What is the Federal Reserve?
The Federal Reserve, often referred to as “the Fed,” is the central bank of the United States. It was created in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system.
The Federal Reserve is composed of three key entities:
- The Federal Reserve Board of Governors: Consists of seven members who oversee the Federal Reserve System. They are appointed by the President of the United States and confirmed by the Senate.
- Twelve Regional Federal Reserve Banks: Located throughout the U.S., serve as the operating arms of the Federal Reserve System. They are supervised by the Federal Reserve Board of Governors.
- The Federal Open Market Committee (FOMC): It is made up of the seven Board of Governors members and five of the regional Federal Reserve Bank presidents. This body is responsible for directing open market operations and setting the country’s monetary policy.
Together, these entities work to achieve the goals of maximum employment, stable prices, and moderate long-term interest rates as mandated by Congress under the Federal Reserve Act.
In doing so, the Federal Reserve manages the nation’s monetary policy, ensures the stability of the financial system, supervises and regulates financial institutions, fosters the safety and efficiency of payment and settlement systems, and promotes consumer protection and community development.
How Does the Federal Reserve Work?
The Federal Reserve utilizes several monetary policy tools to achieve its dual mandate goals of maximum employment and price stability:
- Open Market Operations: By buying and selling U.S. Treasury securities and other assets, the Fed adjusts the level of bank reserves and controls short-term interest rates.
- Reserve Requirements: The Fed sets the minimum amount that depository institutions must hold in reserve against deposits made by their customers. This helps control the economy’s overall monetary supply.
- Interest Rates: Several key interest rates are directly controlled by the Federal Reserve, including the federal funds rate, discount rate, and interest paid on reserves. Adjusting these rates influences broader financial conditions.
- Forward Guidance: Official communications from the FOMC about the likely course of future interest rates are widely followed and shape the expectations of market participants.
- Asset Purchases and Sales: Buying and selling longer-term Treasury securities and agency mortgage-backed securities to ease or tighten broader financial conditions. These operations are commonly known as quantitative easing and tightening.
The FOMC meets regularly to assess economic conditions and determine the appropriate stance of monetary policy to take action that ultimately leads to achieving the Federal Reserve’s mandated goals.
The FOMC’s decisions are implemented by the Federal Reserve through its open market operations and interactions with the banking system.
Policy Tools Used by the Federal Reserve
There are various indicators that tend to be cited by media outlets and financial analysts that are directly associated with the Federal Reserve and that the FOMC keeps track of to make policy decisions.
These are some of the most relevant ones:
- Federal Funds Rate: The interest rate at which depository institutions lend reserve balances to other banks overnight. It is a key benchmark for short-term interest rates set by the FOMC.
- Balance Sheet Size: The total assets held by the Federal Reserve. It reflects the scale of lending programs, securities purchases, and other activities. At the onset of the COVID-19 crisis, the Fed’s balance sheet was about $4.2 trillion but expanded rapidly to more than $7 trillion.
- Reserve Balances: Deposits held by banks within the Federal Reserve system. The level of reserve balances held by banks and related interest rates paid on those balances are monetary policy tools used by the Federal Reserve. Prior to the 2007-2009 financial crisis, reserve balances were around $20 billion but now are maintained at over $3 trillion.
- Inflation and Unemployment Rates: As mandated by Congress, monetary policy decisions by the Federal Reserve seek to foster price stability and maximum employment in the U.S. economy over the long run. The Fed monitors various economic data, including prevalent inflation and unemployment levels, to gauge progress toward these goals.
Key Characteristics and Entities that Make Up the Federal Reserve
The Federal Reserve is made up of many moving parts and performs its actions through a variety of mechanisms, departments, and areas.
Here’s an overview of what the ‘backbone’ pieces of the Fed are and what they do.
Entities / Functions
These are the Federal Reserve Board of Governors, Federal Reserve Banks, and Federal Open Market Committee.
Reserve Bank Districts
The nation is divided into 12 Federal Reserve Districts, each with its own Federal Reserve Bank that is responsible for gathering economic intelligence, conducting bank examinations, distributing fiat currency, and carrying out other centralized Federal Reserve functions.
The five core functions carried out by the Federal Reserve are: conducting monetary policy, promoting financial stability, supervising/regulating banks, facilitating the payments system, and promoting consumer protection.
Depository Institutions in the Federal Reserve System
Institutions like commercial banks that hold deposits maintain accounts at the Fed and participate in the U.S. banking system. They include state-chartered and nationally-chartered banks acting as members or non-members of the Federal Reserve System.
Groups like the Federal Advisory Council, Community Depository Institutions Advisory Council, and others provide input to the Federal Reserve on the state of specific economic sectors or issues like community development.
Financial institutions and utilities like bank/financial holding companies, savings and loan holding companies, state banks, and systemically important financial market utilities are overseen by the Federal Reserve to ensure that they are operated adequately to guarantee the stability of the financial markets.
Actions Performed by the Federal Reserve to Comply With Its Mandates
In practice, the Federal Reserve engages in various activities that foster economic stability and seek to achieve its dual mandate.
Here’s how the Fed regularly acts.
- Setting Monetary Policy
The Federal Open Market Committee holds regular meetings to assess economic conditions and determine the appropriate target level or range for short-term interest rates to achieve its maximum employment and stable inflation goals.
- Providing Liquidity
The Federal Reserve’s lending programs, like the discount window, provide short-term liquidity directly to eligible banks by using collateral while open market operations adjust conditions more broadly in the financial markets. This lending activities are considered backstops for the financial system.
- Supervising Institutions
Teams of bank examiners at each regional Federal Reserve Bank evaluate the financial condition, risk management practices, and regulatory compliance of various banks and financial institutions. If unsafe practices are identified, the Fed can take corrective action.
- Facilitating Payments
Services operated by the Federal Reserve, like Fedwire, FedACH, and check clearing, support the completion and settlement of retail and wholesale payment transactions worth trillions of dollars each day.
- Performing Economic Research
Federal Reserve economists monitor financial system developments, conduct research on monetary policy alternatives, assess risks to the economic outlook, and measure factors like consumer expectations to support informed policymaking.
- Engaging the Public
Federal Reserve policymakers give speeches, testimonies, and interviews to communicate about recent policy actions. The Fed also solicits community input through advisory councils and pursues initiatives to enhance economic inclusion.
Pros of the Federal Reserve
The Federal Reserve is an institution that has clear mandates and functions, here’s why it has helped the US economy thrive for many decades.
Mitigates Financial Crises
The Federal Reserve can act as a lender of last resort during financial crises by providing credit to banks and stabilizing panicking financial markets. This prevents the failure of otherwise solvent banks and the collapse of the financial system.
Provides Banking System Liquidity
Federal Reserve intraday credit and lending facilities help ensure the smooth functioning of the banking system and money markets. This supports economic growth.
Reduces Economic Volatility
Adjustable monetary policy counteracts business cycle fluctuations, reigning at times when there’s excess inflation or cutting interest rates to boost employment during downturns to help stabilize the economy.
Promotes Public Confidence
An independent central bank isolated from short-term political pressures can make policy decisions that promote long-term economic prosperity and stability better than other government agencies.
Brings Regional Perspectives
The presence of 12 regional Reserve Banks means that diverse business and community forces from all areas of the nation contribute to policy deliberations. This results in decisions that are typically more responsive to economic conditions nationwide.
Criticism Against the Federal Reserve and Its Mission
Despite the Fed’s success at managing the economy during complex cycles and downturns, there’s criticism regarding the scope and reach of its operations, including those below.
The Federal Reserve plays an integral role in stabilizing the banking system, regulating financial institutions, steering the U.S. economy, and containing systemic risks.
The Fed wields significant influence over economic, business, and consumer activity in the United States and globally.