member banks within its district. In other words, the Federal Reserve is actually an institution controlled by private banks. Hold on to your questions about this – we'll delve deeper into this later.
These regional banks have some autonomy in administrative matters. However, any critical monetary policy decisions, such as interest rate changes or printing money, are made by a centralized decision-making body called the Federal Open Market Committee (FOMC).
Remember this acronym. The seemingly simple FOMC is crucial. It consists of twelve members who ultimately determine all significant U.S. monetary policies. They are the heart of the Fed's decision-making process.
Consider this: 60% of global foreign exchange reserves are in U.S. dollars, and how many dollars are printed and their interest rate are decided by these twelve people in a room. These individuals could be casually discussing over lunch whether to raise interest rates, triggering trillions of dollars to flow back to the U.S. That's how powerful they are.
Seven of these twelve individuals are members of the Board of Governors, one of whom is the Chair of the Federal Reserve, currently Jerome Powell. The Chair serves a four-year term and can be reappointed. The other six members serve fourteen-year terms.
All seven members of the Board of Governors, including the Chair, are appointed by the President and confirmed by the Senate. The remaining five FOMC seats are filled by rotating presidents of regional Federal Reserve Banks. They take turns serving on the FOMC each year.
Due to the New York Fed's importance, its president always holds one of these seats. The remaining four seats are rotated among the presidents of the other eleven regional Feds.
This forms the twelve-member FOMC supergroup. These twelve individuals meet eight times a year, meaning once every six weeks. This is what we often refer to as the "Fed meeting." The most important monetary policies are discussed during these meetings.
After each meeting, a statement, the minutes of the meeting, is released. Whether the Fed will raise interest rates, and by how many basis points, is announced after the meeting. This is a focal point for global financial markets, as the decisions made within the FOMC hold immense weight.
During my time on Wall Street, we'd analyze the styles of each of these twelve individuals and pay close attention to their speeches. Generally, we categorize these individuals as either "doves" or "hawks."
If you're unsure how to remember this, think of doves releasing doves – representing "release," "relaxation," "easing" – favoring interest rate cuts, stimulus, and printing more money. Hawks, on the other hand, symbolize tightening, representing "locking down" – favoring policies that restrict monetary supply and control inflation.
For example, former Fed Chairs Ben Bernanke and Janet Yellen were considered doves. Current Chair Jerome Powell is seen as relatively neutral.
Among the twelve members, remember, four are rotating regional Fed presidents. This means you have to pay attention to not only the styles of the current four but also the styles of the four next in line.
I remember a person named Neel Kashkari, who became a regional Fed President in 2016. He was a super dove. When he was appointed, the stock market went up. This just goes to show how influential these twelve individuals are.
Each of the twelve regional Federal Reserve Banks has a nine-member Board of Directors. Six of these are elected by commercial banks in the region, and three are appointed by the Board of Governors, representing the government.
Hold on. I'll explain a crucial characteristic of the Federal Reserve after I finish this part. So bear with me.
The Board of Governors, the FOMC, the regional Feds, and the member banks together constitute a simplified framework of the Federal Reserve. The core idea embodied in this framework is "checks and balances" – specifically, checks and balances between the government and private banks.
Within each layer of the board of directors, there are representatives from both banks and the government. The bottom layer is entirely controlled by commercial banks, while the central decision-making body, the FOMC, is largely composed of government-appointed governors.
Although technically chosen by the government, the seven governors on the FOMC are not easily controlled by the government. Once appointed, it's difficult for the government to remove them, requiring a two-thirds majority vote in Congress.
For instance, in late 2018, during an interest rate hike cycle, the government, naturally, was not in favor of rate hikes as they could inhibit economic growth and potentially harm their chances of re-election.
It's important to note that the then-Federal Reserve Chair, Jerome Powell, was appointed by President Trump himself. However, this didn't stop Trump from criticizing the Fed. He stated, "I think the Federal Reserve is a much bigger problem than China right now. I think they made a big mistake...because I have a gut, and my gut tells me more sometimes than anybody else’s brain can ever tell me.”
Of course, take Trump's words with a grain of salt. But at least on the surface, it seemed like the U.S. government had very little control over the Fed. Even those appointed by the President don't necessarily act according to the President's wishes. Powell himself said in an interview that the reason the Fed has such a complex operating mechanism is to ensure its independence and the impartiality of its decision-making.
The Fed knows, and the market knows (including the U.S. government), that the cornerstone of the Fed's power is trust. It wields significant power, but this power is based on the trust the market places in it. The more trust the global market has in the Fed, the more people will use the U.S. dollar, further amplifying the Fed's influence. It's a positive feedback loop. The Fed's neutral mechanism exists to maintain this trust. It means not blindly following the dictates of the U.S. government. The long-term benefits of this trust far outweigh any short-term gains a few monetary policies might bring to the government.
A Historical Example: Paul Volcker and the Fight Against Inflation
Let me share a historical anecdote. After World War II, global markets didn't fully trust the Federal Reserve. But in 1979, Paul Volcker took over as Fed Chair. He went on to win the market's trust and is considered a legend among Fed Chairs.
Volcker's tenure was fraught with challenges, including two oil crises. At the time, inflation in the U.S. was rampant. To curb inflation, he took the drastic step of raising interest rates to over 20%, despite immense social pressure.
While raising interest rates can curb inflation, it can also stifle economic activity. U.S. unemployment rates soared past 10% during that period.
It wasn't just government officials who were unhappy with Volcker's extreme policies; even the public sent him death threats. The government had to deploy the Secret Service for his protection. Even Jimmy Carter, the President who appointed Volcker, was voted out of office after one term. No one could deter Volcker from his resolve to hike rates.
However, after a period of short-term pain, inflation was indeed brought under control, ushering in two decades of high economic growth for the United States. This victory made Volcker a legend. He proved to the world that the Federal Reserve could stabilize the dollar and wouldn't be swayed by U.S. politicians. It gave people confidence to hold U.S. dollars and facilitated the transition from a gold standard era to a floating exchange rate era, essentially, the era of the U.S. dollar's dominance.
Naturally, the Federal Reserve became the most powerful institution in the global financial system. Because it is intertwined with global capital markets, every move the Fed makes is a focal point for global attention.
Many investment platforms nowadays help us track the Fed's every move. For example, our old friend, the all-in-one trading platform Moomoo, has an economic calendar where you can subscribe to key economic data such as the federal funds rate and the CPI. When this data is released, you get a notification and can directly see the historical data compared to the forecast. It's convenient for investors, allowing them to quickly grasp market signals and make decisions.
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The Goals and Tools of the Federal Reserve
Back to the Federal Reserve. We've discussed its structure and decision-making independence. Some of you inquisitive minds might have questions by now.
Didn't we say that the Federal Reserve is jointly held by all its member banks? Shouldn't it prioritize maximizing shareholder profits? How can you say it's independent?
Let's address this shareholding issue. Firstly, the Fed does provide returns to its commercial bank shareholders, and the rate of return is quite impressive at 6%. However, while 6% might sound great, the equity capital of these shareholders is actually very small.
Looking at the Fed's financial reports, in 2022, it distributed a total of only $12 billion to all commercial banks in the U.S. The symbolic significance of this private shareholding far outweighs its actual impact. Moreover, the Fed's stock is completely non-tradable.
Therefore, it's somewhat like a membership deposit that commercial banks pay to join the system. These banks don't rely on the Fed for profits, and the Fed doesn't serve the interests of its shareholders.
So, while some say the Fed is a private company, which might be technically accurate, you can't really think of it as a private company in essence.
However, although it doesn't distribute much money to shareholders, the Federal Reserve is actually very profitable. Where does this money go? To the U.S. government.
This is something many people are unaware of. First, we need to understand how the Fed generates profits. It can't just print money and call it profit – that wouldn't work. The printed money is essentially a zero-interest loan. The Fed can lend this money or use it to buy various investment products. Interest earned on loans or returns generated from investments can be recorded as income. All profits, except for the symbolic dividends, are handed over to the U.S. Treasury Department.
I specifically calculated the data from the Fed's financial statements for the past ten years. On average, the Federal Reserve contributes $90 billion to the U.S. Treasury annually. Recently, due to interest rate hikes and the resulting decline in the value of bonds held by the Fed, its profits have decreased, and it only handed over $59 billion in 2022.
The fact that the Federal Reserve relinquishes its profits actually ensures the impartiality of its decision-making. Its monetary policies are not influenced by how much or how little it earns. The government benefits significantly from this arrangement.
Therefore, in theory, the Fed is entirely independent of the government. However, by having this department, the government receives nearly $100 billion annually, which is a considerable sum even for the U.S. government. Moreover, if you look at the Fed's quantitative easing timeline, you'll notice that regardless of the interest rate, a portion of the U.S. government's debt is purchased by the Fed with printed money. Subsequently, the Fed's profits are returned to the Treasury.
In essence, this roundabout process is equivalent to the U.S. government taking out interest-free loans from the Fed.
The Fed's Objectives and Its Evolving Toolkit
We've covered a lot of ground, but the main focus has been the Fed's independence. Now, as an independent central bank, what are the Fed's objectives, and what tools does it have to achieve them?
Its objectives are quite straightforward. There are two main goals: stable prices and maximum employment.
However, these two goals often conflict. To stimulate employment, you might need loose monetary policy, which can lead to inflation and rising prices. For example, when Paul Volcker sought to combat inflation, he raised interest rates, leading to higher unemployment.
Balancing these two objectives is a delicate act for the Federal Reserve. However, the prevailing economic view is that price stability is more crucial.
What tools does the Federal Reserve have to implement monetary policy? In its early days, its toolkit was quite extensive, encompassing interest rates, lending, and control over various aspects of the financial system.
However, as markets matured, its arsenal simplified, primarily focusing on controlling one thing – interest rates. And not just any interest rate, but the federal funds rate – the interest rate banks charge each other for overnight loans.
When we talk about the Fed raising or lowering interest rates, we're usually referring to this specific rate. I believe this is sufficient for most people to understand. The specifics of how they adjust this overnight rate are not crucial for our discussion.
They essentially have various tools at their disposal, but ultimately, they all boil down to controlling this one-day federal funds rate.
This short-term rate determines the speed at which money circulates in the market and effectively controls the amount of money in the system.
All other interest rates, such as deposit rates, mortgage rates, and government bond yields, are determined by market supply and demand – the Fed cannot directly control them. However, while the Fed can't directly control them, all these interest rates are highly correlated with the one-day federal funds rate that it does control.
The Greenspan Era and the Illusion of Control
By the 1990s, during Alan Greenspan's tenure as Fed Chair, this system seemed nearly invincible. It successfully navigated several stock market crashes and the shock of the Asian financial crisis. It appeared as though the Fed had achieved near perfection.
Imagine the state of physics in the 19th century – they thought they'd figured out the universe, that there was nothing they didn't know except for a few minor discrepancies. However, in the 20th century, quantum mechanics and relativity blew the lid off the world of physics.
The central banking equivalent happened a century later, in the 21st century.
The 2008 Financial Crisis and the Birth of Quantitative Easing
In 2008, Lehman Brothers collapsed, and the global financial crisis hit. To stimulate the economy, the Fed rapidly slashed interest rates from 5.25% to their lowest level in half a century – practically zero.
However, in the face of such a massive economic downturn, simply lowering interest rates was insufficient. Market confidence was in freefall.
Therefore, the Federal Reserve embarked on its next upgrade. They recalled a tactic employed by the Bank of Japan a few years prior – quantitative easing, or QE.
The idea was that instead of simply controlling short-term interest rates, the Fed could directly inject money into the market by purchasing long-term bonds, thereby lowering long-term interest rates.
Wouldn't this allow the entire economy to borrow at a lower cost? This approach carried significant risks. The Fed had no idea what the consequences of QE would be, as it had only been attempted by Japan on a small scale a couple of times. No one else had dared to try it.
Members of the FOMC admitted later that it was essentially an experiment – an experiment with the U.S. economy at stake. But there were no other options.
To prevent the United States from plunging into another Great Depression-like scenario, then-Fed Chair Ben Bernanke decided to try quantitative easing. The Fed would purchase $1.75 trillion worth of bonds – equivalent to a quarter of all outstanding bonds in the market – in just over a year.
This move sent shockwaves through the market. The yield on the 10-year Treasury note plummeted by over 100 basis points in two days. As interest rates fell and bond yields dropped, capital flooded into higher-yielding assets, primarily the stock market.
Stocks soared during QE. Financial markets rejoiced. Rising asset prices, through the "wealth effect," did stimulate the real economy. The wealth effect suggests that when stock prices rise, people feel wealthier and tend to spend more, increasing aggregate demand, thereby boosting overall economic confidence.
In fact, the rising real estate prices in China in previous years also stimulated the Chinese economy to a large extent through the wealth effect.
Finally, the unemployment rate in the United States stopped rising and began to steadily decline.
Seeing its success, the Fed rolled out second and third rounds of QE. After three rounds, the results were pretty good, preventing the United States from falling into a recession. It appeared that the Fed had once again successfully defused the crisis.
However, as it prepared to gradually withdraw these temporary policies, a problem arose: the market had become addicted.
Taper Tantrum: The Market's Addiction to QE
In May 2013, then-Fed Chair Ben Bernanke publicly stated that they were considering reducing the pace of quantitative easing – tapering.
Note that he wasn't even talking about selling the bonds they held, just buying them a little slower, a little less. And he was simply saying "considering" – they hadn't even started reducing yet.
The market panicked.
The bond market experienced a dramatic sell-off, and the yield on the 10-year Treasury note jumped by over 100 basis points in six months.
Seeing the market's drastic reaction, Bernanke immediately backtracked, stating, "We are not tightening. What I said before, just consider it as me passing gas."
Only then did market sentiment stabilize.
This episode is the famous "taper tantrum." It demonstrated that the market had become dependent on the potent medicine of QE. The Fed had brought about a rapid recovery, but the market had become too comfortable, too accustomed to the easy money. Now, as the Fed hinted at reducing the dosage, the market threw a tantrum.
What this signifies is that the Fed's primary achievement with QE was not stimulating the real economy, but rather creating a stock market bubble.
This is meant to be humorous satire, of course.
This actually highlights an awkward aspect of the Fed's monetary policy: when the economy isn't doing well, whether the Fed lowers interest rates or prints money to buy bonds, financial institutions are often reluctant to lend that money out. They prefer to invest it, which in the United States usually means buying stocks. Listed companies, facing lower interest rates, can borrow at a lower cost, but they are also more inclined to repurchase their own shares. In other words, they end up buying stocks as well.
So, in essence, regardless of the specific monetary policy implemented by the Fed, a large portion of the capital injected into the system ends up in the stock market.
The Fed's objectives are to stabilize prices and lower unemployment – there's nothing in there about driving up the stock market. Yet, the outcome is that whenever the Fed implements stimulus measures, the stock market surges.
This is not unique to the Fed. Central banks around the world face similar challenges. They can decide how much money to print and how much to spend, but they can't dictate where that money goes.
It's like the Fed controls an irrigation system, and it wants the water to irrigate, say, rice fields. However, all it can do is open the valve upstream and let the water flow. It has no control over where the water ultimately ends up. Maybe a small portion reaches those rice fields – representing the real economy – but a large portion flows into a nearby reservoir. This reservoir could be the stock market, real estate, or even foreign assets.
Therefore, when it comes to investing in stocks, the most important factor isn't necessarily the financial reports, but rather, what the Fed is doing.
There's a famous saying on Wall Street: "Don't fight the Fed." The Fed has become the sugar daddy of the stock market. Although the Fed strives for independence, Wall Street still exerts pressure through various means, urging the Fed to maintain its easing policies and avoid cutting off the flow of cheap money, arguing that it's beneficial for the U.S. economy.
The COVID-19 Pandemic and the Return of QE
Just as the Fed managed to placate the market and was beginning to consider whether its easing policies had gone too far, the COVID-19 pandemic hit. It was time to repeat the familiar process: zero interest rates and quantitative easing.
This time, however, the Fed was already well-versed in the procedure. When Bernanke first considered QE, it took months of deliberation. This time, Powell implemented it over a weekend. Moreover, this round of QE was the largest in human history. The Fed bought not just government bonds and mortgage-backed securities but also corporate bonds.
With everyone under lockdown and the economy at a standstill, the stock market experienced another boom. Talk about efficiency. Just one year later, as a result of the Fed's massive quantitative easing and the U.S. government's $5 trillion fiscal stimulus package, the ultimate monster the Fed feared most finally awakened: inflation.
The Fed could come up with a hundred reasons to continue flooding the economy with liquidity, but once this beast was unleashed, there was only one option: raise interest rates.
Within a year, the Fed hiked rates by over 500 basis points. Remember, most of the world's currencies and economies are pegged to the U.S. dollar. This triggered widespread economic turmoil across the globe.
Not only did global assets experience a major decline in 2022, but the United States itself witnessed its second, third, and fourth largest bank failures in history within just two months of 2023.
The Fed cannot shirk responsibility for this banking turmoil. It is currently preparing for another upgrade. The long-term side effects and potential crises stemming from over a decade of excessive easing followed by abrupt tightening in the U.S. remain to be seen.
The Importance of Communication and Transparency
Looking back at three decades of Fed policy, one gets the sense that when the economy is booming, the Fed tends to be too loose. Then, when the market crashes, the Fed, to ensure stability, has no choice but to step in for a bailout.
This isn't the Fed's intention. Initially, it hoped for free market competition and maximum efficiency, intervening only when necessary to provide a safety net.
However, over time, this approach created a moral hazard. Wall Street learned that they could take excessive risks, knowing the Fed would bail them out if things went south. These repeated bailouts even fostered a sense of complacency, a second nature, on Wall Street.
In reality, this conflict between Wall Street and the Fed exists at every level of the financial system. The game is rigged so that every player has a safety net. Financial institutions know they have the Fed and the U.S. government to back them up. If regular companies fail, they can declare bankruptcy. Even fund managers, if they lose money, will at worst be fired – their own personal wealth remains largely unaffected. However, if they make money, the sky's the limit – they reap all the rewards.
Finance is essentially a leverage game, a balancing act between risk and return. However, this safety net distorts the balance, making risk and reward asymmetrical.
Imagine playing a coin toss game. Heads, you win; tails, you lose the same amount. Fair and reasonable, right?
Now, imagine the rules change. You still win on heads and lose on tails, but there's a cap on your losses – you can only lose a maximum of, say, $1 million. The penalty is limited. What would be your optimal strategy in this scenario?
You'd bet the maximum amount possible, let's say $100 million. If you win, you gain $100 million. If you lose, you're out $1 million at most. Your expected return has shifted from zero to nearly $50 million.
This loss-capped game structure encourages all players to engage in riskier behavior. The higher the risk, the greater the potential reward.
Fund managers, listed companies, and Wall Street banks understand this game all too well. Upon closer examination, you'll realize that this principle applies not just to the financial industry but to numerous economic activities in the market.
The Fed certainly doesn't want its ability to provide a safety net to encourage financial institutions to endlessly increase leverage. Therefore, after the 2008 financial crisis, it significantly strengthened its regulatory oversight. However, this increased oversight appears to be insufficient. With banks collapsing left and right this year, the Fed is likely already brainstorming its next round of regulatory upgrades.
One thing I think the Fed does exceptionally well is maintain open and transparent communication with the market. Any market participant should appreciate this aspect. It's an approach that earns the Fed a lot of respect.
The Fed goes to great lengths to explain its thought process and the rationale behind each decision. It even discloses how each of the twelve FOMC members voted and their individual opinions.
One particularly useful tool is the "dot plot." After each FOMC meeting, they release this dot plot showing where each of the twelve members thinks interest rates are headed in the future. It provides valuable insight into their individual outlooks.
Sometimes, the dot plot can be even more crucial than the actual interest rate decision. For instance, when it comes to raising rates, whether it's by 25 basis points or 50 basis points, the market usually has a fairly accurate prediction. However, the range of opinions among FOMC members regarding future expectations can be much wider, making it a focal point for market watchers.
The Fed publishes a wealth of economic research data on its website. While the website design might be a bit outdated, it's a treasure trove of information. It includes economic data, theoretical research, educational materials, and even various academic papers.
One well-known publication in the industry is the "Beige Book." This book is updated periodically and contains economic research from the twelve regional Federal Reserve Banks, as well as their assessments of local economic conditions. It's considered essential reading for anyone involved in economics or finance.
While the Fed's ultimate decisions might appear deceptively simple – raise rates or don't, and by how much – they are the result of careful deliberation based on extensive research and analysis. The Fed goes to great lengths to emphasize that its decisions to adjust the "money tap" are not arbitrary but based on thorough analysis. Ultimately, it all comes back to building trust with the market.
In this article, I've provided an overview of the Fed's mechanism, history, goals, and some of the issues it faces, along with my own thoughts on the underlying logic of the game. Central banks around the world generally operate based on similar principles as the Fed.
This article might not be the easiest to digest, as I've included a lot of seemingly unrelated information and personal opinions. Honestly, I think it turned out pretty well, and I couldn't bring myself to cut anything out. If you've made it this far, I applaud you.
If you can connect the dots between this article and our previous discussions on interest rates and inflation, I believe it will significantly enhance your understanding of macroeconomics, macroeconomic policy, and central bank decision-making.