The Federal Reserve System, Its Four Functions, and How It All Works
Is the Fed Really a "Secret Society" That Controls Your Money?
The Federal Reserve System is America's central bank. That makes it the most powerful single actor in the U.S. economy and thus the world. It is so complicated that some consider it a "secret society" that controls the world's money. They’re right about its function, but there is nothing secret about it.
Four Functions of the Federal Reserve System
The Federal Reserve's most critical and visible function is to conduct monetary policy.
It does this to manage inflation and maintain stable prices. To do that, the Fed sets a 2.0 percent inflation target for the core inflation rate. It also pursues maximum employment. The goal is the natural rate of unemployment of 4.7-5.8 percent. The Fed moderates long-term interest rates through open market operations and the fed funds rate. The goal of monetary policy is healthy economic growth. That target is a 2-3 percent gross domestic product growth rate.
Second, the Fed supervises and regulates many of the nation’s banks to protect consumers.
Third, it maintains the stability of the financial markets and constrains potential crises.
Fourth, it provides banking services to other banks, the U.S. government and foreign banks. (Source: "What Is the Purpose of the Federal Reserve System?" Board of Governors of the Federal Reserve.)
To understand how the Fed works, you must know its structure.
The Federal Reserve System has three components. The Board of Governors directs monetary policy. Its seven members are responsible for setting the discount rate and the reserve requirement for member banks. Staff economists provide all analyses. They include the monthly Beige Book and the semi-annual Monetary Report to Congress.
The Federal Open Market Committee oversees open market operations. That includes setting the target for the fed funds rate, which guides interest rates. The board members and four of the twelve bank presidents are members. The FOMC meets eight times a year.
The Federal Reserve Banks supervise commercial banks and implement policy. They work with the board to supervise commercial banks. There is one located in each of their twelve districts.
1. How It Manages Inflation
The Federal Reserve controls inflation by managing credit, the largest component of the money supply. (This is why people say the Fed prints money.) The Fed restricts credit by raising interest rates and making credit more expensive. That reduces the money supply, which curbs inflation. Why is managing inflation so important? Ongoing inflation is like an insidious cancer that destroys any benefits of growth.
When there is no risk of inflation, the Fed makes credit cheap by lowering interest rates. This increases liquidity and spurs business growth. That ultimately reduces unemployment. The Fed monitors inflation through the core inflation rate, as measured by the Personal Consumer Expenditures Price Index. It strips out volatile food and gas prices from the regular inflation rate.
Food and gas prices typically rise in the summer and fall in the winter. That's too fast for the Fed to manage.
The Federal Reserve uses expansionary monetary policy when it lowers interest rates. That expands credit and liquidity, which makes the economy grow faster and creates jobs. If the economy grows too much, it triggers inflation. At this point, the Federal Reserve uses contractionary monetary policy and raises interest rates. High interest rates make borrowing expensive, which slows growth and makes it less likely that businesses will raise prices. For examples, see Who Are the Major Players in the Fight Against Inflation?
Fed Tools: The Federal Reserve sets the reserve requirement for the nation's banks. It states that banks must hold at least 10 percent (less for smaller banks) of their deposits on hand each night.
The rest can be lent out. If a bank doesn't have enough cash on hand at the end of the day, it borrows what it needs from other banks (known as the fed funds). Banks charge each other the fed funds rate on these loans.
The FOMC sets the target for the fed funds rate at its monthly meetings. To keep it near its target, the Fed uses open market operations to buy or sell securities from its member banks. It creates the credit out of thin air to buy these securities, which has the same effect as printing money. That adds to the reserves the banks can lend, thus lowering the fed funds rate. Here's the current fed funds rate.
2. How It Supervises the Banking System
The Federal Reserve oversees roughly 5,000 bank holding companies, 850 state bank members of the Federal Reserve Banking System and any foreign banks operating in the United States. The Federal Reserve Banking System is a network of 12 Federal Reserve banks that both supervise and serve as banks for all the commercial banks in their region.
The 12 banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas 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. (Source: “The Structure of the Federal Reserve System,” Federal Reserve Education.)
The Dodd-Frank Wall Street Reform Act strengthened the Fed's power over banks. If any bank becomes too big to fail, it can be turned over to Federal Reserve supervision. It will require a higher reserve requirement to protect against any losses.
Dodd-Frank also gave the Fed the mandate to supervise "systematically important institutions." In 2015, the Fed created the Large Institution Supervision Coordinating Committee. It regulates the 16 largest banks. Most important, it is responsible for the annual stress test of 31 banks. These tests determine whether the banks have enough capital to continue making loans even if the system falls apart as it did in October 2008. (Source: Jon Hilsenrath, "Washington Strips New York Fed's Power," Wall Street Journal, March 4, 2015.)
On February 3, 2017, President Trump attempted to weaken Dodd-Frank. He signed an executive order that instructed the Treasury Secretary to review areas that need to be amended. But many of theose regulations have already been incorporated into international banking agreements. (Source: “Trump Begins to Chip Away at Banking Regulations,” The Atlantic, February 3, 2017.)
3. How It Maintains the Stability of the Financial System
The Federal Reserve worked closely with the Treasury Department to prevent global financial collapse during the financial crisis of 2008. It created many new tools, including the Term Auction Facility, the Money Market Investor Lending Facility and Quantitative Easing. For a blow-by-blow description of everything that happened while it was going on, see Federal Intervention in the 2007 Banking Crisis.
Two decades earlier, the Federal Reserve intervened in the Long Term Capital Management Crisis. Federal Reserve actions worsened the Great Depression of 1929 by tightening the money supply to defend the gold standard.
4. How It Provides Banking Services
The Fed buys U.S. Treasurys from the federal government. That's called monetizing the debt. That's because the Fed creates the money it uses to buy the Treasurys. It adds that much money to the money supply. Over the past ten years, the Fed has acquired $4 billion in Treasurys. For more, see Is the Federal Reserve Printing Money?
The Fed is called the "bankers' bank." That is because each Reserve bank stores currency, processes checks and, most importantly, makes loans for its members to make their reserve requirement when needed. These loans are made through the discount window and are charged the discount rate (also set at the FOMC meeting). This rate is lower than the fed funds rate and LIBOR
The Federal Reserve System
Just as Congress and the president control fiscal policy, the Federal Reserve System dominates monetary policy, the control of the supply and cost of money. Since monetary policy affects every sector of the economy, the Fed has to be considered coequal with the president and Congress in macroeconomic decision making.
The Fed's StructureThe Federal Reserve system consists of a seven-member board of directors in Washington, D.C., and 12 regional banks, each controlled by its own directors. These regional institutions, owned by commercial banks within their jurisdictions, only do business with the Treasury and their member banks, not with the public at large. They do not lend money for automobiles or homes, and their main assets are U.S. government securities (such as Treasury bonds). The Federal Reserve banks also perform a variety of services for other banks such as check processing and storing and distributing cash. All national and state chartered banks are subject to Federal Reserve supervision and regulation.
The Federal Reserve Board of Governors oversees the entire system. The president appoints six of the governors (subject to Senate confirmation) to 14-year terms and the board's chair to a 4-year term. (The president's and chair's terms of office do not overlap, however.) Alan Greenspan is the current chair.
The Fed's OperationsEven though the Constitution authorizes the government to "coin money," it would be impractical to control its supply by speeding up or slowing down the printing presses. After all, if enough were printed it would soon be worthless. It is also impractical to tie the value of paper money to precious commodities such as gold or silver, since the supply of these commodities does not always keep pace with economic growth. Governments discovered that when these metals didn't keep pace with growth there was usually insufficient currency to finance investment and consumption. Therefore, the Fed relies on its legal authority to manipulate "fiat money": paper currency, coins, funds in checking and savings accounts, and other legally accepted forms of exchange.
The Federal Reserve System manages the money supply in three ways:
Reserve ratios. Banks are required to maintain a certain proportion of their deposits as a "reserve" against potential withdrawals. By varying this amount, called the reserve ratio, the Fed controls the quantity of money in circulation. Suppose, for example, it orders banks to hang on to an extra 1 percent of their deposits. They would then have 1 percent less to lend. One percent may not sound like a lot, but it translates into billions of dollars that are siphoned out of the economy.
Discount rate. When banks temporarily overcommit themselves, they occasionally have to borrow from the Fed to secure the necessary funds to meet their reserve requirements. The interest rate charged for these loans is the discount rate, and it too affects the money supply. If the Fed raises the discount rate, banks cannot afford to borrow as heavily as before and have to curtail their lending and raise their own interest rates. That results in less money flowing into the economy. Conversely, if the Fed relaxes its discount rate, financial institutions have more dollars for their customers. Seen from this perspective, the discount rate has a snowball effect: Raising it means that other interest rates go up as well and, other things being equal, economic activity slows down; lowering it has the opposite effect.
Open-market operations. By far the most important of the Fed's activities are open-market operations, the buying and selling of government securities. After Congress approves an increase in the national debt, the Treasury Department prepares a mix of bonds, bills, and notes that it auctions to private dealers who are authorized to trade government securities. When it wants to influence economic activity, the Fed buys or sells these assets through its Federal Open Market Committee (FOMC) or open-market desk, as it is commonly known.
The process works this way: If the Fed decides to increase the money supply, its open-market manager buys back treasury securities from private dealers, paying for them by simply crediting their bank accounts. It does not transfer any actual cash. (This power distinguishes it from all other financial institutions and gives it its clout.) The dealers' banks now have more money to lend, and these loans ultimately find their way into more banks, which pass a portion of them on to additional borrowers. The Fed's initial purchase thus has a multiplier effect as money ripples throughout the economy. Of course, the process is reversed when the Fed sells off some of its securities, because it in effect deducts the price from the purchasers' accounts, leaving their banks with fewer deposits.
The main idea is that the Fed's accounting maneuvers, not switching the printing presses on and off, produce increases or decreases in the money supply.
The Fed and the Political System How one interprets the Fed in relation to various models of who governs, such as pluralism or the power elite, depends on how much independence from political influence one thinks the system has. On paper the Federal Reserve System appears to be relatively autonomous, since it receives its operating revenues from its constituent banks, not from congressional appropriations, and since its governors, once in office, cannot be dismissed by the president. The governors' long terms mean that an occupant of the White House cannot expect to pick a majority of the governors. The Fed, moreover, conducts its meetings in private and is under no legal obligation to report to the executive branch. Given these conditions, one might think it could escape public accountability altogether.
Yet the Fed is also the creation of Congress, which takes a strong interest in its work and can always amend its charter. Furthermore, as a practical matter, the Fed's officers have to interact daily with senior executives in the Treasury Department, the OMB, and other agencies. The chair frequently testifies before legislative committees and regularly consults with the president's staff. All members of the board of governors realize the value of maintaining support at both ends of Pennsylvania Avenue because they know determined political opposition can undercut their policies. In short, the Federal Reserve's statutory independence does not immunize it from political pressures.
The ill-defined boundaries between the Fed and the rest of the Washington establishment leads to endless debates about its autonomy. Some observers emphasize the Fed's political nature, arguing that it pays close attention to the desires of the White House. Presidents normally want the money supply to flow freely enough to keep the economy booming and will pressure the Fed to achieve that result. Members of the board do not want to antagonize the chief executive and, if pressed, often cave in.
Some political economists go even further: They detect a political monetary cycle (PMC), during which the Fed relaxes monetary policy in the months before a presidential or congressional election, hoping that business will pick up and thus make the incumbent president's party shine in the eyes of the electorate. As soon as the campaign ends, however, it tightens the screws again to hold down inflation. According to this interpretation, the Fed rhythmically starts and stops the economy for partisan purposes. If true, the existence of a PMC would suggest that the Fed is at least indirectly accountable to the people, as democratic theorists hope.
Others, however, doubt the Fed's susceptibility to presidential influence and question the whole PMC concept. It seems unlikely, they claim, that the Fed would act so blatantly on anyone's behalf because such partisan behavior would tarnish its reputation in financial circles for competence and objectivity. It is also doubtful whether the Fed has sufficient data and knowledge to fine-tune the supply of money on short notice. Monetarism, in the last analysis, is a broadsword, not a scalpel, and cannot be wielded with the precision assumed by the PMC hypothesis. Finally, several empirical studies dispute the existence of a political monetary cycle. One economist said that he could not uncover a "single episode...in the Fed's history to suggest that [it] had bowed to presidential election pressures, and a lot of episodes to suggest that it resists them."
If the Federal Reserve System avoids the tugs of partisanship, what factors do affect its actions? It could be argued that it has many of the trappings of a power elite. In the first place, monetary policy is by any reasonable standard a trunk decision. The availability of money and magnitude of interest rates affect employment, prices, savings, investment, growth, and productivity and hence touch the lives of everyone from the smallest consumer to the largest corporation. These policies are developed and enforced by the Fed's board of governors and its operating arm, the FOMC, two tiny, nonelected groups of men and women with close connections to the banking and financial communities. Indeed, the background of the Fed's highest officers is one of its most distinguishing features. Though many of them come from modest origins, they have spent the bulk of their careers in major banks and Wall Street investment firms and many, like former Fed Chairman Paul Volcker and the present chair, Alan Greenspan, have shuttled back and forth between jobs in these private financial institutions and important positions in the U.S. government.
Spending one's life in banking, business, and commerce creates the sorts of loyalties the power elite school predicts. One expert, who does not necessarily accept the power elite thesis, nonetheless lends it credibility when he writes that "Federal Reserve officials work in a milieu that is significantly shaped by the interests and concerns of the commercial banks."
In brief, as much as fiscal policymaking seems to conform to the pluralist interpretation of American politics, monetary policy approximates the power elite model. Yet before accepting either of these theories, we need to see what influence the public as a whole exerts.
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