Federal reserve aims to preserve system, curb pain.

• Author: Adams, Tucker Hart
• Position: ECONOMIST

What is the Federal Reserve trying to accomplish? To prevent the implosion of the international financial system to lessen the depth and severity of the recession.

With a little luck, the first has been accomplished, although things are still fragile. We'll never know for sure about the second, since there is no way to know what the alternative was.

The Fed has three primary tools at its disposal:

* Buying and selling government bonds in the open market, just as you and I do when we call our broker to purchase or sell a Treasury bond. This is the most important and frequently used tool.

* Making loans at the discount window and setting the appropriate interest rate (the discount rate). Until recently, this was limited to commercial banks but was extended to investment banks during the financial crisis. Banks generally borrow when they run short of cash (a black mark against them) and for seasonal needs (e.g., banks in agricultural communities that have high loan demand in the spring and deposits coming in during the fall), which is OK.

* Changing within limits set by Congress the reserve requirement, the percentage of consumer and business deposits that commercial banks must in turn deposit with the Fed. When we make a deposit into our bank account, most of that money is loaned out to other businesses or consumers, but about 10 percent must be held on deposit at the Fed. Until October 2008, no interest was paid on these accounts.

* In addition, the Fed can use moral suasion or jaw-boning. If the Fed isn't happy with what banks are doing, they are called in for a heart-to-heart talk. It is also responsible for 33 separate regulatory activities, such as bank capital requirements and interest paid on member bank deposits.

In normal times, the Fed focuses on inflation and unemployment. It uses open market operations to keep overall price increases low and the economy growing at a rate that provides jobs. It doesn't try to control asset bubbles or the exchange rate, although it certainly pays attention to such things.

When inflation starts to increase, usually because the economy is strong and demand for goods and services is pushing up their price, the Fed will sell Treasury securities from its portfolio. This reduces the amount of money circulating...