United States Federal Reserve

The U.S. Federal Reserve - known colloquially as “the Fed” – is the Central Bank for the U.S. banking system. Established by the Federal Reserve Act of 1913, the Federal Reserve is responsible for conducting the nation’s monetary policy, supervising the banking system, and managing the production and distribution of U.S. currency. While the Federal Reserve is afforded a high degree of autonomy with respect to monetary policy, the Fed is ultimately accountable to the government and the President.^[1]

Federal Reserve History

During the late nineteenth and early part of the twentieth century, the U.S. economy suffered several bank failures that forced business closures and other disruptions to the economy. Banking was, for the most part, unregulated during this period, and when combined with the system’s inability to provide adequate liquidity to depository institutions in times of crisis, many banks were unable to meet their demand deposit liabilities. During the “Great Depression” of the 1930s, over 10,000 banks failed because of a lack of liquidity.

In small towns throughout much of the U.S. at this time, the local bank was the only supplier of hard currency and a sudden increase in demand often resulted in a lack of cash for the local economy. Keep in mind that this was before the widespread availability of credit so businesses and consumers both relied on cash to pay their bills and provide for their families. A shortage of currency was a genuine hardship which sometimes even led to payment defaults, personal and corporate bankruptcies, and other serious economic hardships.

In response to these and other problems in the system, the U.S. Congress passed the Federal Reserve Act which created an official central bank for the United States. The Federal Reserve Act called for the “establishment of Federal Reserve banks, to furnish an elastic currency, to afford means rediscounting commercial paper, to establish more effective supervision of banking in the United States, and for other purposes”.^[2]

The act was signed into law on December 23rd, 1913 by President Woodrow Wilson. In this act lay the groundwork for what would become the U. S. Federal Reserve System. Although created primarily as a means to ensure sufficient short-term financing for the U.S. banking system, it soon became clear that the act had much wider implications through the passing of a series of additional acts including:

• The Banking Act (1935)
• The Employment Act (1946)
• The Bank Holding Company Act (1956)
• The International Banking Act (1978)
• The Monetary Control Act (1980)
• The Financial Institutions Reform, Recovery, and Enforcement Act (1989)

Federal Reserve Mandate

With the changes and updates to the original Federal Reserve Act of 1913, the role of the Federal Reserve System expanded dramatically from its original design. The Federal Reserve now defines its mandate as consisting of the following goals:^[3]

1. Conduct the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices
2. Supervise and regulate bank institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers
3. Maintain the stability of the financial system and contain systemic risk that may arise in financial markets
4. Provide certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation’s payments systems

Accountability

The Federal Reserve System is responsible for implementing a monetary policy that meets the government’s fiscal policy goals, but it still exists as an [[Monetary Policy and the Role of the Central bank|independent central bank.] This ensures that monetary decisions made by the Federal Reserve such as the setting of short-term interest rates, do not require ratification by the President or other members of the executive branch of the U.S. government.

Despite the Federal Reserve’s ability to implement monetary policy without specific approval, it is still subject to oversight. Regular reviews of the Federal Reserve are conducted by Congress which has the power to impose changes to the overall responsibility of the Federal Reserve by way of statutes. The Federal Reserve is also expected to work within clearly prescribed guidelines that support the government’s economic and financial objectives.

Funding for the Federal Reserve

When the Federal Reserve Act was created, a key stipulation required that the Federal Reserve System remain as sheltered as possible from the pressures of every day politics. In addition to allowing policy decisions to be implemented without direct government approval, the Act also made provisions for the Federal Reserve to be self-funding thereby eliminating the need for Congress to provide funds for its operation. This removes Congressional expenditure reviews that other government bodies must face, but in order to ensure financial accountability, independent reviews are conducted by an outside auditor.

The Federal Reserve receives much of its income through interest earned from investments in U.S. government securities acquired on the open market. It also receives interest on foreign investments, fees paid by depository institutions for services including check clearing, funds transfers, and interest on loans to the depository institutions. Any profit remaining from these resources after the Federal Reserve pays its operating expenses, are turned over to the U.S. treasury.

When Congress first considered the creation of the Federal Reserve System, one of the main priorities was to ensure representation and input from all regions of the country. In order to provide this, an approach featuring a strong central agency with oversight over a series of regional Federal Banks was proposed. The structure that was settled upon consisted of the establishment of a Board of Governors comprised of members from the regional banks.

Federal Reserve Board of Governors

The Federal Reserve Board of Governors consists of seven members all appointed by the President of the United States to fourteen-year terms. In order for the appointments to take effect, they must also be confirmed by the U.S. Senate. Each appointment to the Federal Reserve Board of Governors is for a fourteen-year term, and appointments are staggered to ensure that the Board does not lose several experienced Governors at the same time.^[4]

Bank System Supervision

The Board of Governors is head-quartered in Washington D.C. and is responsible for determining the course of action with regards to the nation’s monetary policy. The Board of Governors also participates in the supervision and regulation of the banking industry and there are approximately nine hundred member banks in the Federal Reserve System. In addition, there are over five thousand bank holding companies and national banks that are required by law to operate under the Federal Reserve jurisdiction.

Chair and Vice-Chair Appointments

The President nominates a Chair and Vice-Chair for the Federal Reserve, and these appointments require the confirmation of the Senate. These terms are for four years and the nominees must be members of the Board or appointed to the Board at the same time they are nominated for the Chair or Vice-Chair positions.

Unlike the Board of Governors who cannot be re-appointed once they complete their fourteen-year term, the Chair and Vice-Chair can serve multiple terms. Alan Greenspan for instance, served as Chairman from 1987 until he was replaced by Ben S. Bernanke on February 1st, 2006.

Advisory Committees for the Board of Governors

There are three committees that advise the Board of Governors on matters of monetary policy:^[5]

1. Federal Advisory Council

The Federal Advisory Council advises the Board on all matters that fall within the Board’s area of responsibility. It consists of representatives of the banking industry and typically meets four times a year as required by the Federal Reserve Act. The meetings are normally held on the first Friday of February, May, September, and December and take place in Washington. Each regional Reserve Bank selects one individual to represent their region. Members of the Federal Advisory Council customarily serve three, one-year terms and the council selects its own officers.

2. Consumer Advisory Council

This council was established in 1976 and serves to advise the Board of Governors on its responsibilities under the Consumer Credit Protection Act specifically, as well as other consumer financial services matters. Members of this council represent both the interests of consumers and the financial services industry. The council meets three times a year in Washington, D.C. and members are appointed by the Board of Governors; members serve three-year, staggered terms.

3. Thrift Institutions Advisory Council

Thrift institutions are financial institutions formed primarily as a depository for consumer savings such as a savings and loans or mutual savings bank. Originally, thrift institutions were limited to using their deposit funds in the residential mortgage market but after the Depository Institutions Deregulation and Monetary Control Act of 1980, these institutions were permitted to offer a wider range of services including commercial and consumer loans. With this act, Federal Reserve requirements and access to the Discount Window were extended to the thrift institutions.

In order to ensure that the needs of the thrift institutions were being addressed within the Federal Reserve System, the Thrift Institutions Advisory Council was formed. This council meets three times a year in Washington, and consists of representative of savings and loans institutions, mutual savings banks, and credit unions. Members are appointed for two-year terms by the Board of Governors.

Advisory Committees for the Regional Federal Reserve Banks

The Regional Reserve Banks also use a system of advisory committees to provide specific feedback concerning matters of regional importance, and each regional Bank establishes its own advisory committee. Some of the more important committees provide updates on subjects including agriculture, small business, and labor.

Regional Federal Reserve Banks

To ensure representation from all areas, the Federal Reserve Act created twelve regional Federal Reserve Banks together with their associated branches. Individual Reserve Banks are located in districts across the country and each district is identified with a number. The Reserve Banks are located in the following districts:

Regional Reserve Bank Board of Directors

Each of the Regional Reserve Banks has a Board of Directors consisting of three Class A Directors, three Class B Directors, and three Class C Directors for a total of nine members. All Directors must be from outside the Federal Reserve Bank system, meaning that they must not be currently employed by the Federal Reserve Bank.

Class A and B Directors are elected by the commercial banks in the district to which they belong, and the Board of Governors in Washington appoints the three Class C Directors. Class A Directors represent the commercial banks while Class B and C Directors represent the interests of the public. The Directors of each Regional Reserve Bank nominate a President and Vice President and these nominations must be approved by the Board of Governors.^[6]

Duties of Regional Reserve Banks

The primary responsibility of the Regional Reserve Banks is to provide information for the specific region that the Bank represents to the Board of Governors. This information is used by the Federal Open Market Committee (FOMC) and the Board of Governors to plan monetary policy decisions.

The Board of Directors of each Regional Reserve Bank is also expected to recommend interest rates for the Bank’s Discount Window rate. The Discount Window is a monetary policy whereby the Reserve Banks lend money to depository institutions to provide appropriate liquidity to ensure smooth operation within the financial industry.

The Beige Book

Regional Reserve Banks print summaries of the economic conditions of their districts in what was originally known as the Red Book. This was designed for use by the Federal Reserve Board of Governors and was not intended for the public. However, in 1983, the information contained in the Red Book was made available, and the report was packaged with a different color cover to indicate the change in policy and it is now referred to as the Beige Book.

The Beige Book is released two weeks before each of the eight annual Federal Open Market Committee meetings. Each Federal Reserve Bank provides input on their region’s economic conditions and this information is summarized and included in the Beige Book.

Federal Reserve Monetary Policy

The Federal Reserve mandate as described by the Federal Reserve Act of 1913, includes the directive that the Federal Reserve shall “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”^[7] While on the surface these instructions appear rather vague, the truth however, is that national economies have evolved to become highly complex systems with a series of identifiable inter-dependencies. Referred to generically as monetary tools, these inter-dependencies enable central banks to concentrate on managing one aspect of the economy with the expectation of obtaining certain results in other areas of the economy.

The Federal Reserve has three main monetary tools at its disposal:

1. Federal Reserve Open Market Operations
2. The Discount Window Program
3. Federal Reserve Deposit Requirements

Federal Reserve Open Market Operations

The most effective tool available to the Federal Reserve – and the one it most often relies on – is the buying and selling of government securities on the open market. Known simply as Open Market Operations, the premise is that by buying and selling government securities such as treasury bonds, bills, and notes, the Fed can control the money supply.

For example, if the Fed wants to increase the money supply in a bid to stimulate the economy and encourage spending, the Fed will buy securities from financial institutions. The Fed pays for these transactions by crediting the institution’s account at its regional reserve bank. All member banks of the Federal Reserve System must have accounts with the Federal Reserve and mandated minimums must be maintained in the account.

By selling securities to the Federal Reserve, the institution receiving the funds now has a greater surplus of cash. This can be used to provide additional commercial loans or even to lend to other institutions with a temporary cash shortage. Cash shortages may arise from unexpected end-of-day processing that leaves an institution short on its required minimum deposit, which is a common occurrence. Institutions with cash shortages can turn to the overnight market (i.e. Federal Funds transfer) to borrow sufficient funds to meet reserve minimums. The interest on these loans is known as the Federal Funds Rate, and this rate naturally fluctuates in response to market conditions.

For example, when there is extra money available in the overnight market, the Federal Funds Rate will be lower as there is ample supply and lending institutions will lower their asking rate in order to be competitive. Because institutions can now borrow money at a lower interest rate, rates for other loans including commercial loans to business and consumers, may also fall which may lead to more spending.

This may seem like a very convoluted process, but it is really quite simple. By buying securities from commercial banks, the Federal Reserve supplies these institutions with more money which they can use themselves or lend to other institutions. Basic laws of supply and demand dictate that when supply exceeds demand, the price falls and this is exactly what is happening in this scenario.

Of course, the Fed may decide that it needs to slow economic growth due to inflationary concerns. In this case, the Fed will use Open Market Operations to decrease the money supply. To do this, the Fed sells government securities to financial institutions and debits the amount from the institution’s Federal Reserve account. This reduces the amount of cash that the institution has available to lend to other institutions or to use for commercial loans, leading to an increase in the Federal Funds Rate. Because it now costs financial institutions more to acquire funds, this additional cost is reflected in higher commercial loan rates which could reduce consumer and business spending thereby meeting the Fed’s original objective.^[8]

Federal Reserve Open Market Committee Members

Open market operations are managed by the Federal Open Market Committee (FOMC). This group is made up of twelve voting members, consisting of all seven members of the Federal Reserve Board of Governors and five of the twelve Regional Federal Reserve Bank presidents.

The president of the Federal Reserve Bank of New York is a full-time member of the FOMC, while the presidents of the other Reserve Banks serve rotating, one-year terms. You should note however, that all Reserve Bank presidents attend FOMC meetings to ensure input from all regions of the country. While Reserve Bank presidents not serving in the FOMC attend scheduled meetings, they do not participate in committee voting.

For 2008 and 2009, in addition to the seven Federal Reserve Board of Governors, presidents from the following Reserve Banks will be assigned to the Federal Open Market Committee:^[9]

The Federal Open Market Committee holds eight scheduled meetings each year. The FOMC members as well as the non-voting Reserve Bank members use these meetings to evaluate current economic conditions and determine projections for real and nominal growth for gross domestic product (GDP), unemployment rates, and inflation for the upcoming year. The findings of these meetings are delivered to Congress each February and July in the form of the Monetary Policy Report and should be considered mandatory reading for all currency traders. Archived Monetary Policy Reports are also available on the Federal Reserve website.

Discount Window Program

The Federal Reserve also supplies operational capital to depository institutions under the Discount Window program. Although the volume of discount window borrowing is minor in comparison to the amounts exchanged by way of the open market operations, the Discount Window interest rate is watched very closely by analysts. This is because the Discount Rate – that is, the interest rate the Federal Reserve banks charge for money lent through the Discount Window – is the only interest rate that the Federal Reserve sets directly.

While it may take time for the Fed’s open market actions to result in a change to interest rates, a change to the Discount Rate is a clear and transparent indication of a change in the monetary policy. For this reason, Discount Rate changes tend to impact commercial interest rates almost immediately.

There are three Discount Window loan types available for eligible depository institutions:

1. Adjustment Credit – to help depository institutions meet short-term liquidity needs
2. Seasonal Credit – to help depository institutions meet regular or seasonal swings in the demand for loans and deposits
3. Extended Credit – to help depository institutions meet longer-term liquidity needs arising from unexpected and exceptional circumstances

These loans are only available to qualifying institutions and must be for appropriate reasons and borrowers are expected to have exhausted all other, reasonable alternatives before applying to the Discount Window. Historically, the Discount Rate has been pegged about one percentage point above the Federal Funds rate, but in early 2003, the Federal Reserve made significant changes to the Discount Window program.^[10]

Due to increased administrative costs and the fact that some discount window loan types were not being used – extended credit loans for example had not been used since 1995 – the Fed determined that sub-federal funds rate discount window loans were not necessary given the other forms of short-term credit available. Use of the Discount Window has generally been very low as there is a "lender of last resort" aspect to the program that is sometimes seen as a confession of weakness on the part of the borrower.^[11]

Federal Reserve Deposit Requirements

The Fed also uses the minimum reserve amount it imposes on depository institutions as another means to influence interest rates. For those institutions that must borrow additional funds through the Federal Funds transfer system, increased demand could lead to an increase in the Federal Funds Rate. The additional cost incurred by the banks will then be passed on to corporate customers and individual consumers in the form of higher rates.

On the other hand, the Federal Reserve can cause a decline in commercial interest rates by lowering the reserve requirements. Reducing the reserve minimums results in extra money being available in the banking system, and this usually leads to a drop in the Federal Funds rate which then triggers a reduction in commercial rates.

Note that funds held in Federal Reserve accounts do not generate interest for the institutions. Therefore, it is to the institution's advantage to lend as much of their reserve surplus as possible even if at a reduced interest rate.

Demand for Federal Funds Balances

There are three primary factors that influence the demand for Federal Funds access:

1. Required Reserve Balances

As discussed earlier, all commercial banks, credit unions, and even U.S. branches of foreign-owned banks must maintain minimum reserve balances. The Federal Reserve establishes a minimum ratio of reserves and institutions that fall short, must borrow through the overnight market to remain compliant.

2. Contractual Clearing Balances

Depository institutions also use their reserve accounts to clear financial transactions. Due to the unpredictability of the amounts needed to clear transactions, institutions can find themselves in a deficit situation, forcing them to make use of the federal funds transfer system to make up the shortfall.

As noted earlier, institutions do not earn interest on funds they keep in their reserve Federal Reserve accounts. To assist depository institutions, the Federal Reserve allows for the creation of a contractual clearing balance – this is an agreed-upon amount the depository institution agrees to hold in addition to the required minimum reserve. This contractual clearing balance is used specifically for clearing transactions.

In return, the depository institution earns credits that can be used to offset some of the costs of the services provided buy the Federal Reserve and charged to the institution. These services include check clearing and wire transfer of funds and securities. Note that if the depository institution does not maintain the contractual clearing balance, an additional service charge could be levied against the institution.

3. Excess Reserve Balances

Understandably, depository institutions seek to keep excess funds in their reserve accounts as low as possible given that these balances do not earn interest. However, it may be necessary for a depository institution to purposely hold excess funds as additional protection against an overnight overdraft or to ensure there is no chance of falling under its reserve requirements or contractual clearing balance. This component of reserve fund demand is the least predictable as needs can vary greatly from day-to-day.

Related Links

Federal Reserve Website

FOMC Meeting Dates

Federal Reserve Chairman Ben Bernanke

Commentary - Subprime Mortgage Meltdown

Commentary - The Fed Gets Creative

References

1. ↑ Federal Reserve Learning website
2. ↑ Federal Reserve website
3. ↑ Federal Reserve website
4. ↑ "The Federal Reserve System Purposes and Functions" - published by the Federal Reserve Board of Governors, June 2005
5. ↑ "The Federal Reserve System Purposes and Functions" - published by the Federal Reserve Board of Governors, June 2005
6. ↑ Federal Reserve Bank of Richmond
7. ↑ Federal Reserve Act of 1913
8. ↑ "The Federal Reserve System Purposes and Functions" - published by the Federal Reserve Board of Governors, June 2005
9. ↑ Federal Reserve website
10. ↑ "Proposal to Revise the Federal Discount Program" - Federal Reserve Press, May 2002
11. ↑ "Recent Developments in Discount Lending" - James A. Clouse, Division of Monetary Affairs, Federal Reserve Bank