Since it plays such a pivotal role in the U.S. economy, it has become very controversial. Some politicians, such as Republican Texas Congressman Ron Paul, advocates that it be closed. Find out the truth about the Fed -- how it works, who owns it and how it helps you.
How Does the Fed Work?The Fed works by using its monetary policy tools. Setting low interest rates is called expansionary monetary policy, and makes the economy grow faster. If the economy grows too fast, it triggers inflation. Raising interest rates is called contractionary monetary policy. It slows economic growth by making loans and other forms of credit more expensive. This restricts the money supply. As demand falls, businesses lower prices. This can create deflation, which further lowers demand because consumers delay buying while waiting for prices to fall further.
How does the Fed cut interest rates? It lowers the target for the Fed funds rate. Banks usually follow the Fed's lead, cutting LIBOR and the prime interest rate. The Fed can also use its other tools, such as lowering the discount rate banks use to borrow funds directly from the Fed's discount window.
To combat the financial crisis, the Fed had to get creative. It started buying mortgage-backed securities from banks directly as a way to pump liquidity into the financial system. It also started buying Treasuries. Both purchases became known as quantitative easing, a controversial strategy that had critics worrying about hyperinflation because they thought the Fed was just printing money. However, banks weren't lending, so the money supply wasn't growing fast enough to cause inflation. Instead, they were hoarding cash to write down a steady stream of housing foreclosures. The situation didn't start to improve until 2011. By then, the Fed was cutting back somewhat on quantitative easing.
Who Owns the Fed?The Fed is an independent entity established by Congress, not a government agency. Its decisions don't have to be approved by the President, legislators or any elected official. Furthermore, the Fed does not receive its funding from Congress. Although its Board members must be approved by the President and Congress, their terms deliberately don't coincide with those of elected officials.
However, the Federal Reserve Chairman (currently Ben Bernanke) must report on its actions to Congress, which can alter the statutes governing the Fed. For example, the Dodd-Frank Wall Street Reform Act limited the Fed's powers by requiring that the emergency loans it made during the financial crisis be audited by the Government Accountability Office(GAO). It also required the Fed to make public the names of banks that received any emergency loans or TARP funds. In the future, the Fed cannot make emergency loans to companies, like Bear Stearns or AIG, without approval by the Treasury Department.
The Fed is not a private company, so its actions aren't accountable to shareholders. However, the 12 regional Federal Reserve Banks are set up similarly to private banks. They store currency, process checks and make loans to the private banks within their area that they regulate. These banks are considered members of the Federal Reserve banking system, and must maintain reserve requirements. In return, they can borrow from the 12 Federal Reserve Banks at the discount rate, when needed.
To be a member of the Federal Reserve System, these commercial banks must own shares of stock in the 12 regional Federal Reserve banks by law. However, owning Reserve Bank stock is nothing like owning stock in a private company. These stocks can't be traded, and they don't give the member banks voting rights. They do pay out dividends, but its mandated by law to be six percent. (Source: Federal Reserve, Who Owns the Federal Reserve?)
(Article updated January 16, 2012)