An Introduction to the Federal Reserve
Introduction to the Federal Reserve
As the economy has fluctuated in recent years, the Federal Reserve Bank of the United States has received press for its impact on the economy. The Fed’s actions have significant influence over financial markets domestically and abroad. So what is the Federal Reserve, and how does it influence the economy?
ABSTRACT
Since its creation in 1913, the Federal Reserve Bank has defined the role of monetary policy in the U.S. economy. It was designed specifically to take on powers delegated from Congress, such as issuing legal tender for the United States.1
- Creation of the Institution
- Roles & Responsibilities
- Structure
- Traditional Monetary
- Tools
- The Fed Today
Economic conditions, members of the central bank, and economic trends of the day can have effects on how monetary policy is designed and implemented through the monetary tools of the Federal Reserve. In this briefing, we provide a detailed overview of how the institution began and how it has grown in order to understand the significance of recent changes and adjustments in policy actions.
Creation of the Institution
After financial crises like the Panic of 1907, in which banks experienced a six-week run2, it became clear the banking system was prone to panics and the currency unresponsive to fluctuations in demand. The fragmented nature of bank regulations plagued the banking system in cases of an economic shock.3 A central bank, as a “lender of last resort,” would institute a level of confidence and stability into the financial system that would help to prevent depositors from pulling all of their money from banks in fear that the banks would become insolvent.4
The Federal Reserve Act of 19135 created the Federal Reserve System as an independent agency so that the central bank could serve protected from political pressures or influences from private industries.6 The Federal Reserve is not funded by Congress but earns income from the interest on government securities that it purchases through open market operations.7
Roles and Responsibilities
According to the Congressional Research Service (CRS), Congress endowed The Fed with a mandate: “to achieve maximum employment, stable prices, and moderate long-term interest rates” through monetary policy. Monetary policy, according to the Federal Reserve, is the action that it takes to influence the cost and availability of money and credit in the economy.8 More broadly, this includes the many policies, directives and speculation about future economic conditions that are made by or associated with the current chairman of the Federal Reserve Board of Governors.9
The Federal Reserve looks at the historical long-run level of output and employment in the economy, and during times of weak demand it attempts to use monetary policy to stimulate the economy back to its long-run level.10 The Fed’s mandate to keep prices stable tends to be geared toward making sure that inflation remains in check. The Federal Reserve issued a recent specification to this mandate in January, 2012, when it was announced that the goal of annual inflation would be two percent.11
Structure
The Federal Reserve is made up of a Board of Governors whose role is to achieve maximum employment and stable prices through the setting of monetary policy.12
The current Board of Governors is comprised of:
- Ben Bernanke: Appointed to the Board of Governors in 2006, currently in his second term as Board of Governors chairman and chairman of the Federal Open Market Committee (FOMC).
- Janet Yellen: Vice chair of the Board of Governors, previously served as President and CEO of the San Francisco Federal Reserve Bank.
- Elizabeth Duke: Previously served as Executive Vice President at Wachovia and SouthTrust Bank, as well as senior executive vice president at TowneBank.
- Daniel Tarullo: Previously worked for the Clinton administration and was a professor of law at Georgetown University Law Center.
- Jerome Powell: Served as assistant secretary and undersecretary for the U.S. Treasury Department under President George W. Bush and was a visiting scholar at the Bipartisan Policy Center.
- Jeremy Stein: Appointed as a member of the Board of Governors in May, 2012, and was previously a professor of economics at Harvard University and an advisor to the secretary of the Treasury under the Obama administration.
- Sarah Raskin: Before her appointment to the Board of Governors, Raskin worked at the Federal Reserve Bank of New York and was commissioner of financial regulation for Maryland.13
Traditional Monetary Tools
Federal Reserve District Banks: Established in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco.14
Federal Open Market Committee (FOMC): Consists of the Board of Governors and five of the presidents of the district reserve banks.15
Traditional Monetary Tools
In order to promote confidence and stability in the U.S. banking system,16 the Fed established reserve requirements. Reserve requirements determine the amount of money that a bank or depository institution “must hold in reserve for specified deposit liabilities”17 (such as checking and savings accounts and CD’s).18
- Reserves can either be cash held or deposits at the Fed.19
- The lower percentage of reserve requirements that are mandatory, the more money the bank has available loan to borrowers.20
These requirements are currently set on a three-tiered system, based on an institution’s total transactions:21
$0-11.5 million - 0 percent reserve requirement
$11.5 million-71.0 million - 3 percent reserve requirement
$71.0 million and above - 10 percent reserve requirement
The Fed has three ways to increase or decrease money and credit:22
- Open market operations, or the purchase and sale of treasury securities. These securities are debt obligations of the United States, and effectively are IOUs from the U.S. Department of Treasury. These securities include Treasury bills, notes and bonds.23
- Changing how much reserves banks and depository institutions must hold.
- Permit depository institutions to borrow directly from the Fed.
The Fed’s monetary success and failure is based up on the cost of money or the growth of money and credit.24
Open market operations: These are carried out through the purchase and sale of U.S. Treasury securities in the secondary market—the market where these securities are traded after they have been issued—to alter the reserves of the banking system.
- By altering bank reserves, the Fed can influence short-term interest rates, and hence overall credit conditions. The goal of lowering short-term interest rates is a financial environment where it is less risky for investors to borrow money and have easier access to credit.
The Fed Today
- The Fed’s target for open market operations is the federal funds rate, the rate at which banks lend to one another on an overnight basis.25
- When it purchases Treasury securities it does so with newly issued currency, which expands the reserve base in the United States and the amount of money in circulation.26 This increases the ability of banks and other financial institutions to make loans and expand credit.
- Federal funds rate: unlike the name suggests, the federal funds rate is not related to the federal government. It is the interest rate that banks pay when they borrow from each other, usually overnight, in order to maintain their bank reserves. These overnight loans ensure an adequate level of liquidity among banks to lend to borrowers.27
Traditionally, the Federal Reserve has used a targeted federal funds rate as its main monetary policy instrument. The onset of the financial crisis in 2008 led to the target rate being set effectively at zero, and so the Federal Reserve has a limited ability to lower it significantly further. In order to ease monetary policy without changing the federal funds rate, the Federal Reserve implemented a new policy in which it purchased large quantities of Treasury bonds with medium and long maturities.28
A new policy of paying interest on reserves in banks is intended to help the Fed achieve its target funds rate. Paying interest on required reserves avoids the implicit tax that reserve requirements impose on banks29. In other words, when the bank is required by the Fed to hold a certain amount of money in reserve, it is missing the opportunity to loan that money to borrowers and earn interest on those loans. By paying interest on the reserves, it reduces the cost to the bank of holding the reserves and provides an incentive to meet the requirements.
Almost 100 years after its establishment, the Federal Reserve has played a much more interventionist role in stimulating the economy, most notably during and after the financial crisis of 2008. As of 2011, a U.S. dollar is worth about $0.04 in terms of purchasing power when the Federal Reserve Act was passed in 1913.30 The Federal Reserve’s balance sheet today is three times the size it was when the financial crisis began in the U.S.31
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- Board of Governors. Federal Reserve Act, Section 16: Note Issue. Updated August 13th, 2008. Accessed July 17, 2012. http://www.federalreserve.gov/aboutthefed/section16.htm ↩
- Smithsonian Magazine. “The Financial Panic of 1907: Running from History.” October 10, 2008. http://www.smithsonianmag.com/history-archaeology/1907_Panic.html ↩
- Federal Reserve Bank of Boston. “Panic of 1907.” Page 1. Accessed April 30, 2012. http://www.bos.frb.org/about/pubs/panicof1.pdf ↩
- Congressional Research Service. Monetary Policy and the Federal Reserve: Current Policy and Conditions. July 6th, 2012. Summary. http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
- Library of Congress. “Federal Reserve Act of 1913”. Accessed April 30, 2012. http://www.llsdc.org/attachments/files/105/FRA-LH-PL63-43.pdf ↩
- Congressional Research Service. “Structure and Functions of the Federal Reserve System.” November 10th, 2010. Summary. Accessed April 30, 2012. http://www.fas.org/sgp/crs/misc/RS20826.pdf ↩
- Congressional Research Service. “Structure and Functions of the Federal Reserve System.” November 10th, 2010. P,. 1. Accessed April 30, 2012.
http://www.fas.org/sgp/crs/misc/RS20826.pdf ↩ - Congressional Research Service. Monetary Policy and the Federal Reserve: Current Policy and Conditions. January 30, 2012. Summary. http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
- Congressional Research Service. Monetary Policy and the Federal Reserve Current Policy and Conditions. January 30, 2012. P.1.http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
- Federal Reserve Bank of San Francisco. “About the Fed.” Accessed April 30, 2012. http://www.frbsf.org/publications/federalreserve/monetary/goals.html ↩
- Board of Governors of the Federal Reserve System. Press Release. January 25th, 2012. Accessed July 9, 2012. http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm ↩
- Congressional Research Service. Structure and Functions of the Federal Reserve System. November 10th, 2010. Accessed July 17, 2012. Page 2.
http://www.fas.org/sgp/crs/misc/RS20826.pdf ↩ - Board of Governors of the Federal Reserve System. “About the Fed: Members of the Board.” March 30th, 2012. Accessed April 30, 2012. http://www.federalreserve.gov/aboutthefed/default.htm ↩
- Congressional Research Service. Structure and Functions of the Federal Reserve System. November 10th, 2010. Page 4. http://www.fas.org/sgp/crs/misc/RS20826.pdf ↩
- Congressional Research Service. Structure and Functions of the Federal Reserve System. November 10th, 2010. Page 2. http://www.fas.org/sgp/crs/misc/RS20826.pdf ↩
- Congressional Research Service. Systemic Risk and the Federal Reserve. October 28th, 2009. Page 3. http://assets.opencrs.com/rpts/R40877_20091028.pdf ↩
- Board of Governors of the Federal Reserve. “Reserve Requirements.” October 26th, 2011. Accessed April 27th, 2012. http://www.federalreserve.gov/monetarypolicy/reservereq.htm ↩
- Congressional Research Service. Monetary Policy and the Federal Reserve: Current Policy and Conditions. January 30, 2012. Page 2. http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
- Congressional Research Service. Monetary Policy and the Federal Reserve: Current Policy and Conditions. January 30, 2012. Page 2.. http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
- Congressional Research Service. Monetary Policy and the Federal Reserve: Current Policy and Conditions. July 6th, 2012. Page 3. http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
- Board of Governors of the Federal Reserve. “Reserve Requirements.” October 26th, 2011. Accessed April 27th, 2012. http://www.federalreserve.gov/monetarypolicy/reservereq.htm ↩
- Congressional Research Service. Monetary Policy and the Federal Reserve: Current Policy and Conditions. January 30, 2012. P.3. http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
- U.S. Security and Exchange Commission. “Treasury Securities.” April 19th, 2001. Accessed July 9, 2012. http://www.sec.gov/answers/treasuries.htm ↩
- Congressional Research Service. Monetary Policy and the Federal Reserve: Current Policy and Conditions. January 30, 2012. P.3. http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
- Congressional Research Service. “Financial Turmoil: Federal Reserve Policy Responses.” Page 3. July 15th, 2012. Accessed April 27th, 2012.
http://assets.opencrs.com/rpts/RL34427_20100715.pdf ↩ - Congressional Research Service. “Monetary Policy and the Federal Reserve: Current Policy and Conditions.” January 30th, 2012. Accessed April 27th, 2012. http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
- Congressional Research Service. “Financial Turmoil: Federal Reserve Policy Responses.” Page 3. July 15th, 2012. Accessed April 27th, 2012. http://assets.opencrs.com/rpts/RL34427_20100715.pdf ↩
- Federal Reserve Bank of New York Staff Reports. “Large-Scale Asset Purchases by the Federal Reserve: Did They Work?” March 2010. Accessed April 30th, 2012. Page 1. http://www.ny.frb.org/research/staff_reports/sr441.pdf ↩
- Richmond Federal Reserve. “Economic Brief: The Effect of Interest on Reserves on Monetary Policy.” December 2009. Accessed 27th, 2012. http://www.richmondfed.org/publications/research/economic_brief/2009/pdf/eb_09-12.pdf ↩
- Measuring Worth. “Purchasing Power of Money in the United States from 1774 to Present”. Accessed April 30, 2012. http://www.measuringworth.com/ppowerus/ ↩
- Congressional Research Service. “Monetary Policy and the Federal Reserve: Current Policy and Conditions.” January 30th, 2012. Accessed April 30, 2012.
http://www.fas.org/sgp/crs/misc/RL30354.pdf ↩
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