One of the more mysterious areas of the economy is the role of the Fed. Formally known as the Federal Reserve,
the Fed is the gatekeeper of the U.S. economy. It is the central bank
of the United States -- it is the bank of banks and the bank of the
U.S. government. The Fed regulates financial institutions, manages the
nation's money and influences the economy. By raising and lowering
interest rates, creating money and using a few other tricks, the Fed
can either stimulate or slow down the economy. This manipulation helps
maintain low inflation, high employment rates, and manufacturing
In this article, we'll visit the mystical world of the Fed and
talk about terms like monetary policy, discount rates, and open market
operation. We'll find out just what kinds of tasks fill Alan
Greenspan's day, and see how his and the Federal Reserve Board's
decisions affect our everyday lives.
Why do we need the Fed?
Sometimes, in order to understand why you need something, it helps to
find out what it was like before that "something" was created. Before
the Federal Reserve was created in 1913, there were over 30,000 different currencies
floating around in the United States. Currency could be issued by
almost anyone -- even drug stores issued their own notes. There were
many problems that stemmed from this, including the fact that some
currencies were worth more than others. Some currencies were backed by
silver or gold, and others by government bonds. There were even times
when banks didn't have enough money to honor withdrawals by customers.
Imagine going to the bank to withdraw money from your savings account
and being told you couldn't because they didn't have your money! Before
the Fed was created, banks were collapsing and the economy swung wildly
from one extreme to the next. The faith Americans had in the banking
system was not very strong. This is why the Fed was created.
The Fed's original job was to organize, standardize and
stabilize the monetary system in the United States. It had to set up a
method that could create "liquidity"
in the money supply -- in other words, make sure banks could honor
withdrawals for customers. It also needed to come up with a way to
create an "elastic currency," meaning it had to control inflation by making sure prices didn't climb too quickly, and
it needed a way of increasing or decreasing the country's supply of
currency in order to prevent inflation and recession. In the next two
sections, we'll discuss these inflation and recession.
Inflation is not a good thing because it slows down economic growth.
For example, when inflation is high, things cost more and people spend
less. They also do less long-term planning that involves spending
money, such as building houses and investing.
Businesses are affected in the same ways. When inflation is high, it
tends to fluctuate quite a bit. This uncertainty makes people wary of
spending money for fear that inflation will increase even more and they
won't be able to pay their bills.
High inflation also adds additional costs to long-term interest
rates. These costs are to offset the risk associated with inflation.
The additional costs make borrowing money less attractive. When people
don't buy things (when demand is down), then the supply of goods gets
too high, production has to decrease, and unemployment increases -- in
other words, recession hits.
When prices are stable (when inflation is low), consumers make
more purchases, investments, etc., production output is maintained and
employment remains high.
When recession hits, the Fed can lower interest rates
in order to encourage people to borrow money and make purchases. This
works in the short run, but it has to be handled carefully so that
inflation isn't impacted in the long run.
The Fed has to carefully balance the short term goals of increasing
output and employment with the long term goals of maintaining low
The Fed regulates financial institutions, acts as the U.S. government's
bank, acts as a bank's bank, and is responsible for managing the
nation's money. The Fed has two divisions: One group, the Board of Governors, is responsible for setting monetary policy and managing the nation's money; the other group, the 12 regional Reserve Banks,
acts as the service division that carries out the policy and oversees
financial institutions. The regional Reserve Banks represent the
private sector. Both of these groups have the same goals.
Maximum employment doesn't necessarily mean that
everyone is working. Economists have a "natural rate" of unemployment
that is ultimately the goal. If the unemployment rate is pushed too low
-- below 5% or so -- inflation rises because more money is in the
economy, and that goes against the long-term Fed goal of stable prices.|
In its role as money manager, the Fed has two primary goals:
It achieves these goals indirectly by raising or lowering
short-term interest rates. Although these are two separate goals, the
outcome of each is the same -- a stable economy. In the following
sections, we'll discuss the goals and the way the Fed goes about
- Maintain stable prices (control inflation)
- Ensure maximum employment and production output
Fed Tasks: Monetary Policy
Monetary policy refers to the actions the Fed takes to influence financial conditions in order to achieve its goals.
The Fed's primary control is in the raising and lowering of short-term interest rates. In doing this, the Fed can indirectly
influence demand, which then influences the economy. For example, if
interest rates are lowered, borrowing money to make purchases becomes
less expensive, and people are more motivated to spend money because
they can get a better deal on the loan. Spending money, in turn,
stimulates economic growth, which is what the Fed is trying to do in
that instance. If there is too much money in the economy, however,
people spend more money and demand increases at a faster rate than
supply can match. Prices rise too quickly because of the shortage of
products, and inflation results. If there is too little money in the
economy, people don't have excess spending money, and there is little
The Fed watches economic indicators closely to determine in
which the direction the economy is going. By forecasting increases in
inflation or slow-downs in the economy, the Fed knows whether to
increase or decrease the supply of money.
Influencing inflation takes a long time and has to be looked at
as a long-term goal. Influencing employment and output, however, can be
done more quickly and therefore is a short-term goal. Finding the
balance between the two is key. The lags in the effects that monetary
policy has on the economy are significant. This is why the Fed has to
make forecasts of inflation prior to it actually happening -- one, two
or even three years in advance. If the Fed waited until inflation were
apparent, then it would be extremely difficult to catch up and get it
back under control. We'll talk about the economic indicators shortly.
Fed Tasks: Financial Institution Regulator
a regulator for financial institutions, the Fed establishes the rules
of conduct that these institutions must follow. The regional Reserve
Banks then carry out the supervision and enforcement of these
regulations. These regional banks monitor the activities of banks
within their regions and ensure that they are operating appropriately.
The Federal Reserve also watches out for the public interest by
monitoring banks that are seeking to merge with other banks or holding
companies. The Fed rules on these requests according to the impact the
merger will have on the local community and general public interest.
Fed Tasks: A Bank's Bank
banks serve their customers, the Fed acts as a bank for banks. The Fed
keeps the pipeline of transactions flowing. It processes and clears
one-third of all the checks
processed in the country -- that's about 20 billion checks per year.
The regional Reserve Banks provide these services to the banks within
their regions. The transactions are done on a fee basis, which is part
of how the Federal Reserve supports itself. Banks are not required to
use the Reserve Banks; they can choose to use a private competitor.
This helps to ensure that the processing fees being charged are kept
Fed Tasks: The Government's Bank
The Fed maintains the checking account of the U.S. Treasury.
As the largest bank customer in the country, the U.S. government does
quite a bit of business and performs a lot of financial transactions,
all of which are handled by the Fed. These transactions amount to
trillions of dollars and include all of the tax deposits and
withdrawals for U.S. citizens. It also includes securities such as
savings bonds, Treasury bills, notes, and bonds that are bought by and
for the U.S. government.
Photo courtesy U.S. Treasury
Treasury Secretary Lawrence H. Summers and Treasurer
Mary Ellen Withrow unveil the new five and 10 dollar bills in November
Coin and paper currency produced by the U.S. Treasury's Bureau
of the Mint and Bureau of Engraving and Printing is distributed to
financial institutions by the Fed as part of its role as the
The Fed also monitors the condition of currency and either sends
it back into circulation or has it destroyed. Because there are times
during the year when people need more cash, currency is stored at
Reserve Banks so that banks can order more paper money as they need it.
These "orders" are paid for with funds from the bank's reserve account balance held with the Fed.
The Fed Tool Box: The Reserve Requirement
The most important job the Fed has is to manage the nation's money and
the overall economy. Controlling the inflation rate and maintaining
employment and production aren't easy tasks. The Fed has to have some
pretty hefty tools up its sleeve in order to influence the economy of
an entire country -- especially one the size of the United States. The
Fed has to be able to affect the rate at which consumer banks and
financial institutions create "checkbook" money for customers through
the loans they grant and investments they offer. They do this by
influencing short-term interest rates and the amount of money in
But how does it do that? The Fed uses three tools:
The Reserve Requirement
- The reserve requirement
- The discount rate
- Open market operations
to combat the problems of insufficient cash reserves (and the inability
to pay depositors) that were faced before the creation of the Federal
Reserve System, banks now have to set aside a certain amount of cash in
"reserve." The reserve balance that banks must maintain is typically a
percentage of their total interest-bearing and non-interest-bearing
checking account deposits (currently 3% to 10%). In other words, the
amount of a bank's required reserves will fluctuate depending on their
account totals. The reserve is very important because it helps to
ensure that the bank will always be able to give you your money when
you ask for it.
This percentage of required reserves directly affects how much
money they can "create" in their local economies through loans and
investments. It is this connection between the required reserve amount
and the amount of money a bank can lend that allows the Fed to
influence the economy. If the reserve requirement is raised, then banks
have less money to loan and this will have a restraining effect on the
money supply. If the reserve requirement is lowered, then banks have
more money to loan.
Reserve money is used to process check and electronic payments
through the Federal Reserve and to meet unexpected cash outflows. These
reserves can be held as "cash on hand," as a reserve balance at a
regional Reserve Bank, or both.
Although the Fed has the power to do so, changing the amount of
reserve cash a bank has to have can have dramatic effects on the
economy; for this reason, this tool is rarely used. The Fed more often
alters the supply of reserves available by buying and selling
securities. When the Fed sells securities, it reduces the banks' supply
of reserves. This makes interest rates go up. When the Fed buys
securities, it increases the banks' supply of reserves. This makes
interest rates go down.
All of this buying and selling is referred to as open market operations (discussed below).
In the event that a bank's money supply drops below the required
reserve amount, that bank can borrow either from another bank or from a
Reserve Bank. If it borrows from another bank's excess reserves, then
the loan takes place in a private financial market called the federal funds market. The federal funds market interest rate, called the funds rate, adjusts according to the supply of and demand for reserves.
If a bank chooses to borrow emergency reserve funds from a Reserve Bank, then it pays an interest rate called the discount rate.
The Fed Tool Box: The Discount Rate
The "discount rate" is the interest rate that a regional Reserve Bank
charges banks and financial institutions when they borrow funds on a
short-term basis. The Fed discourages banks from borrowing except for
occasional, short-term emergency needs.
The discount rate often plays a larger role in the overall
monetary policy than would be expected because it is a visible
announcement of change in the Fed's monetary policy. Typically, higher
discount rates indicate that more restrictive monetary policies are in
store, while a lower rate might signal a less restrictive move.
Changes in the discount rate can affect:
- Lending rates (by making it either more or less expensive for banks to get money to lend or hold in reserve)
- Other open market interest rates in the economy (because of its "announcement effect")
How do loans "create" money?
When banks loan money, that money is spent on goods or
services. These goods or services create income for the people
providing them, which they in turn spend on other good and services.
When lots of loans are made, even more spending is done and more money
is pumping through the economy.
When the Fed sees that too much money is going through
the economy and prices are rising too quickly (inflation), they put the
brakes on by selling securities. This reduces the amount of reserves
available to banks, causing interest rates to rise, and banks will not
make as many loans because it costs more for consumers to borrow.
Ultimately, the economy slows down and inflation slows down with it.
The Fed Tool Box: Open Market Operations
most effective tool the Fed has, and the one it uses most often, is the
buying and selling of government securities in its open market
operations. Government securities include treasury bonds, notes, and
bills. The Fed buys securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow.
Here's how it works. The Fed purchases securities from a bank (or
securities dealer) and pays for the securities by adding a credit to
the bank's reserve (or to the dealer's account) for the amount
purchased. The bank has to keep a percentage of these new funds in
reserve, but can lend the excess money to another bank in the federal
funds market. This increases the amount of money in the banking system
and lowers the federal funds rate. This ultimately stimulates the
economy by increasing business and consumer spending because banks have
more money to lend and interest rates are lowered.
When the Fed wants to decrease the money supply, it sells
securities. That transaction deducts the purchase amount from the
bank's reserve (or the dealer's account). This reduces the amount of
money the bank has to lend in the federal funds market and increases
the federal funds rate. This move ultimately slows the economy down by
decreasing the amount of money banks have to loan, which increases
interest rates and typically reduces consumer and business spending.
These decisions are made by the Federal Open Market Committee
(FOMC), which consists of the seven members of the Board of Governors,
the president of the Federal Reserve Bank of New York, and four
rotating members from the other eleven Reserve Banks. This committee
has eight meetings per year to discuss and direct the monetary policy.
Additional emergency meetings are called when needed. The FOMC
specifies either a quantity of reserves to be purchased or sold or a
specific change in the federal funds rate. (The federal funds rate is
the interest rate at which banks lend reserves to other banks.)
The Fed Setup: Decentralization & Board of Governors
The Federal Reserve System was established in 1913 when Congress passed the Federal Reserve Act.
Although the Fed is independent of the government, it is ultimately
accountable to Congress because Congress can amend the Federal Reserve
Act at any time. Its actions, however, do not require any kind of
approval from the government.
The Fed is called a "decentralized" central bank, which
in itself seems to be a contradiction. It works, however, because the
Fed is uniquely structured to eliminate government control but still
remains accountable to both the government and the public. The Board
represents the interests on the government side, and the regional
Reserve Banks (whose boards of directors consist of local citizens)
represent the interests of the private side. In order to operate
independently of the government, the Fed finances its own operations.
The Board of Governors
The Fed has a seven-member Board of Governors and 12 regional Reserve
Banks. The U.S. president appoints (and the Senate confirms) the seven
Governors, whose 14-year terms are staggered to prevent a single
president from being able to appoint too many governors. The chairman
of the Federal Reserve, who serves a four-year term, is also appointed
by the president.
The Fed Setup: Directors, Regionals, FOMC
Each of the 12 Reserve Banks has nine directors on its
board. The directors are responsible for the overall operations of
their banks and report to the Board of Governors. The directors are
divided into three groups that represent a cross-section of ideas and
interests for the region. These groups are called Class A, Class B and
Class C. Class A represents commercial banks that are members of the
Federal Reserve System. These member banks elect both the Class A and
Class B directors. Class B and C directors do not come from the banking
industry. They represent the economic interests of the local district,
including agriculture, manufacturing, labor, consumers and nonprofits,
and are elected by the Board of Governors. This allows both the private
sector and the government/public sector to have representation.
Any national bank that is chartered by the federal
government is automatically a member of the Federal Reserve System.
State banks have to meet specific standards that the Board of Governors
sets in order to become members.
Member banks are required to buy stock
in their regional Reserve Banks. This stock doesn't give the bank any
kind of voting privileges and cannot be sold or used as collateral for
loans. What the banks do get is a six percent dividend on the stock and
the ability to vote for the Class A and Class B directors of the
Regional Reserve Banks
regional Reserve Bank president is appointed to a five-year term by the
bank's Board of Directors, but the Board of Governors gets the final
say-so in the appointment.
The Federal Open Market
Committee (FOMC) consists of the seven members of the Board of
Governors, the president of the Federal Reserve Bank of New York, who
acts as vice chairman, and four members from the other eleven Reserve
Banks that rotate at the end of each year.
In order to develop the nation's monetary policy, the
FOMC looks at many economic indicators. This gives the FOMC a feel for
what the economy is doing and what direction it may be taking. It also
looks to the The Beige Book,
which is a report that summarizes comments received from businesses and
other contacts outside of the Federal Reserve. This, in addition to
economic indicators, forms the basis for the FOMC's monetary policy.
Money Supply Measures
The Fed categorizes money based on its liquidity. It is divided into three categories:
- M1 - The actual cash money supply, spending money, checking accounts and currency
- M2 - A larger category that includes M1, small savings accounts and time deposits at banks, and money market mutual funds
- M3 - Larger and less liquid, including corporate CDs, etc.
The Federal Reserve chairman accesses data about the economy
every half hour or so when things in the economy are calm, and every 15
minutes when things aren't. This is simply to make sure nothing is
happening in the economy that the chairman doesn't know about. The
chairman can also tap into a network of business contacts that provide
insight into a wide range of businesses, revealing who is buying what
and in what amounts. By staying on top of where the economy is right
now and where it is going, the Fed can project future changes and act
Here are the economic indicators examined by the Fed:
- Consumer Price Index (CPI) - This indicates the change in
price for a fixed set of merchandise and services intended to represent
what a typical consumer might purchase over a given period. It is
compiled monthly by the U.S. Department of Labor's Bureau of Labor
Statistics. By keeping track of the rate of change in the CPI, the Fed
can get an accurate measure of inflation.
- Real Gross Domestic Product (GDP) - The GDP is the
total of all of the goods produced in the United States, regardless of
who owns them or the nationality of the producers. The measurement is
produced quarterly and accurately represents national output, meaning
it uses real terms so inflation doesn't distort the numbers. It is used
as an indicator of the performance and growth of the economy.
- Housing Starts - Because housing is very sensitive
to interest rates, this indicator is tells the FOMC how financial
changes are affecting consumers. Housing starts are an estimate of the
number of housing units that started construction in a given period.
The report is produced monthly.
- Nonfarm Payroll Employment - This measurement
includes the total number of payroll jobs that are not in the farming
business. It is produced each month by the U.S. Department of Labor's
Bureau of Labor Statistics and also includes information about the
total number of hours worked and hourly wages earned by workers. It is
helpful to the FOMC as an economic indicator because it indicates the
pace (or changes in the pace) of economic growth. The average hourly
earnings number also shows trends in supply and demand.
- S&P Stock Index - The Standard & Poor Index
shows the FOMC the changes in price in a very wide variety of stock.
S&P compiles the index daily. The value of watching this index as
an indicator of the economy is that it often indicates the confidence
consumers and businesses have in the economy. If the market is rising,
then investments and spending will rise; if the market is low or
falling, then investments and spending will also slow down.
- Industrial Production/Capacity Utilization - This
measures industrial output both by product and by industry. It is
compiled by the Board of Governors each month and is useful because it
tells the FOMC about the current growth of the Gross Domestic Product.
By understanding the level of capacity utilization, the FOMC can
understand how well resources are being utilized. All of this can
indicate future changes in the rate of inflation.
- Retail Sales - This is a total of all merchandise
sold by retail merchants in the United States. The numbers are
presented in dollar amounts, and are adjusted for seasonality but not
for inflation. The U.S Department of Commerce produces this report each
month. This measurement tells the FOMC how much consumers are buying.
This is called the personal consumption expenditure and indicates future growth or lags in the economy.
- Business Sales and Inventories - This is a
measurement of the total sales and inventories for the manufacturing,
wholesale, and retail sectors. This report is compiled monthly by the
U.S. Department of Commerce and can be a good indicator of growth or
slow downs in the economy because it shows the level of inventory and
whether it is moving or not. Inventory that isn't moving indicates a
future slow down; inventory that is moving may indicate an increase in
- Light-Weight Vehicle Sales - Because changes in car
sales can account for a large portion of the change in the GDP from
quarter to quarter, this measurement has to be taken into account. The
report is compiled by Ward's Automotive Reports and the American
Automobile Manufacturer's Association, and seasonally adjusted numbers
are generated by the U.S. Department of Commerce and the Bureau of
- Yield on 10-year Treasury Bond - This is simply
the current market rate for U.S. Treasury bonds that will be maturing
in 10 years. This is good as an indicator because mortgage rates tend
to follow it. Changes in mortgage rates, in turn, indicate future
changes in the housing industry.
- M2 - Because there is often a link between the
supply of money and the growth of the GDP, this measurement is yet
another indicator that the FOMC looks to when making decisions about
monetary policy. The report is produced by the Board of Governors
weekly and monthly.
Economic Indicators: Leading, Coincident, Lagging
Economic indicators are categorized as leading, coincident, or lagging. Leading indicators anticipate the direction in which the economy is going. Coincident indicators tell the Fed about the economy's current status. Lagging
indicators help the Fed determine how long a downturn or upturn in the
economy will last because these indicators are affected months after an
upturn or downturn has begun.
By studying the indicators as they fall into these categories,
the Fed can determine the phase of the business cycle that the economy
is in at the time. The four phases of the business cycle are:
The categories of "leading," "coincident," and "lagging"
indicate the turning points of the economy relative to the business
cycle. As the economy moves from one phase to the next, these
- Expansion or recovery
- Contraction or recession
For more detailed information about how economic indicators work, check out Economic Indicators on the Fed 101 Web site.
How does the Fed support itself?
order to remain independent of the U.S. government, the Federal Reserve
totally supports itself. It generates its income for the most part from
interest. This interest comes from many sources, including:
The Fed is also paid fees for services it provides such as funds transfers (Fedwire), check processing,
and automated clearinghouse (ACH) operations. (ACH options are
electronic alternatives to the paper-based check system. Examples
include automatic payroll deposits and electronic bill paying.)
- Government securities that it acquires through open market operations
- Foreign currency investments
- Bank/depository institution loans that the Fed makes using the discount rate
Any money the Fed has left over after it pays all of its expenses
are sent to the U.S. Treasury. Since the Federal Reserve System began
in 1914, about 95 percent of the Reserve Banks' net earnings have ended
up being paid into the Treasury.
Information about the income and expenses of the Federal Reserve Board can be found in the Board of Governor's Annual Report.
Checks and Balances
of the Federal Reserve was carefully laid out to incorporate a strong
system of checks and balances. Its decentralized status and broad range
of participants eliminates the chances of any one group having too much
Each of the Fed's tools is under the authority of a different
group within the system. For example, the Board of Governors has the
authority to change bank reserve requirements; the boards of directors
for the individual Reserve Banks can initiate changes to the discount
rate (which then has to be approved by the Board of Governors); and the
open market operations (the most important tool) is controlled by the
FOMC, which represents both groups.
These checks and balances, along with the overall structure of
the Federal Reserve, make sure that partisan interests don't have too
much control and ensure that the Fed's decisions represent the broad
interests and needs of the entire United States.