Federal Reserve and how it affects you

The Fed: Our Central Bank

From:
http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm


An overview of the Federal Reserve and how it affects you.

Introduction
The Fed...

To some the name evokes images of money stacks; to others it is just a dim memory from a high school economics class. To most, the overall picture is unclear--a hazy image that needs to be focused. Even the language associated with the Federal Reserve may seem as mysterious as an alchemist's formula. The FOMC, the discount window, open market operations--what exactly do they mean? What does the Fed do and how does it affect us?

Put most simply, the Federal Reserve System is the central bank of the United States. Congress created the Federal Reserve through a law passed in 1913, charging it with a responsibility to foster a sound banking system and a healthy economy. This remains, today, the broad mission of the Fed and its component parts: the 12 Federal Reserve Banks nationwide, each serving a specific region of the country; and the Board of Governors in Washington, D.C., set up to oversee the Fed System.

To accomplish its mission, the Fed serves as a banker's bank and as the government's bank, as a regulator of financial institutions and as the nation's money manager, performing a vast array of functions that affect the economy, the financial system, and ultimately, each of us.




A Bank for Banks

Each of the 12 Fed Banks provides services to financial institutions that are similar to the services that banks and thrifts provide to businesses and individuals. By serving as a "banker's bank" the Fed helps assure the safety and efficiency of the payments system, the critical pipeline through which all financial transactions in the economy flow.

Each day the Fed processes millions of payments in the form of both paper checks and electronic transfers. So when you cash a check or have money electronically transferred, there is a good chance that a Fed Bank will handle the transfer of funds from one financial institution to another. Each of the Fed Banks offers these and other services, on a fee basis, to the depository institutions in its Federal Reserve District. Institutions can choose to use the Fed's services or those offered by other competitors in the marketplace.

Together, the 12 Fed Banks process more than one-third of the checks written in the U.S., a total that exceeds $14 trillion annually. And the dollar volume transferred through the Federal Reserve's electronic network is far greater, over $343 trillion or many times our nation's gross national product.

Another important Federal Reserve responsibility is servicing the nation's largest banking customer--the U.S. government. As the government's bank or fiscal agent, the Fed processes a variety of financial transactions involving trillions of dollars.

Just as an individual might keep an account at a bank, the U.S. Treasury keeps a checking account with the Federal Reserve through which incoming federal tax deposits and outgoing government payments are handled. As part of this service relationship, the Fed sells and redeems U.S. government securities such as savings bonds and Treasury bills, notes and bonds.

The Federal Reserve also issues the nation's coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation's cash supply; the Fed Banks then distribute it to financial institutions. The currency periodically circulates back to the Fed Banks where it is counted, checked for wear and tear, and examined for counterfeits. If the money is still in good condition, it is eventually sent back into circulation as institutions order new supplies to satisfy the public's need for cash. Worn-out bills, however, are destroyed by shredding. The average $1 bill circulates for approximately 18 months before being destroyed.




Supervisor and Regulator

As part of its mandate to foster a sound banking system, the Federal Reserve supervises and regulates financial institutions.

As a regulator, the Fed formulates rules that govern the conduct of financial institutions. As a supervisor, the Federal Reserve examines and monitors institutions to help ensure that they operate in a safe and sound manner and comply with the laws and rules that apply to them. The Fed's supervisory duties are carried out on a regional basis. Each of the Reserve Banks is responsible for monitoring bank holding companies (organizations that own one or more banks) and state member banks (banks that are chartered by the state and are members of the Federal Reserve System) based in its District.

The Federal Reserve also helps to ensure that banks act in the public's interest by ruling on applications from banks seeking to merge or from bank holding companies seeking to buy a bank or engage in a nonbanking activity. In making these rulings, the Fed takes into consideration how the transaction would affect competition and the local community. The Federal Reserve also implements laws--such as Truth-in-Lending, Equal Credit Opportunity, and Home Mortgage Disclosure--meant to ensure that consumers are treated fairly in financial dealings.

Another way the Fed helps maintain a sound banking system is as the "lender of last resort." A financial institution experiencing an unexpected drain on its deposits, for example, can turn to its Reserve Bank if it is unable to borrow money elsewhere. This loan from the Fed would not only enable the institution to get through temporary difficulties, but most importantly, would prevent problems at one institution from spreading to others. The basic interest rate charged for these loans is called the discount rate.

The Fed's Structure

The Federal Reserve System

The nation's central bank
A regional structure with 12 districts
Subject to general Congressional authority and oversight
Operates on its own earnings

Board of Governors

7 members serving staggered 14-year terms
Appointed by the U.S. President and confirmed by the Senate
Oversees System operations, makes regulatory decisions, and sets reserve requirements

Federal Open Market Committee

The System's key monetary policymaking body
Decisions seek to foster economic growth with price stability by influencing the flow of money and credit
Comprised of the 7 members of the Board of Governors and the Reserve Bank presidents, 5 of whom serve as voting members on a rotating basis

Federal Reserve Banks

12 regional banks with 25 branches
Each independently incorporated with a 9-member board of directors from the private sector
Set discount rate, subject to approval by Board of Governors.
Monitor economy and financial institutions in their districts and provide financial services to the U.S. government and depository institutions.



Money Manager

The most important of the Fed's responsibilities is formulating and carrying out monetary policy. In this role, the Fed acts as the nation's "money manager." It works to balance the volume of money and credit and their price--interest rates--with the needs of the economy. Simply stated, too much money in the economy can lead to inflation, while too little can stifle economic growth. As the nation's money manager, the Fed seeks to strike a balance between these two extremes.





To achieve this goal, the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold.

In general, depository institutions are subject to rules requiring that a certain percentage of their deposits be set aside as reserves and not used for loans or investments. These reserve determine the amount of money an institution can create through lending and investing. Through reserves, then, the Fed indirectly affects the flow of money and credit through the economy by controlling the raw materials that institutions use to create money. The Fed's action triggers a chain of events that affects interest rates and the levels of prices, employment, and overall growth in the economy. The Fed has three tools for affecting reserves:

Reserve Requirements
Altering the percentage of deposits that institutions must set aside as reserves can have a powerful impact on the flow of money and credit. Lowering reserve requirements can lead to more money being injected into the economy by freeing up funds that were previously set aside. Raising the requirements freezes funds that financial institutions could otherwise pump into the economy. The Fed, however, seldom changes reserve requirements because such changes can have a dramatic effect on institutions and the economy.

Discount Rate
An increase in the discount rate can inhibit lending and investment activity of financial institutions by making it more expensive for institutions to obtain funds or reserves. But, if funds are readily available from sources other than the Fed's "discount window," a discount rate change won't directly affect the flow of money and credit. Even so, a change in the discount rate can be an important signal of the Fed's policy direction.

Open Market Operations
The most flexible, and therefore most important, of the monetary policy tools is open market operations--the purchase and sale of government securities by the Fed. When the Fed wants to increase the flow of money and credit, it buys government securities; when it wants to restrict the flow of money and credit, it sells government securities.

As with the other tools, the Fed's open market operations affect the supply of money through the reserves of depository institutions. If, for example, the Federal Reserve wished to increase the supply of money and credit, it might purchase $1 billion in government securities from a securities dealer. The Federal Reserve would pay for the securities by adding $1 billion to the account that the security dealer's bank keeps at the Fed, and the bank would in turn credit the security dealer's account for that amount. While the dealer's bank must keep a certain percentage of these new funds in reserve, it can lend and invest the remainder. As these funds are spent and re-spent, the stock of money and credit will eventually increase by much more than the original $1 billion addition.

The procedure is reversed to decrease the money supply. If the Fed were to sell $1 billion in government securities to a dealer, that amount would be deducted from the reserve account of the dealer's bank. The bank, in turn, would deduct $1 billion from the account of the dealer. The end result--less money flowing through the economy.




The Fed's Checks and Balances

The Federal Reserve's policymaking process highlights the careful way in which it was structured to incorporate broad participation and a system of checks and balances. Authority for each of the Fed's policy tools is vested in a different component of the Federal Reserve System. The authority to change reserve requirements, for example, is held by the Board of Governors. Changes in the discount rate are initiated by the boards of directors of the individual Reserve Banks, subject to approval by the Federal Reserve Board of Governors. Open market operations, the System's most important tool, are directed by a group that brings together the Federal Reserve Board and Banks--the Federal Open Market Committee (FOMC).

The FOMC, the Fed's most important policymaking body, is made up of all 7 members of the Board of Governors and the presidents of the Reserve Banks. At any point in time, only 5 of the 12 presidents serve as voting members. The president of the New York Fed, which handles the open market securities transactions on behalf of the System, serves as a permanent voting member, while the other presidents rotate annually. Although only 5 presidents vote, all 12 participate fully in each FOMC meeting, bringing grass-roots, first-hand information and views about the economy to the decision-making process.

This broad participation in the policy process is just one example of the checks and balances built into the Fed System. Like those who guided the formation of the American system of government, the framers of the Federal Reserve System were concerned about vesting too much power, especially money power, in the hands of too few. Therefore, they gave the Fed a number of contrasting elements:

It is a central bank, but it is decentralized with a system of regional Reserve Banks responsive to local needs. It is a public institution with a public purpose, but it has some private features--directors, "stockholders," and selling services. It is governmental, but it is independent within government. On the one hand, it was created by and reports to Congress; its highest officials, the members of the Board of Governors, are appointed by the President and confirmed by the Senate; and its earnings ultimately are returned to the U.S. Treasury. On the other hand, the Fed operates on its own earnings rather than Congressional appropriation; the Board of Governors terms are long and staggered, limiting the President's influence; and unlike some other nations central banks, it is separate from the Treasury.

With this complicated system of checks and balances, the Federal Reserve is the unmistakable offspring of the American political process. Congress created the System in 1913 in an effort to respond to the needs of a growing U.S. economy, and to avoid the cyclical pattern of booms and busts that had characterized much of the 1800s. By the early 1900s, there was general consensus that the country needed a central bank, but little agreement on how to structure it. As a result, the creation of the Federal Reserve turned into a legislative tug-of-war marked by frequent disagreement, occasional suspicion, but in the end, compromise. Eventually, the Fed--basically a creature borne of compromise--emerged with a structure designed to reconcile the needs, fears, and prejudices of many different interests.

This complicated structure, no doubt, can be confusing. But it ensures that the Fed's decisions are broadly based and properly insulated from narrow and partisan interests. In the end, this structure helps the Fed accomplish its overall mission: fostering a sound financial system and a healthy economy.

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