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What is the Federal Reserve?
By Jim Surowiecki (TMF Cinder)

The Federal Reserve System is among the strangest of all government organizations. It was created in 1913 to bring Federal oversight to a largely unregulated banking system, the consequences of which had been severe booms and busts over the previous century. The "System" includes 12 regional Federal Reserve Banks, each of which is privately chartered but subject to federal authority held by the Federal Reserve Board.

The Federal Reserve Board, or "Fed," is made up of seven Presidential appointees, including the Fed Chairman, whose terms are 14 years in length. Their job is to govern the Federal Reserve System. Its members also serve on the Federal Open Market Committee (FOMC), which sets monetary policy. The other members of the FOMC include 5 presidents of the 12 district Federal Reserve Banks.

The Federal Reserve Banks are used to clear checks, to lend money to banks that are temporarily strapped for reserves, to issue currency, and to hold reserve deposits of member banks. Reserves are required in what is known as a "fractional reserve system." In such a system, a bank holds a fraction of its loans as liquid deposits. The Fed decides what this "fraction," or percentage, will be and can loosen that fraction to try to stimulate economic activity or raise that fraction to remove liquidity from the banking system, thereby tightening credit.

The Fed also decides the margin requirements for securities investors or traders, or the amount of collateral required to borrow money from a brokerage to buy securities on margin. To check speculative excess, the Fed also decides which securities are suitable to be used as collateral in brokerage accounts.

The Federal Reserve System does much of the mundane work that is necessary in any monetary system -- processing checks, serving as a clearinghouse for bank transactions, processing Treasury securities transactions, and lending money. National banks, signified in the "N.A." part of a bank's name, must own common stock in one of the 12 district Federal Reserve banks. Federal Reserve member banks and their holding companies must also submit to the supervision of the Fed, which also gives the thumbs up or thumbs down to mergers and acquisitions in the banking industry.

What Is the Federal Open Market Committee (FOMC)?

The Fed's real authority, and the reason for its enormous prominence in the financial world, is its influence over monetary policy. That influence is exercised by the Federal Open Market Committee (FOMC), which is made up the seven members of the Federal Reserve Board and five Federal Reserve Bank presidents, who serve on the Committee on a rotating basis.

The FOMC meets eight times a year. The meetings traditionally feature summaries of international economic developments, reports on conditions in the domestic financial markets and the banking system, and a presentation on the U.S. economy as a whole, which is accompanied by a staff-prepared forecast of the future. Policy options are then laid out and a long discussion follows, at the end of which a vote is taken that decides whether the Fed will act. If no action is taken, the only report the press receives is, "The Fed met today." The fact that no action has been taken is never mentioned. The minutes of Fed meetings are only made available months after the fact.

If the FOMC does take action, it has two different tools at its disposal, although only the first is generally given much attention. The Fed can raise or lower the Federal Funds Rate, which is the interest rate banks charge each other for overnight credit. Banks holding excess reserves will lend their reserves to other banks, which may need to purchase reserves (borrow) because they don't have enough cash on hand to meet their reserve requirements (which, remember, are set by the Fed).

Contrary to widely held belief, the Fed doesn't have full autonomy over the Federal Funds Rate. This also driven by market forces such as the need of consumers and businesses for short-term liquidity and by the flow of funds in and out of the country for international trading needs. For instance, the Federal Funds Rate might go up during the Christmas holidays when cash is taken out for shopping and banks draw down their cash for short periods of time. At tax time, when so much money is moving from private citizens to the government, short-term cash needs for banks can increase and drive up the Federal Funds Rate. When the Treasury spreads that cash back through the system by making deposits in the Federal Reserve Banks, the Federal Funds Rate is likely to return to its former equilibrium level.

The Fed can also change the discount rate, although technically each of the twelve district banks can submit a proposal to charge a higher or lower rate at its "discount window." The discount rate is the rate at which banks can borrow from the Federal Reserve System to satisfy short-term liquidity needs. The discount rate is generally lower than the Fed Funds Rate because the discount window is where troubled depository institutions can borrow to get them through short periods of problems. Originally, it was designed to help depository institutions quell "runs on the bank." Borrowing at the discount window is frowned upon if an institution doesn't need the help.

Another tool of monetary policy available to the FOMC is its Open Market Operations, under which it can make what are called open-market purchases or sales of Treasury securities. This is the most immediate and direct way of either injecting or withdrawing liquidity from the system. These purchases also affect the Federal Funds Rate because they impact the amount of money in the banking system, the immediate supply/demand balance in the money market, and quite importantly, the psychology of money market participants.

Even the threat of Fed intervention can force private parties to sell short-term securities, which drives up short-term interest rates because supply has suddenly overwhelmed demand for short-term securities. When the Fed wants to restrict credit, it sells securities, and the dollars that are spent to buy those securities leave the system, shrinking the supply of money available to lend. When the Fed wants to expand credit, it buys securities with dollars essentially created out of thin air, thus increasing the supply of money available to lend.

How Is the Fed Connected to the Economy?

Got all that? What makes the whole process especially confusing is that the Fed's instruments are only indirectly connected to the economy as a whole. Although the Fed exercises enormous influence over the financial markets, it can't force banks to raise or lower interest rates, which have, for example, remained at historically high levels in real terms ever since the early 1980s. The Fed doesn't control the market, but it does hold sway over short-term interest rates -- not only because that's part of the interest rate spectrum affected by its open market operations, but because the market fears the Fed. "Suasion" is still one of the strongest tools of the Fed precisely because of that fear.

Because the market for debt is so much larger than the market for equity in this country, interest rates across the yield curve add up to an aggregate expression of borrowers, lenders, savers, speculators, highly leveraged companies, the Fed, and any other debt market participant. That it is why the debt market is the most efficient securities market in the world. It expresses the most up-to-date view of inflation and money supply and demand, totally eclipsing the Fed or any other single economic actor on the economic stage.

For all of this, though, the Fed's tools, crude as they are, have proved remarkably effective in the right hands. For at least the last five years, the go-slow/speed-up signals have been effective, with the exception of what some saw as an over-tightening in 1994, which led to the worst bond market decline since 1930. For all of his influence in the world market, Fed Chairman Alan Greenspan finds himself in a position of lessened importance when the Bank of Japan is ready to lend at short-term interest rates below 1% and when General Electric Capital Corp. can deploy more short-term reserves than he can. Greenspan knows the power of the jawbone, but reserves it for cases when he thinks things might be going too far.

In an era of quickening financial disintermediation, where General Electric Capital Corp. doesn't have to meet Fed requirements and when short-term interest rates are based on the London Inter-Bank Offering Rate (LIBOR), the Chairman has taken a more laissez-faire attitude. Institutions have evolved, as have economies. Though the Fed carries less weight than it did, it is still a vital participant in evening out liquidity cycles and providing a strong central bank during times of crisis. It's a delicate balancing act for a lion to retain his roar when the other animals might sense that there are fewer teeth behind that roar. Still, the Fed is the king of the economic savannah precisely because its roar is feared and because it is far from being toothless.

Next Article: Who is Alan Greenspan?


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