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The Federal Reserve System and Its Function

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The Federal Reserve System Board logo

The logo of the Federal Reserve System Board.

What Is the Federal Reserve System?:

The Federal Reserve System is America's central bank. This makes it the most powerful single actor in the U.S. economy, and therefore the world. The Federal Reserve was created by Congress in 1913, and has four components:
  1. A seven-member Board of Governors that direct monetary policy.
  2. A 12-member Federal Open Market Committee (FOMC) that sets the target for the Fed funds rate, which guides interest rates. All Board members sit on the FOMC.
  3. Twelve regional member banks, located throughout the U.S., that supervise commercial banks and implement monetary policy.
  4. Staff economists who provide reports including the Beige Book and the Monetary Report to Congress.

The Function of the Federal Reserve System:

The Federal Reserve's most primary function is to control inflation without triggering a recession. In addition to that, the Fed has three other less visible, but no less critical, functions:
  1. Supervise the nation’s banking system to protect consumers.
  2. Maintain the stability of the financial markets and constrain potential crises.
  3. Be the central bank for other banks, the U.S. Government, and foreign banks.

How the Federal Reserve Manages Inflation:

The Federal Reserve controls inflation by managing credit, the largest component of the money supply. (This is why people say the Fed prints money.) The Federal Reserve can restrict credit by raising interest rates and making credit more expensive. This reduces the money supply, which curbs inflation. Why is managing inflation so important? Ongoing inflation is like an insidious cancer that destroys any benefits of growth.

When there is no risk of inflation, the Fed makes credit cheap by lowering interest rates. This increased liquidity, spurs business growth, and ultimately reduces unemployment. The Fed monitors inflation through the core inflation rate, as measured by the Consumer Price Index. The core inflation rate doesn't count volatile food and gas prices, which typically rise in the summer and fall in the winter -- too fast for the Fed to manage.

The Federal Reserve Sets Monetary Policy:

The Federal Reserves uses expansionary monetary policy when it lowers interest rates, expanding credit and liquidity, which makes the economy grow faster and creates jobs. If the economy grows too fast, it triggers inflation. At this point, the Federal Reserve uses contractionary monetary policy and raises interest rates. High interest rates make borrowing expensive, which slows growth and makes it less likely that businesses will raise prices. For more on how this works, see monetary policy and inflation.

Federal Reserve Tools:

The Federal Reserve sets the reserve requirement for the nation's banks. This basically states that banks must hold 10% (less for smaller banks) of their deposits on hand each night. The rest can be lent out. If a bank doesn't have enough cash on hand at the end of the day, it borrows what it needs from other banks (known as the Fed funds). Banks charge each other the Fed funds rate. The FOMC sets the target for the Fed funds rate at its monthly meetings. To keep the Fed funds rate near its target, the Fed uses open market operations to buy or sell securities from its member banks. It creates the credit out of thin air to buy these securities, which has the same effect as printing money. This adds to the reserves the banks can lend, thus lowering the Fed funds rate.

How the Federal Reserve Supervises the Banking System:

The Federal Reserve oversees roughly 5,000 bank holding companies, 850 state bank members of the Federal Reserve Banking System, and any foreign banks operating in the US. The Federal Reserve Banking System is a network of 12 Federal Reserve banks that both supervise and serve as banks for all the commercial banks in their region.

Known as the "bankers' bank," each Reserve bank stores currency, processes checks and, most importantly, makes loans for its members to make their reserve requirement when needed. These loans are made through the discount window, and are charged the discount rate (also set at the FOMC meeting). This rate is lower than the Fed funds rate, and LIBOR. However, most banks avoid using the discount window, as there is a certain stigma attached. It is assumed the bank can't get loans from other banks. That's why the Federal Reserve is known as the bank of last resort.

The 12 banks are located in: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco. The Reserve Banks serve the U.S. Treasury by handling its payments, selling government securities and assisting with its cash management and investment activities. Reserve banks also conduct valuable research on economic issues. (Source: Federal Reserve Education The Structure of the Federal Reserve System)

The Fed's power over banks has been greatly enhanced with the Dodd-Frank Wall Street Reform Act. If any bank becomes too big to fail, it can be turned over to Federal Reserve supervision, which can then increase its reserve requirement enough to protect against any losses.

How the Federal Reserve Maintains the Stability of the Financial System:

The Federal Reserve worked closely with the Treasury Department to prevent global financial collapse during the financial crisis of 2008. It created many new tools, including the Term Auction Facility, the Money Market Investor Lending Facility, and Quantitative Easing. For a blow-by-blow description of everything that happened, while it was happening, see Federal Intervention in the 2007 Banking Crisis.

Two decades earlier, the Federal Reserve intervened in the Long Term Capital Management Crisis. Federal Reserve actions actually worsened the Great Depression of 1929 by tightening the money supply to defend the gold standard.

How Does the Federal Reserve Affect You?:

The Federal Reserve's power has made its Chairman, currently Ben Bernanke, as famous as any rock star. Every utterance he makes (or any other Federal Reserve Board member) is scrutinized by the press for clues as to how the economy is performing, and what the Federal Reserve will do about it. Therefore, the Fed directly affects your stock and bond mutual funds and your loan rates. By having such an influence on the economy, the Fed also indirectly affects your home's value and even the possibility that you may get laid off or rehired. (Article updated June 24, 2013)

Make the most of your money despite troubling financial times.

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