The Federal Reserve is the central banking system of the United States, and it has been around for over a century. The Fed supervises the nation's largest banks, conducts monetary policy, and provides financial services to the U.S. government. It also promotes the stability of the financial system.
How Does the Federal Reserve Work?
To understand how the Fed works, you must know its structure. The Federal Reserve System has three primary components:
- The seven members of the board of governors guide the entire Fed system. They direct monetary policy and set the discount rate for member banks. Staff economists provide all analyses.
- The 12 regional Federal Reserve Banks work with the board to supervise the nation's commercial banks and implement policy.
- The Federal Open Market Committee (FOMC) oversees open market operations. The seven board members, the president of the Federal Reserve Bank of New York, and four of the remaining 11 regional bank presidents are members. The FOMC meets eight times a year.
Congress created the Fed's board structure to ensure its independence from politics. Board members serve staggered terms of 14 years each. The president appoints a new one every two years, and the U.S. Senate confirms them. If the staggered schedule is followed, then no president or congressional party majority can control the board.
The Fed's independence is critical. With autonomy, the central bank can focus on long-term economic goals, making decisions based solely on economic indicators.
What Does the Federal Reserve Do?
The Federal Reserve has four main functions:
- Manage inflation: This is the Fed's most visible function. It also promotes maximum employment and ensures interest rates remain moderate over time.
- Supervise the banking system: The Fed regulates the nation’s largest banks to protect consumers.
- Maintain the stability of the financial system: It does this to prevent potential crises.
- Provide banking services: The Fed provides services to other banks, the U.S. government, and foreign banks.
Manage Inflation
The Fed manages inflation while promoting maximum employment and stable interest rates. The Fed sets a 2% inflation target for the core inflation rate. The core rate strips out volatile food and gasoline prices because they have a wider range of volatility. On Aug. 27, 2020, the Fed announced it would tolerate inflation above 2% in the short term if it maximized employment. The Fed uses the Personal Consumption Expenditures Price Index (PCE) to measure inflation.
The Fed has many powerful tools at its disposal for this purpose. Its most well-known tool is setting the target for the federal funds rate, which guides interest rates.
If a bank doesn't have enough cash on hand at the end of the day, it borrows what it needs from other banks. The funds it borrows are known as federal funds. Banks charge each other the federal funds rate on these loans. The fed funds rate is a benchmark for other interest rates.
- The Federal Reserve uses expansionary monetary policy when it lowers interest rates. This makes loans cheaper, spurs business growth, and reduces unemployment.
- The opposite, when the Fed raises interest rates, is known as contractionary monetary policy. High interest rates make borrowing expensive. Increased loan costs slow growth and keep prices low.
The FOMC sets the target for the fed funds rate. Banks set their own effective fed funds rate. To keep it near its target, the Fed uses open market operations to buy or sell securities from its member banks. That adds to the reserves the banks can lend and results in the lowering of the fed funds rate.
Supervise the Banking System
The Federal Reserve Banking System is a network of 12 Federal Reserve banks under the supervision of the board of governors. These 12 banks supervise and serve as banks for commercial banks in their region. They are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis, and San Francisco.
The Reserve Banks serve the U.S. Treasury by handling its payments, selling government securities, and assisting with its cash management and investment activities. Reserve banks also conduct valuable research on economic issues.
Maintain the Stability of the Financial System
The 2008 financial crisis revealed regulations on individual banks weren’t enough. The financial system had become so interconnected that the Fed, and other regulators, needed to look at it as a whole.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 strengthened the Fed's ability to maintain stability. Each bank with over $50 billion in assets had to submit a "living will" to the Fed outlining its financial health and ability to handle a crisis.10 This was to prevent another bankruptcy on the scale of Lehman Brothers. In 2018, Congress waived Dodd-Frank regulations on banks with less than $10 billion in assets.
The Fed's Large Institution Supervision Coordinating Committee (LISCC) regulates the largest and most systematically important banks. It conducts stress tests to determine whether the banks have enough capital to make loans even in a financial crisis. (Board of Governors of the Federal Reserve System. "SR 20-30: Financial Institutions Subject to the LISCC Supervisory Program.")
Provide Banking Services
The Fed is called the "banks' bank" because each Reserve Bank stores currency, processes checks, and makes loans for its members to meet their reserve requirements when needed. These loans are made through the discount window.
Banks are charged the discount rate, which is a little higher than the fed funds rate. Most banks avoid using the discount window because there is a stigma attached. It is assumed the bank can't get loans from other banks—that's why the Federal Reserve is also known as the bank of last resort.
History of the Federal Reserve
President Woodrow Wilson tcreated the Federal Reserve System following the Panic of 1907. He called for a National Monetary Commission to evaluate the best response to prevent ongoing financial panics, bank failures, and business bankruptcies. In 1913, Congress passed the Federal Reserve Act of 1913. It established Federal Reserve banks, managed the currency, and supervised banks. Congress has since expanded the Fed's power to include monetary policy.
