The Federal Reserve

The Federal Reserve System is the central bank of the United States. The Fed was created by an act of Congress in 1913. The basis of this creation was to create a government entity directed with the responsibility to foster a sound banking system and a healthy economy. The Federal Reserve System is comprised of the Board of Governors in Washington, D.C., and twelve Federal Reserve District Banks. The Federal Reserve System acts not only as the United States central banker but also the controller, regulator and inspector.

The U.S. Congress structured the Fed to be independent within the government. The Fed is accountable to the Congress and its objectives are established by the laws of congress. The conduct and implementation of monetary policy is, however, sheltered from political pressures and interference of Congress. It is governmental, but it is independent within government. On the one hand, it was created by and reports to Congress; its highest officials, the members of the Board of Governors, are appointed by the President and confirmed by the Senate; and its earnings ultimately are returned to the U.S. Treasury. On the other hand, the Fed operates on its own earnings rather than Congressional appropriation; the Board of Governors terms are long and staggered, limiting the President’s influence; and unlike some other nations central banks, it is separate from the Treasury.

This complicated structure, no doubt, can be confusing. But it ensures that the Fed’s decisions are broadly based and properly insulated from narrow and partisan interests. In the end, this structure helps the Fed accomplish its overall mission: fostering a sound financial system and a healthy economy.

The Federal Reserve System is comprised of twelve separate district banks. Each district bank has a president and board of directors. The whole Federal Reserve System is run by a seven-member board of governors. Under the direction of the chairman, it sets monetary policy, supervises bank operations, and is one of the biggest controls on economic growth in the U.S.

As the nations banker, the Fed maintains bank accounts for the U.S. Treasury as well as most government agencies. Similar to an individual account at a bank, the U.S. Treasury keeps a checking account with the Federal Reserve. Payments of social security and Medicare pass through these Fed accounts. Corporate taxes, income taxes, various excise taxes and related collections go through the Fed. The Fed handles most all banking affairs of the U.S. government.

The Fed acts not only as a clearinghouse for the government checks but also acts as a clearing house for billions of check transactions per year through member banks. Each day the Fed processes millions of payments in the form of both paper checks and electronic transfers. Institutions can choose to use the Fed’s services or those offered by other competitors in the marketplace. A function of the clearing services and government accounts, the Fed sells and redeems U.S. government securities such as savings bonds and Treasury bills, notes and bonds.

The Federal Reserve also issues the nation’s coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation’s cash supply; the Fed Banks then distribute it to financial institutions. The currency periodically circulates back to the Fed Banks where it is counted, checked for wear and tear, and examined for counterfeits. If the money is still in good condition, it is eventually sent back into circulation as institutions order new supplies to satisfy the public’s need for cash. Worn-out bills, however, are destroyed by shredding.

The Fed interprets and acts on laws passed by congress that regulate the banking industry. A number of rules and regulations established to protect the banking system, lending and consumer protections pertaining to credit are established and enforced by the Fed. As a regulator, the Fed formulates rules that govern the conduct of financial institutions. As a supervisor, the Federal Reserve examines and monitors institutions to help ensure that they operate in a safe and sound manner and comply with the laws and rules that apply to them. The Fed’s supervisory duties are carried out on a regional basis. Each of the Reserve Banks is responsible for monitoring bank holding companies (organizations that own one or more banks) and state member banks (banks that are chartered by the state and are members of the Federal Reserve System) based in its District.

The responsibility with the greatest long term focus is role the Fed plays in the job of stabilizing output in the short run and promoting price stability in the long run. The Fed can’t control inflation or influence output and employment directly; instead, it affects them indirectly. The Fed has various tools that are used to implement. The Federal Reserve has many functions within its responsibility to oversee economic and monetary policy.

First, the Fed tries to estimate how the economy is doing now and how it’s likely to do in the near term—say, over the next couple of years or so. Then it compares these estimates to its goals for the economy and inflation. If there’s a gap between the estimates and the goals, the Fed then has to decide how forcefully and how swiftly to act to close that gap. Of course, the lags in policy complicate this process.

Fed helps maintain a sound banking system is as the “lender of last resort.” The Fed is a banker to the member banks of the Federal Reserve. A financial institution experiencing an unexpected drain on its deposits, for example, can turn to its Reserve Bank if it is unable to borrow money elsewhere. This loan from the Fed would not only enable the institution to get through temporary difficulties, but most importantly, would prevent problems at one institution from spreading to others. If a member banks needs to borrow money, they have the available use of the discount window to borrow funds. The discount rate is the rate set by the Fed for loans taken out at the discount window.

The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. Open market operations are conducted by the Federal Reserve Bank of New York.

This entry was posted on Sunday, October 12th, 2008 at 12:07 pm and is filed under Banking and CD Guide. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.