An Overview of the Federal Reserve System

The Federal Reserve System—commonly called the “Fed”—is often mentioned in news stories concerning the economy and financial issues. But exactly what is the Federal Reserve System? What does it do? Why is it important? You are not alone if you cannot answer these questions. Many Americans do not know much about the Fed and do not understand the crucial role it plays in our economy.

What Is the Fed?

The strength of any country’s economy depends on a disciplined and well-managed monetary system—the system that controls the supply of money and regulates banking practices. Supervising and regulating a country’s monetary system is the role of a country’s central bank. In the United States, this central bank is called the Federal Reserve System. Congress created the Federal Reserve System in 1913 in response to frequent instability—and resulting “panics”—in the banking industry.

Structure of the Fed

At the top of the Federal Reserve System is the Board of Governors, located in Washington, D.C. The Board consists of seven members, called governors, who are appointed by the president of the United States and confirmed by the Senate. Heading up the Board are the chairman (currently, Ben Bernanke) and vice chairman (currently, Donald Kohn). The Board of Governors regulates banks, determines national monetary policy and oversees the activities of regional Federal Reserve Banks.

The Federal Reserve System is divided into 12 districts. Each district is served by a regional Federal Reserve Bank. These banks conduct research on the economy in their regions, supervise their regions’ banks and provide financial services to banks and the U.S. government.

The Fed as Payment Processor

As the banker to the nation’s commercial banks, the Fed stores excess currency, processes checks and electronic payments, maintains the Treasury Department’s checking account and clears U.S. Treasury checks.

The regional Federal Reserve Banks process various Treasury payments, including Social Security and payroll checks; issue transfers; redeem U.S. Treasury securities; and conduct Treasury securities auctions.

The Fed as Lender

The Fed lends money to banks and other depository institutions to help them endure temporary, unexpected changes in their deposits or loan portfolios, assists institutions that have seasonal or emergency credit needs and serves as the lender of last resort to the nation’s largest banks.

The Fed as Regulator

The Fed supervises and regulates financial institutions to ensure their fiscal soundness and compliance with laws. The Fed monitors bank holding companies (companies with significant ownership of one or more banks), state-chartered banks that are members of the Federal Reserve System and various international banking operations. It also enforces several laws protecting consumers in their financial dealings.

The Fed’s Direct Influence on Economic Growth

Using input from many sources, including the Federal Reserve Banks’ reports on local economic conditions, the Fed implements policies to manage the flow of money and credit in the economy. If this flow increases too rapidly, businesses cannot produce enough goods and services to keep up with increased spending. Prices may rise, causing inflation. On the other hand, if the flow of money and credit decreases too quickly, spending and business activity may decline, workers may lose their jobs and a recession may result. The Fed conducts monetary policy to attempt to balance these two extremes.

The Federal Open Market Committee (FOMC) is the arm of the Fed responsible for setting policies designed to foster a healthy economy. The seven Board members constitute a majority of this 12-member committee. The other five members are regional Federal Reserve Bank presidents. The FOMC meets eight times a year in Washington, D.C., to discuss economic forecasts and developments in the financial and foreign exchange markets. The Committee then reviews monetary policy options that would best promote the economy’s sustainable growth, while simultaneously controlling inflation.

After these deliberations, members vote to increase, decrease or maintain the target for the federal funds rate. The federal funds rate is the rate charged by banks to other banks for overnight lending of funds held at the Fed. The federal funds rate is a key determinant of lending rates and credit practices throughout the banking system, since most banks take their cue from the Fed when deciding what to charge their borrowers.

By setting a target federal funds rate and using monetary policy to achieve this target rate, the Fed and the FOMC seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates,” as required under the Federal Reserve Act.

Through the combined efforts of the Board of Governors, the regional Federal Reserve Banks and the FOMC, the Federal Reserve System can help guide economic policy, provide a robust banking network and ensure an effective payment system—all of which contribute to a healthy national economy. However, a national economy is a highly complex system, and the Fed’s actions are only one influence among many on citizens’ economic behavior. The Fed is neither omniscient nor omnipotent, as some in the media would have us believe, and its policies are only as good as the research informing its members and shaping their decisions.

Resources

For the latest information on Federal Reserve activities and policies, access their website at http://www.federalreserve.gov.