The Fed

Q: Could you explain what "The Fed" is? -- M.S.Y., from the Web

A: The Federal Reserve Board, or "Fed," is made up of seven presidential appointees whose terms are 14 years in length. The Fed's job is to govern the Federal Reserve System, which was created in 1913 to bring federal oversight to a banking system that at the time was best described as "one big ugly mess."

The Federal Reserve System does much of the mundane work that is necessary in any monetary system -- processing checks, processing Treasury securities transactions, lending money and, of course, keeping various large, marbled bank halls well-polished. Federal Reserve member banks and their holding companies must also submit to the supervision of the Fed, which votes a movie critic-style "thumbs up" or "thumbs down" to proposed mergers in the banking industry.

The Fed's real authority, and the reason it is mentioned on the news even more often than which celebrities might run for president, is its influence over monetary policy. That influence is exercised by the Federal Open Market Committee (FOMC), which is made up of 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 include a selection of tasty beverages and fine breakfast rolls as well as 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. When the members of the FOMC have finished breakfast, policy options are laid out and a long discussion follows, at the end of which a vote is taken that decides whether the Fed will act, and possibly what to order for lunch. The minutes of Fed meetings are made available only months after the fact, and disclosures about dinner plans are never announced.

If the FOMC does take action, it is typically to 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 to other banks, which may need to borrow funds because they don't have enough cash on hand to meet their own reserve requirements (which, remember, are set by the Fed). The raising or lowering of this interest rate can have important effects on the cost of operating America's businesses and the expectations of profits for companies borrowing money.

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. 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, in the short term, sometimes "fears" the Fed.

WHAT NOW? Go out and get a subscription to The Motley Fool Monthly, with nary a mention of the Fed.

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