The Federal Reserve: What It Is

Flag of the Federal Reserve            Image Credit: Wikimedia Commons

The Federal Reserve System is one of those government organizations that most people hear about from time-to-time but they are not quite sure what it exactly does except that it has something to do with money. Therefore, I will use this post to explain what the Fed does and how it fits into the scheme of things. Then I intend to criticize it unmercifully in future posts.

The  Federal Reserve is an example of what is called a national central bank, created for the purpose of controlling the nation’s money supply. Congress created the Federal Reserve with the Federal Reserve Act of 1913, and it currently holds three mandated missions.

• Determine how much money should be created or destroyed over any period of time so that maximum employment in the private sector would be encouraged. What the Fed decides in determining monetary levels is known as the Fed’s monetary policy.
• While the Fed must encourage maximum employment, it must do so consistent with its second mission of maintaining stable prices.
• The third mission, which is given little attention, is to maintain moderate interest rates.

People’s attention is usually focused on the first two of these objectives, which are often referred to as the Federal Reserve’s dual mandate.

Actually, it is more accurate to call the Federal Reserve a fourth branch of government, since it does its work more-or-less independently from the other three branches of government. The Fed does not have to obtain the approval of anyone in government for any of its decisions, although it must report what it does to the Congress and the President. It was hoped by giving the Fed independence, the Fed’s decisions would be insulated from politics; the Fed would then (it was hoped) make their decisions only for sound economic reasons.

At its top level the Fed is controlled by a Board of Governors, also known as the Federal Reserve Board, appointed by the President. Below the Board of Governors is the Federal Open Market Committee (FOMC) that sets monetary policy. Below that is a system of 12 regional Federal Reserve Banks, each in a separate Federal Reserve district and each supervised by a regional President. Their purpose is  (1) to oversee private member banks to ensure they are complying with monetary policies, and (2) to keep track of economic activity in their district.

Banks of all sizes can be members of the Federal Reserve System. By law all nationally chartered banks must be members, but state chartered banks may also be members if they meet requirements. Each member bank  must own stock in their district reserve bank, for which they are paid an annual interest.  Also, each bank must hold a set fraction of their assets as reserves in the Federal Reserve.

The Federal Open Market Committee (FOMC) is composed of all 12 presidents of the regional reserve banks plus the seven governors of the Federal Reserve Board. The FOMC meets approximately every six weeks  to determine if changes in monetary policy should be made.

So how does the Fed control the nation’s money supply? In its war on inflation/deflation and on unemployment, the Fed has three major weapons.

1. A change in reserve requirements, called the reserve ratio.  This is the percentage of a bank’s total assets (all deposited bank accounts) held as reserves with the Federal Reserve, That is, it is the ratio of bank reserves to the money deposited in the bank. To pull money out of the economy, The Fed would increase the reserve ratio; to increase the money in the system, it would decrease the reserve ratio.
2. A change in the discount rate, also known as the Federal Funds Rate or Fed Funds Rate. This is the interest rate the Fed charges member banks for borrowing from the reserves that it holds. To discourage money from flowing from the reserves to the economy, the discount rate would be raised; if the fed wanted to encourage the opposite flow, it would lower the discount rate.
3. Open-market operations, where  the Fed either sells government securities to the member banks or it buys them back from the banks. The first two weapons in the Fed arsenal were used to adjust the levels of already created money active in the system. Open-market operations either created brand new money if securities were bought from banks, or destroyed money if they were sold.

With open-market operations, if money flows from the Fed to bank reserves, the bank’s reserves have gone up while the money deposited in accounts remains constant. Thus, if nothing else happens, the bank’s reserve ratio increases above what the Fed requires. To adjust, a bank will generally find ways to lend out money until the reserve ratio meets Fed requirements. Since the money lent out is considered separate money from the bank reserves, the total amount of money in the system has increased by more than the Fed’s deposits into the reserve account. This bit of legerdemain is called fractional reserve banking, and it causes growth of the entire money supply.

The “Quantitative Easing”(QE) programs were open-market operations of this kind. There was a really novel aspect to QE however, in that the Fed bought not only treasury bills from the banks, but mortgage backed securities as well, allowing the Fed at QE’s height to inject $85 billion of new money per month into the system. Of course, this was not the end of the tale with QE since the Fed immediately lured about 80% of this new money back into reserves by paying interest on these excess reserves. See “What Has Happened to All that QE Money”.

This pretty much finishes the relating of the nuts and bolts of the Federal Reserve. What comes next in my next post on the Fed will be the fun part: a discussion of why the Federal Reserve increased the money supply the way it did, and what the effects on the economy were.

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