What is the Federal Reserve?
The Federal Reserve is one of those institutions that you can hear about a lot without knowing exactly what it is or what it does. The Federal Reserve, sometimes shortened to just "the Fed," features often in newspapers, TV news reports, and articles on economics, yet it is still rarely explained.
The simplest way to describe the Federal Reserve is to say that it is the country's central banking system. That definition is correct, but it still leaves you in the dark about just what that means and what the role of the Federal Reserve is in banking and the economy.
In fact, in the 1970s, Congress identified the role of the Federal Reserve in what is known as "the dual mandate." The first mandate of the institution is to maintain what is called "maximum employment." This doesn't mean making sure that every single person has a job but that employment is maintained at a healthy rate for a normally functioning economy. The second mandate is to balance prices with interest rates that are moderate.
Most countries have a central bank that is tasked with maintaining that country's monetary policies and regulations, and the Federal Reserve is no different in this respect.
The Federal Reserve was originally created in 1913 to bring stability to banking in the United States, but its role has expanded over the years.
Origins of the Federal Reserve
In the latter half of the 19th century in the U.S., panics that led to people trying to withdraw their money from banks en masse, known as "runs," became increasingly frequent. As is the case today, banks generally did not keep enough cash around to allow every single customer to make a full withdrawal at the same time, so runs could lead to bank failures. In addition, runs had a tendency to multiply, spreading to other banks.
When a 1907 panic led to a crisis so severe that the financier J.P. Morgan had to step in to prevent a collapse of the system, demands for reform grew much louder. From those demands, in 1913, Congress passed the Federal Reserve Act with the support of President Woodrow Wilson, and the Federal Reserve was created.
Just as banking systems have changed over the years since the creation of the Federal Reserve, the Federal Reserve itself has evolved, but it still retains its main function of keeping the country's financial system in good working order.
Further breaking down the goals and duties of the Federal Reserve can help in understanding what it does. The Fed is responsible for regulating banks and ensuring that the rights of consumers are protected.
One of the places where people are most likely to hear about the Federal Reserve is when it comes to interest rates. The Fed raises and lowers interest rates, but this must be balanced against controlling inflation and maintaining employment rates. The monetary policy set by the Federal Reserve is not the sole influence on inflation and employment, but it is significant.
The Federal Reserve is supposed to operate independently of politics. It funds itself rather than relying on government funding by charging fees to banks and earning interest on loans and securities.
It does not need to go to Congress or the President for policy approval. It is audited annually and provides regular reports to Congress. In addition, it is possible for Congress to make changes to laws regarding the Federal Reserve.
Structure of the Federal Reserve
There are two parts to the Federal Reserve: a seven-member Board of Governors and 12 regional banks, each in its own district with a bank president. The Board of Governors is also called the Federal Reserve Board.
Everyone on the Board of Governors is appointed by the President, but in an effort to avoid any one president having a substantial amount of power, they are not all appointed by the same president. One person's term expires every two years.
While a term of service is 14 years, it is actually possible for someone to serve for longer if they are first appointed to finish someone else's term and then appointed to serve their own 14-year term.
There are several other requirements. Governors are supposed to come from different industries to ensure that all interests are represented, so an appointee might be from the commercial, agricultural, financial or industrial sector. They must each be from different Federal Reserve Districts.
This team of seven governors does not work in isolation. Economists and other staff work alongside them to create and implement economic policy.
The Chair of the Federal Reserve is the most prominent person in the organization. Generally, even if you are largely unfamiliar with the workings of the Fed, you hear the name of the Chair mentioned frequently if you stay on top of national current events.
The 12 cities where the regional banks are found are Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco.
The importance of these regional banks in the overall structure means that the Federal Reserve is--despite being a central bank--less centralized than that of most other countries although this is consistent with the smaller role of the federal government throughout the U.S. Regional banks and branches also have boards of governors.
Federal Reserve Banks do not operate like your own local bank branch. Their role is to act as a kind of bank for the federal government itself, to work with commercial banks by lending money, processing payments and distributing actual physical money--coins and bills--to commercial banks.
Within these two bodies that form of the structure of the Federal Reserve, there is also the Federal Open Market Committee. The FOMC is a policymaking body that consists of the Board of Governors plus the Federal Reserve Bank of New York's president. In addition, the presidents of four other regional banks rotate through positions on the committee. Although you may not realize it, it is the actions of this body that you are probably most familiar with since the FOMC determines when interest rates will be raised or lowered.
The functions of the Federal Reserve can seem esoteric if you are not already interested in economics in the first place, but in fact, the institution's policies have an effect on the lives of everyone living in the U.S. The interest rates on your loans, the availability of jobs and inflation are all tied to Federal Reserve policy and decisions. Understanding this can help you better understand the state of the economy in general.