The Federal Reserve Banking System, also known as the Fed, is the central bank for the U.S. This position makes it the most powerful actor in the global economy. It is not a company or government agency and its leader is not an elected official. This makes it seem highly suspicious to many people because it's not beholden to voters or shareholders.
Since it plays such a pivotal role in the U.S. economy, it has become very controversial. Some politicians, such as former 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.
Who Owns the Federal Reserve?
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 it's mandated by law to be six percent. (Source: Federal Reserve, Who Owns the Federal Reserve?)
How Does the Fed Work?
The Fed's primary function is to set monetary policy to control inflation. Ongoing inflation is like an insidious cancer that destroys any benefits of growth. For this reason, in recent years the Fed's primary responsibility has been to manage inflation. Its most important tool is the Fed funds rate. However, during the financial crisis of 2008, it deployed innovative tools to stabilize the global banking system. Since the recession, it has also taken on the charge to reduce unemployment and spur economic growth.
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. Article updated January 7, 2013