What is the Federal Reserve and What Does it Do?

An Overview

The Federal Reserve is the central banking system of the United States. It consists of three separate entities: the Board of Governors, the Federal Open Market Committee, and 12 regional Federal Reserve Banks. The Federal Reserve is both private and public. The Board of Governors is an independent governmental organization while the Federal Reserve Banks are set up like private corporations. With three distinct parts forming one quasi-governmental organization, “the Fed,” as it is affectionately called, is the Holy Trinity of monetary policy. The Federal Reserve works to preserve the financial stability of the U.S. economy.

The members of the Board of Governors are appointed by the President of the United States and approved by the Senate and the Federal Reserve Banks and Branches — the Fed’s operating entities across the country. The Board of Governors is directly accountable to Congress. The board consists of seven members who are experienced in economics and banking. Currently, Jerome Powell is the chairman of the Board of Governors.

The Federal Open Market Committee, or FOMC, consists of the members of the Board of Governors and the individual Reserve Bank Presidents. The chair of the Board of Governors is also the FOMC chair. The FOMC is the monetary policy-making body of the Federal Reserve System.

The 12 Reserve Banks, each with their own President, oversee the regional banks and are responsible for ensuring the wellbeing of the banking system in their region while promoting the interest of the people in central banking.

The Federal Reserve as a whole serves five key functions:

  1. Conducting the nation’s monetary policy
  2. Helping maintain the stability of the financial system
  3. Supervising and regulating financial institutions
  4. Fostering payment and settlement system safety and efficiency
  5. Promoting consumer protection and community development

Conducting monetary policy is what the Federal Reserve is most known for. Congress has provided three goals for the Federal Reserve to achieve through central banking: maximum employment, stable prices, and moderate long-term interest rates. The Fed conducts monetary policy by implementing strategies to control the level of short-term interest rates and the cost and availability of credit in the economy. This directly affects interest rates and indirectly affects stock prices, wealth, and currency exchange rates.

The Federal Reserve buys and sells securities issued or backed by the U.S. government on most business days in order to stay on target in keeping the short-term money market interest rate — called the federal funds rate — at the level set by the FOMC. The effective federal funds rate is the rate by which depository institutions like banks and credit unions can borrow from and lend to each other to meet business objectives. This rate has varied widely over time in response to economic conditions. During the financial crisis in 2007, the Federal Reserve brought interest rates near zero in order to encourage lending and help restart the economy.

Another crucial aspect to the Federal Reserve’s monetary policy is that inflation must be kept stable and low. Inflation is the tendency of money to lose value over time. The Fed wants confidence in the U.S. dollar to remain strong and utilizes monetary policy to keep prices stable. This keeps the economy operating efficiently and allows both households and businesses to make accurate long-term financial decisions. The Federal Reserve aims to keep inflation at 2% per year over the long run.

Maximum employment is just what it sounds like — keeping as many Americans employed as possible. The FOMC does not set a specific goal for employment since there are many factors such as policy, population, and workforce developments that affect it. Four times each year, the FOMC releases their Summary of Economic Projections in which all FOMC participants lay out their opinions on economic outlook, record the unemployment rate, and forecast future unemployment.

Interest rates and employment are connected within the Federal Reserve’s monetary policy goals. Low interest rates promote employment, although there are times that inflation becomes more of a concern to the FOMC than employment, requiring a change in policy and sometimes the raising of interest rates.

A Brief History

The first attempt at central banking was in 1791 when Alexander Hamilton urged Congress to establish what would become the First Bank of the United States. Headquartered in Philadelphia, Pennsylvania, the bank was a massive corporation that was dominated by big money interests. This caused many Americans to be fearful of the bank’s power. When the bank’s charter expired after 20 years, Congress did not renew it.

A number of financial panics proceeded the second attempt at central banking — one in 1863 and one in 1907. In both instances, financial mogul J.P. Morgan was called upon to intervene and in 1907 he worked to solve the problem by organizing bankers to funnel money from large institutions to smaller ones. These crises increased support among most Americans for a new central banking system.

In 1912, President Woodrow Wilson was presented with a new piece of legislation entitled the Federal Reserve Act when Virginia Representative Carter Glass, who would soon become the chairman of the House Committee on Banking and Finance, and Parker H. Wells, a former professor of economics at Washington and Lee University, created the central bank proposal. The Federal Reserve Act of 1913 established the Federal Reserve System as the central bank of the United States in order to provide the nation with a safe, stable, and flexible monetary and financial system. The law clearly defines the purposes and structure of the system, and Congress has the power to amend the act, which it has done multiple times over the years.

Modern Concerns

Due to the effects of the COVID-19 pandemic, Congress has passed multi-trillion-dollar stimulus packages that the Federal Reserve must support by purchasing a projected $3.5 trillion in government securities with newly-created dollars in an effort to prop up the economy, according to Oxford Economics.

The Federal Reserve can virtually create new money to pay down its own debt, and with the nation’s overall debt currently topping $25 trillion, one must wonder when the cycle will stop. The fear of hyper-inflation and a financial “bubble” is dominating the news cycle and the Twitter feeds of many Americans. Younger Americans are rushing to cryptocurrency while older folks buy gold in an effort to protect their financial assets from inflation.

No one knows what is going to happen in the long run, but the Federal Reserve is adamant that the current inflation spike is transitory. Due to supply chain issues amid the worldwide pandemic, the Fed believes that the soaring prices in commodities like lumber and copper will eventually subside. At this point in time, the Fed is more concerned with unemployment as many Americans lost their jobs during the pandemic and millions filed for unemployment benefits. The Fed projects inflation to recede to normal levels and is prioritizing the reopening of the economy. According to Fed chairman Jerome Powell, interest rates are not expected to be raised until sometime between 2022–2023.

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