Understanding the Federal Reserve System

The Federal Reserve Systems, popularly known as The Fed, is the central bank of United States that acts as a public authority in regulating the nation’s depository institutions and controlling the quantity of money in circulation.  The Fed does not provide banking services directly to the individuals and businesses, but serves as a banker to the government and banker to banks like Citibank, Bank of America, Wells Fargo, etc.  In the recent past, we have heard a number of criticisms in the news about the Fed’s action during the recession and blaming it on its chairman Ben Bernanke.  Although, Mr. Ben Bernanke comes to our mind when we think about the Fed, we need to understand that behind Bernanke there are a number of economists and technical experts advising and briefing him about various monetary issues.  So it would be good to understand the composition, objectives, goals, and monetary tools of the Federal Reserve, which this article talks about. 

The Goals of the Fed

To define broadly, the main goal of the Fed is to contribute towards the long term economic growth of the country through its monetary policies.  To support the long term growth of United States, the Fed needs to keep inflation under control, maintain full employment level, and moderate the fluctuation in business cycles.  Although the Fed tries to get closer on meeting its goals, it is impossible for them to meet all the targets in a given point in time.  And financial market participants have a range of opinions on Feds success in improving the economic performance of the country.  To achieve its main objectives, the Fed mainly uses its monetary tools like Open Market Operations, Fed Funds Target Rate, and Reserve Requirement, which would be talking about later in this article.

The Structure of the Fed

The Board of Governors
The Regional Federal Reserve Banks
The Federal Open Market Committee

The Board of Governors of the Federal Reserve System is composed of seven members, who are appointed by the President of United States and confirmed by the Senate.  The full term for each board member is fourteen years, and the appointments are staggered so that it expires every two years on January 31st.  After serving a full term, a board member may not be re-appointed for another.  The President appoints one of the board members as the chairman for a term of four years and the terms are renewable. The Board and, under delegated authority, the Federal Reserve Banks, supervise approximately 900 state member banks and 5,000 bank holding companies.

The Federal Reserve Banks: A network of twelve Federal Reserve Banks provide check-clearing services to commercial banks and other depository institutions, hold the reserve accounts of commercial banks, lend reserves to banks, and issue currency notes. The boards of the Reserve Banks, a group of nine directors from outside the Banks, are intended to represent a cross-section of banking, commercial, agricul¬tural, industrial, and public interests within the Federal Reserve District.  And the New York Fed occupies a special place in the Federal Reserve System because it implements the policy decisions of the Federal Open Market Committee (FOMC).

The Federal Open Market Committee is composed of the seven members (including the Chairman) of the Board of Governors and five of the twelve regional Federal Reserve Bank presidents, which includes the New York Fed president who is a permanent member.  This committee meets every six weeks to discuss the state of the economy and decide on the appropriate policy actions that need to be performed.

Looking at the brief description of the structure of the Fed gives us an impression that all the power resides with Board of Governors, but it is the Chairman of the Board who has the largest influence on the Fed’s monetary policies.  The current Chair of the Fed, Mr. Ben Bernanke, a former Professor of Economics at Princeton University, was initially appointed in 2006 by then President George W. Bush and re-appointed in 2010 by President Barrack Obama.   The power of influence of the chairman (Mr. Ben Bernanke) of the Fed mainly stems from three sources.  First, the chairman controls the agenda and dominates the meeting of the FOMC.  Secondly, he contacts with economists and technical experts on a day-to-day basis to get a detailed briefing on monetary policy issues.  Lastly, the chairman is the main spokesperson for the Fed to the President and government of United States, and other Foreign Country governments and central banks.

The Federal Reserve Policy Tools

Earlier in the article, we touched upon the different objectives and goals of the Federal Reserve in achieving strong economic growth of country.  To achieve its objectives and goals, the Fed has a number of monetary policy tools that it uses to create a stable economic environment that is beneficial for businesses and citizens of the country. The three key tools are Discount Rates, Open Market Operations, and Required Reserve Ratio.

Required Reserve Ratios:  The minimum percentage that all the depositary institutions must hold as reserves with the Fed is called the required reserve ratio.  The Fed determines the required ratios for different types of deposits.  Reserve requirements are imposed on all depository institutions, which include commercial banks, savings banks, savings and loan associations, and credit unions, as well as U.S. branches and agencies of foreign banks.  The Fed can increase or decrease the Reserve Ratio depending on the economic environment.  If Fed wants to conduct an expansionary policy, it lowers the reserves requirement for banks.  A lower reserve ratio for banks means that they have more funds to lend out to businesses and consumers, which results in increase in money supply into the economy.

Discount Rate (Fed Funds Rate):  Fed Funds rate is the interest rate that Federal Reserves lends reserves to the member depositary institutions.  Like the above, if Fed wants to conduct an expansionary policy by increasing the money supply, they would decrease the Fed Fund rate (a rate that bank charge each other for overnight loans).  A reduction in fed funds rate induces the Prime rate to decrease, making borrowing for businesses and consumer cheap.  A cheap credit or lower interest rates may induce more economic activity, but it exposes the economy to a threat of inflation.  So the Fed needs to balance the money supply to trigger economic growth at the same time creating a stable inflationary environment.  

Open Market Operations is purchase or sale of US Treasury Notes and Bonds by the Federal Reserve in the open markets.  The Fed conducts the open market transactions with banks or businesses in the economy.  To increase money supply, the Fed buys government bonds and notes from banks, businesses, and consumers for money; which results in more money trickle into the economy and trigger expansionary growth. .