Federal Reserve guides direction of economic market

May 15, 2005

It is difficult to open any business publication without encountering a reference to the Federal Reserve. The Federal Reserve is the central bank of the United States. The human component of "the Fed" is the seven-member Federal Reserve Board of Governors. The comments of the Fed's chairman, Alan Greenspan, are constantly anticipated, reproduced, and analyzed. Ophthalmologists must understand the Fed in order to appreciate the current business position of their practices, and to plan their personal and business financial futures properly.

The Fed is responsible for setting the direction for national monetary policy. Monetary policy essentially reflects the condition of money and credit in the U.S. economy. For these purposes, "money" is considered to be cash in circulation, plus cash that has been deposited in personal and business bank accounts. "Credit" is the amount available for lending by banks and other lending institutions.

Federal Reserve goals The Fed, through its actions, seeks to accomplish stated goals. These goals include stable prices, high employment, and maximum sustainable national growth. The Fed tries to maintain the appropriate balance among these often-competing goals.

For example, an understanding of current employment levels will help physicians determine if the wage rate they provide employees of varying skill levels is appropriate. An environment in which efforts are being made to curtail inflation will have an impact on decisions regarding equipment purchases.

A number of mechanisms are available to the Fed to aid in pursuit of its goals. One of the principal techniques is known as "open market operations." Open market operations refer to the purchase of previously issued U.S. Treasury securities, or the sale of such securities.

Consider the instances when the Fed sells U.S. Treasury securities, such as U.S. Treasury bonds, to the public. This decreases the supply of money in circulation, since the public (individuals plus businesses) now owns more securities and less cash. This decrease in supply leads to an increase in the cost of money, or interest rate. The important interest rate here is known as the federal funds rate. The federal funds rate is the interest rate on short-term loans that banks charge each other. The federal funds rate has moved in a range between 1% and 2% over the past year or so.

This sale of securities, leading to an increase in the federal funds rate, has the effect of "tightening" the economic market. A purchase of securities has the opposite effect. A purchase leads to "easing" or "loosening" in the economic market.

It is fairly clear why lower interest rates in the broad sense stimulate economic activity, since lower interest rates make it more attractive to borrow money. This borrowed money may be used for immediate gratification, or to finance investments with the hope for future returns.

A less obvious, but also important mechanism by which lower interest rates stimulate investment should also be considered. Assume returns obtained by lending excess money or depositing the money in a savings account are meager because of a low prevailing interest rate. In this case, use of the funds for investment becomes relatively more attractive.