What is the Federal Reserve?

What Is the Federal Reserve?

The Federal Reserve (also referred to as the Fed) is a central bank. Like all central banks, this institution is in charge of two key functions to keep the economy running smoothly:

1. Maintain low unemployment
2. Control inflation

While it has a dual mandate, its responsibilities also extend to bank regulating and being a lender of last resort.

The Fed is somewhat unique in its independence from the U.S. federal government. It’s run by the Federal Reserve Board of Governors, with seven board members who oversee the Fed itself. The chairman of the board acts as the chief executive of the central bank. The U.S. president nominates the positions. Each term lasts 14 years.

The U.S. President appoints governors and the Senate confirms them. Still, Fed governors act completely independently of the U.S. government.

Then there’s the Federal Open Market Committee or FOMC. This committee sets monetary policy and votes to raise or decrease interest rates. There are seven members of the Board of Governors and five Reserve Bank presidents.

A Network of Regional Fed Banks

The Federal Reserve is a multi-layered entity. There are 12 regional Federal Reserve banks. Each one manages many of the day-to-day operations of the central bank. The Regional Federal Reserve banks are spread across the United States. They are designed to make sure the Fed board is aware of regional interests.

Within each regional Federal Reserve bank, there is a president and a board of nine directors. Three are chosen by the regional bank’s shareholders as their representatives, while three are meant to represent the public’s interests. The final three are chosen by the board of governors and represent the public.

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What does the Federal Reserve do?

There are several other things that the Fed is responsible for:

1. Facilitating monetary policy

National policy decisions are undertaken by a 12 member committee. Seven are from the board of governors and five from the regional banks. The New York Fed has a permanent seat while the remaining four positions rotate.

The Federal Reserve is in charge of maximizing employment and controlling inflation. Both of these are tied to economic growth and are managed through interest rate mechanisms. Interest rate decisions made by the Federal Reserve have far-reaching consequences that affect everyone in an economy. The Fed does most of its work to move interest rates through its Open Market Operations. Those decisions are made by the Open Market Operations Committee which we will discuss later.

The regional bank's role is to make sure that all depository institutions, such as banks and credit unions, can access cash at a discounted rate. They also provide research and data to help the FOMIC and the Fed understand economic situations in their respective regions.

While interest rates have a direct impact on inflation, another important tool of the Federal Reserve is signaling to the market. Economies can react violently to sudden changes in inflation. This can cause a loss of control where people rush to buy things before prices increase. This, in turn, increases prices further.

To stem this, the chairman of the Federal Reserve must carefully communicate goals to the public. Rather than suddenly pursuing a new target, the Fed will try its best to ease the public and the market into the change, without stroking any fears.

2. Supervising member institutions

A secondary function of the regional Federal Reserve banks supervising the member institutions that are members of their branch. The regional banks routinely check audits, stress tests, and monitor the stability of each member and its credit policies. The Federal Reserve tries to prevent situations where member banks fuel speculative lending, which can lead to distorted asset prices or bubbles. The Fed also makes sure that each bank holds the right reserve ratio or the proportion of deposits that must be held as cash.

If a member bank is violating these policies, it is given a warning and time to fix whatever the issue is. But if the issue persists, the Board of Governors can take steps to temporarily suspend the member bank from all credit facilities of the Fed, significantly impairing its operational capabilities.

3. Servicing the Government

As a central bank, the Federal Reserve has the privilege of printing the national currency. Today currency is printed through computer systems. U.S. currency is the jurisdiction of the United States Treasury Department, which causes both institutions to work closely together.

Rather than depositing the government’s money into accounts with commercial banks, all of the operating bank accounts of the U.S. Treasury, as well as its transactions, are done through the Federal Reserve. Essentially, the Federal Reserve acts as the U.S. Treasury’s bank. Additionally, member banks receive a dividend from their shares in their regional Federal Reserve branches. As the Federal Reserve is not a for-profit organization, whatever income earned on its reserves after the dividend distribution is also given to the Treasury.

Following the 2008 financial crisis, the Federal Reserve has developed a new avenue of servicing the government. Quantitative easing (QE) is a new monetary policy where the Federal Reserve buys all new government bonds auctioned by the U.S. Treasury. The Fed, thereby, increases demand and lowers yields. This policy was undertaken as a response to the financial crisis after rate cuts had a minimal effect. As a result of this policy, the relationship between the Federal Reserve and the U.S. Treasury is closer than ever.

4. Servicing depository institutions

In addition to its many key monetary duties, the Federal Reserve also acts as a key infrastructure for the commercial banking system. The Fed is the main clearinghouse for all the checks that go through America. This means that the central bank is in charge of receiving and rerouting billions of checks annually.

The Federal Reserve also handles all the routing of wire transfers through its electronic system. This makes it a key mechanism for the smooth financial operations of the country. Finally, the Fed also services its depositors with physical cash during periods of increased demand.

This ties in nicely with what may be the Fed’s most important function with its depository institutions: acting as the lender of last resort. The original idea behind central banks was the prevention of bank runs. This is when consumers collectively lose faith in a bank’s ability to pay its obligations. Due to the nature of fractional reserve banking, if everyone withdrew their cash at once, it would ironically collapse the bank. Now if there is a bank run, the Federal Reserve can extend liquidity to that member bank for it to get through unscathed.

Why was the Federal Reserve created and what's its history?

While perhaps the most powerful and important central bank in the global economy today, the Federal Reserve wasn’t the first central bank. In fact, the United States was one of the largest economies that operated without one throughout the 19th century. The U.S. only enacted a central bank in 1913 under President Woodrow Wilson.

The United States had toyed with the idea of a central bank repeatedly to deal with credit shortages and the issues stemming from each colony printing its own currency. The main opposition to the idea centered around the question of individual state vs. centralized government rights. For the most part, state sovereignty prevailed when a central bank was established on a trial basis and then abolished when it came time to ratify its charter.

The first major step in creating the Federal Reserve was liquidity issues faced by the country during the Civil War. During this period, thousands of independent banks issued their own currencies of questionable value with no federal oversight. And due to war disruptions, they would disappear overnight. In 1863 Congress passed the National Banking Act. This created a single currency and only permitted nationally-chartered banks to print the new centralized currency.

This all came to a head in 1907 after the infamous San Francisco earthquake. Over the course of six weeks, the economy faltered and banks across the nation faced bank runs. This risked the collapse of the entire financial system. Total collapse was averted thanks to famed financier J.P. Morgan, who stepped in and personally guaranteed a loan to the government that stabilized the financial system. This reliance on a wealthy private individual opened many people’s eyes to the risks of not having a central bank. After much negotiation, the Federal Reserve Act was passed in 1913.

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Federal Reserve vs. Federal Open Market Committee

The principal way the Fed impacts the monetary system of the United States is through its Open Market Policy Committee. It is here that we see most of the headlines related to Federal Reserve decisions.

These open market operations are the buying and selling of U.S. Treasuries. By expanding or constricting the supply of treasuries in the market, the Federal Reserve can control the liquidity in the economy and impact the federal funds rate. Known as the interbank lending rate, this is the interest rate banks charge each other to hold assets overnight. This rate also sets the basis for all interest rate products in the economy — from corporate bonds and treasuries to mortgages.

Member banks must keep a certain amount of these treasuries on their balance sheet at all times and must buy or sell with the Federal Reserve when it chooses a certain policy. As a result, the Federal Reserve can essentially dictate how much free cash banks have to lend out to the economy. If the Fed buys up treasuries from the member banks, banks have fewer reserves and have more liquid capital to lend. The opposite is true when the Federal Reserve sells treasuries in exchange for liquid capital.

For example, if the Federal Reserve felt that the economy was overheating, it could set a target to raise the federal funds rate. This would increase interest rates across the economy. This reduces consumption and encourages savings by selling member banks more treasuries. This increases member banks' reserves and sucks out liquid capital from their balance sheets. Because these banks now have less liquidity, the interest rate they charge each other will go up to compensate them. The federal funds rate rises and yields across the economy will often rise as well to reflect that.

Why is the Federal Reserve important?

We’ve spoken at length about the far-reaching effects each decision the Federal Reserve takes has on every corner of the economy. Its stimulating actions, such as QE, have been a huge part of the bull market in equities for the past decade. Even now, the Fed’s extraordinary response to the economic damage due to the coronavirus has had a buoyant effect on the stock market. Many detractors see this as an issue. They fear that the Federal Reserve may be sowing the seeds of the next big financial crash due to asset bubbles.

The Federal Reserve also has an important global impact. As the most powerful economy in the world today, the economic strength and weakness of the United States can have spillover effects globally. We saw this with the great financial crisis. The interest rate decisions of the Federal Reserve also have a significant impact on the international flow of capital.

It is not an exaggeration to say that when the United States sneezes, the world catches a cold. The Federal Reserve is the tissue for that sneeze and for that reason, remains an institution closely watched globally.