What is the Federal Reserve?
Alan Greenspan and the Federal Reserve

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Greenspan and the Fed
By Motley Fool Staff

So, who or what is "the Fed" that everyone talks about whenever there's a change in interest rates? The Federal Reserve System is a unique government organization, and was created in 1913 to bring federal oversight to a largely unregulated banking industry, which had experienced severe booms and busts over the previous century.

The Federal Reserve System consists of a central Board of Governors in Washington, D.C., and 12 regional Federal Reserve Banks, each of which is privately chartered but subject to the federal authority held by the Board. The System also includes the Federal Open Market Committee (FOMC), which makes the monetary policy decisions regarding interest rates that get all the attention.

The Federal Reserve Board of Governors
The Board of Governors is made up of seven presidential appointees, who are also confirmed by the Senate, and who serve one 14-year term. The president also selects a chairman and vice chairman of the Board, who serve four-year terms, and who may be reappointed. The chair of the board is also traditionally selected as the chair of the FOMC, and of course that person, since 1987, has been Alan Greenspan.

The Board's chief responsibility is to serve on the FOMC (see below). In addition, the Board oversees the Federal Reserve's other responsibilities, most of which are carried out by the regional Federal Reserve Banks. These other duties include:

  • Regulating and auditing banks and other depository institutions;
  • Holding reserves for national and state banks that are members of the Reserve System;
  • Performing banking functions for federal government agencies;
  • Providing a payment system for financial institutions;
  • Distributing currency to banks and other depository institutions;
  • Clearing checks -- about 18 billion a year -- for member banks; and
  • Administering laws regarding consumer credit protection.
The Federal Reserve Banks
The 12 regional Federal Reserve Banks are supported by 25 branches. They carry out most of the functions listed above, generally on behalf of member banks, which include all national banks chartered by the federal government and state-chartered banks that choose to join the Federal Reserve System, and that meet the requirements to do so. By the way, the Fed is separate from the Federal Deposit Insurance Corporation (FDIC), which insures bank accounts.

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 primarily exercised by the FOMC, which is made up of the seven members of the Federal Reserve Board and five of the twelve Federal Reserve Bank presidents. One of the five is always the president of the Federal Reserve Bank of New York, while the other four are Reserve Bank presidents that serve on a rotating basis. The FOMC meets eight times a year, and it is at these meetings that decisions are made surrounding short-term interest rates, specifically the federal funds rate, discussed below.

The Fed and monetary policy
Like central banks in other free-market countries, the Federal Reserve oversees monetary policy, which involves using the money supply and availability of credit to maintain sustainable economic growth and stability (or at least try). The goals of the Fed's monetary policies are spelled out in law: "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

The Federal Reserve has several tools to use in conducting monetary policy:
  • The federal funds rate, which is the rate banks charge each other for overnight loans. The FOMC sets a target for this rate -- not the actual rate itself -- at its regular meetings (though it can also change the target between meetings, at the behest of the Chair, as happened January 3rd, 2001). This is the short-term rate that news accounts are referring to when they report what the Fed decided regarding interest rates.

  • The discount rate, which is the rate banks pay when they borrow funds from a Federal Reserve bank. This is usually lower than the federal funds rate, though closely tied to it. The Board of Governors works with the Reserve Banks to set the discount rate.

  • Reserve requirements, which is a proportion of their deposits that all banks and other depository institutions are required to hold in reserve, some in their own vaults and some at the Reserve banks. This proportion is set by the Board of Governors, but usually is around 10%.
Of the three tools, the federal funds rate is the most important. According to the Fed, reserve requirements are changed "only infrequently." In addition, banks try to avoid borrowing at the discount rate from a Reserve bank, since it is generally seen as a sign of potential weakness. As a result, the effectiveness of those other tools is limited.

So, what's the big deal about the federal funds rate? Since banks are subject to the reserve requirements mentioned above, and since they frequently fall below those requirements while conducting day-to-day business, they regularly have to borrow from each other's reserves in order to maintain their required levels. This essentially creates a market in reserve funds, with banks and other depository institutions borrowing and lending as needed, and paying the federal funds rate when they borrow.

By increasing or decreasing the federal funds rate, the Fed can impact, over time, practically every other interest rate charged by U.S. banks. To influence the federal funds rate, and move it towards the target set by the FOMC, the Fed can increase or decrease the supply of reserves held by the banks.

Does any of this sound complicated? For more info on how this process works, and how it in turn affects the larger economy, check out our next article in this series.

Next: Effects on Economy?