Federal Reserve (Fed)

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.

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	Description
Key Entities	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.
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.
Advisory Councils	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.
Supervised Entities	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.

Pros	Description
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.

Criticism	Description
Potential Overreach	Some argue that the Federal Reserve has too much discretionary power over interest rates and the financial system with insufficient oversight. This could theoretically allow it to implement experimental policies with negative economic consequences without proper checks and balances.
Politicized Decision-Making	While technically independent, there are concerns that the non-elected Federal Reserve Board members may still be influenced by political considerations and lobbying instead of basing their decisions purely on objective economic analysis.
Ineffective Tools	The Fed’s monetary policy actions may have more limited effectiveness during extremely sluggish economic environments when interest rates are near zero. This can constrain its ability to meet policy goals.
Lagging Crisis Response	Bureaucratic processes may delay the necessary interventions during rapidly unfolding financial crises.
Accommodative Policy Risks	If mismanaged over an extended period, a highly accommodative monetary policy could run the risk of allowing excessive inflationary pressures to build up.

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.