The Federal Reserve is the central bank of the United States. It is often referred to as the Fed and is an independent entity that was established by Congress on December 23, 1913. Prior to the Fed’s inception, the U.S. did not have a formal organization for examining and implementing monetary policy.
The Federal Reserve is actually a group of entities, known as the Federal Reserve System, with 12 regional central banks located in major cities across the US.
The framers of the Federal Reserve Act purposely rejected the concept of a single central bank.
Instead, they provided for a central banking “system” with three primary features:
- A central governing Board.
- A decentralized operating structure of 12 Reserve Banks.
- A combination of public and private characteristics.
The goal of the Fed is to promote sustainable economic growth, high employment rates, moderate long-term interest rates, and preserve the purchasing power of the U.S. dollar.
It performs five general functions to promote the effective operation of the U.S. economy and, more generally, the public interest.
The Federal Reserve:
- conducts the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.
- promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad.
- promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole
- fostering payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments.
- promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.
Structure of the Federal Reserve System
Although the Fed is an independent organization, it is subject to oversight by Congress.
There are three key entities in the Federal Reserve System:
- The Board of Governors
- The Federal Reserve Banks (Reserve Banks)
- The Federal Open Market Committee (FOMC)
The Board of Governors, an agency of the federal government, and made up of seven presidential appointees.
It reports to and is directly accountable to Congress, provides general guidance for the System, and oversees the Reserve Banks.
There are 12 Federal Reserve banks in the United States.
In establishing the Federal Reserve System, the United States was divided geographically into 12 Districts, each with a separately incorporated Reserve Bank.
District boundaries were based on prevailing trade regions that existed in 1913 and related economic considerations, so they do not necessarily coincide with state lines.
The banks generate income from:
- Earned interest on government securities.
- Services provided to banking institutions.
- Foreign currency income.
- Earned interest on loans to depository institutions.
This income is used to finance the Fed’s operations. Any surplus is deposited back into the U.S. Treasury. The United States is the Federal Reserve’s biggest banking customer.
The bank handles all revenue generated by tax dollars and all government payments are managed through the Federal Reserve’s banks. Additionally, the Fed sells and redeems government securities, which include bonds, notes, and Treasury bills.
The Federal Reserve banks issue all paper and coin currency and take currency out of circulation when damaged from wear and tear.
The Federal Open Market Committee, or FOMC, meets at least eight times per year to decide whether monetary policy should be modified by lowering or raising the federal funds rate, the rate at which banks lend money to one another overnight to meet loan reserve requirements.
Within the Federal Reserve System, certain responsibilities are shared between the Board of Governors in Washington, D.C., whose members are appointed by the President with the advice and consent of the Senate, and the Federal Reserve Banks and Branches, which constitute the System’s operating presence around the country.
While the Federal Reserve has frequent communication with the Executive branch and congressional officials, its decisions are made independently.
Federal Reserve and Monetary Policy
The Federal Reserve of the United States has a number of methods for influencing the American money supply. Chief among these is the power of the Fed to increase or decrease the amount of currency in circulation.
The Fed can purchase or sell government securities to its primary traders, which brings additional Federal Reserve Notes into circulation or removes excess paper money from the supply.
The Fed also works with the U.S. Mint to print additional paper money, or to destroy unneeded currency.
Another of the Fed’s financial powers is its ability to influence the short-term interest rate. The Fed does this by changing the default rate at which it loans money to fellow banks.
Since the Fed’s default rate is one of the major factors in determining the nationwide prime interest rate, the Fed’s actions can indirectly increase or decrease the yield from interest-accruing assets.
This, in turn, plays a role in determining investor behavior, and the trends of the market as a whole. In more detail, the rate that the Fed lends money to depository institutions is called the Discount Rate.
That is set above the ”nominal rate” which is the rate that the depository institutions lend money to each other to meet reserve requirements at the Fed. The nominal rate is what is commonly known as the Federal Funds Rate. It is set by open market operations.
Since the money supply is a factor in determining the overall trade balance between currency markets, foreign exchange traders keep a close eye on the actions of the Federal Reserve.