Federal Reserve (The Fed)

What Is The Federal Reserve (The Fed)?

The Federal Reserve, headquartered in Washington D.C., is the central banking system of the United States of America. It is the key economic establishment in the U.S.

It supplements the operations of the U.S. economy. The Fed preserves a strong influence over the global economy, making it an internationally influential and important financial institution.

It acts in the public interest to encourage financial system stability by adjusting interest rates, money supply, and bank regulations. It is responsible for administering Monetary Policy with a degree of independence from legislation within the established framework and oversight from the government.

The Fed has the authority to perform five key functions within the U.S. economy:

1. Conducting the U.S. Monetary Policy 
2. Promoting Financial System Stability
3. Promoting Financial Institutional Safety and Soundness
4. Supervision of Payment Systems
5. Promoting Customer Protection and Community Building 
6. Lender of Last Resort

History Of The Fed

The origins of the Federal Reserve (the Fed) can be traced back to the aftermath of the "Panic of 1907" and the economic challenges of the late 19th and early 20th centuries in the United States.

Periodic recessions marked this era, leading prominent figures such as J.P. Morgan and John D. Rockefeller Jr. to advocate for the establishment of a new central banking system.

Responding to the nation's precarious financial conditions, Republican Senator Nelson Aldrich initiated two separate commissions to examine both the American monetary system and European central banking models. Aldrich drew inspiration from the Bank of England and the German monetary system.

Despite facing initial rejections of his proposals in Congress, a revised bill was eventually approved on December 22, 1913.

Functions of the Federal Reserve

Some of the major key functions of the Fed within the US are:

Conducting Monetary Policy

It's a key instrument where the federal funds rate is impacted. The Fed influences interest rates, which, in turn, can impact spending on capital goods, consumer products, and housing services.

Changes in interest rates can influence import and export spending. The Federal Reserve may adjust rates as part of its strategy to stimulate economic activity.

Monetary policy is not targeted at specific variables, and it is designed to achieve the lowest levels of unemployment and price stability in the U.S. 

Financial Stability

It is monitored by the Fed by ensuring connections between financial institutions where the financial market constructs financial strength to withstand volatility and provide goods and services to consumers.

The Dodd-Frank Act

The Dodd-Frank Act grants the responsibility of the Federal Reserve to aid those nonbank financial companies that are in financial trouble and distress and whose financial activities may pose a threat to the financial stability in the U.S., considered to be systemically important. 

This is protection against the failure of nonbank financial institutions to promote health, vitality, safety, and soundness in the financial system. 

The Fed Monitors and Oversees

The Fed monitors the policies, systems, and operations of depository institutions and other agencies, including independent bodies like the SEC (Securities and Exchange Commission).

It handles the infrastructure of domestic and foreign financial market infrastructures. These policies are designed to enhance the efficiency and performance of the payment system in the U.S. and clear issues within the financial market.

The Fed's supervisory responsibilities necessitate a wide range of engagement at operational levels as well as policymaking levels. 

The Fed is also responsible for protecting consumers in lending and depository transactions. The FED’s examiners ensure credit costs and interest rates carry the correct values with clear statements.

Lender of Last Resort

It is when the Fed creates short-term loans to non-bank firms and institutions at a discounted rate based on certain conditions in an emergency.

The Fed was established in 1913 to create a safe, flexible, and stable financial system in the act of Congress. The key goal was to ensure the American banking system was stable. There was a need for financial discipline, and the FED suited the role of a bank.

Several banks had failed, and there was an outbreak of panic and payment suspensions due to inelastic currency. The money note supply was unresponsive to changes in demand in the event of an unforeseen circumstance.

In 1907, a company called The Knickerbocker Trust Company failed as it lacked suitable funding to meet depositor demands for cash withdrawals.

As there was no lender of last resort, there was panic which led to bank failure, a reduction in money supply, and recession. Congress soon created the federal commission to assess the economy, leading to the Federal Reserve’s establishment in 1913. 

The introduction of the Federal Reserve System was a breakthrough for the U.S. financial system. 

Structure Of The Fed

The Fed generates money and currency using Open Market Operations. It purchases securities through the market using either newly created currency or by creating bank reserves issued to commercial banks.

The bank reserves multiply through reserve banking as banking institutions lend a part of deposits on hand. 

Since the Fed has the authority to control inflation by influencing interest rates, it can lower interest rates and control the money supply by encouraging spending and borrowing, therefore impacting aggregate demand.

It carries a target inflation of 2%. Long-term economic growth is achieved by using price stability and inflation control. Exceeding the 2% inflation rate demonstrates a dangerous economic position for the operating economy.

The Federal Reserve System has a dual structure where it is segmented into the Board of Governors situated in Washington D.C. and an extensive network of twelve Federal Reserve Banks located across the U.S. 

The Federal Open Market Committee brings members of the Board of Governors and Fed Reserve Banks to implement the monetary policy. The Fed’s structure was established to ensure the monetary policy was protected against political pressure. 

The Fed's decisions are designed to be protected against direct intervention. However, Congress retains the power to alter laws governing the Fed and its structure. 

The Fed also reports to Congress on auditing and monetary policy. However, the independence of the Fed's structure from direct government control is maintained.

It is independent, as monetary policy decisions are not necessarily approved by the Fed. Congressional oversight, supervisor, and the Fed must collaborate within a government framework of economic and fiscal policy objectives.

Monetary Policy and the Fed

Monetary policy refers to what the Federal Reserve does to impact money quantity and credit in the American economy.  

Monetary policy is linked to inflation. Inflation, a persistent increase in the price of goods and services over time, can potentially reduce consumer spending and purchasing power. When the money supply rapidly increases over time, inflation occurs.

The Federal Reserve's funds come from income generated by U.S. government security holdings and service fees provided to financial institutions. After expenses are paid, 90% of earnings are returned to the U.S. Treasury. 

The objectives of the monetary policy include promoting full employment, stable prices, and interest rates. An effective monetary policy contributes to the Fed’s objectives and supports economic growth, efficiency, and productivity. 

Monetary Policy Instruments

The three key instruments optimized in the monetary policy are:

• Open Market Operations (also known as OMO): Mean the purchasing and selling of government securities and are considered flexible and familiar, and dealers compete on the prices of securities. 
• Discount rate: This is the rate of interest charged by the Fed to add a deposit on a depository institution on a short-term loan.
• Reserve requirements: These are depository portions where banks maintain their deposits in a Fed bank. 

The Federal Open Market Committee, also known as FOMC, is the institution that generates the monetary policy consisting of seven members as part of the BOG, the Board of Governors, the president of the Fed bank, and presidents of four reserve banks coordinating operations on an annual basis. 

The FOMC meeting occurs eight times annually, where developments of foreign exchange markets are discussed between officials at the Fed, and monetary policy options are created without a recommendation on policy. 

It implements the monetary policy by affecting the rate of federal funds and the interest rate that financial institutions charge one another for loans for reserves in the market. The Fed’s monetary policy actions impact the federal funds rate.

Any changes in the federal funds rate affect short-term interest rates that impact the cost of borrowing for firms and customers, total money quantity and credit in the firm, inflation, and employment. 

It uses monetary policy to impact the federal funds rate and stabilize inflation prices. Monetary policy can either tighten or contract. 

To reduce inflation and economic pitfalls, it uses monetary policy instruments to decrease the federal funds rate. The monetary policy either eases or becomes expansionary. 

$1.25 trillion were Federal Reserve money notes out of $1.29 trillion in October 2014.

The Federal Reserve’s Response to COVID-19

Its mission is to promote stable prices and full employment for Americans and stimulate financial system stability. 

Any type of economy might be subject to a crisis at any given time: the COVID-19 pandemic is a prime example. 

It takes critical actions to mitigate economic consequences and prevent the worst circumstances, such as an economic recession or depression, from occurring and adversely impacting the interconnectivity of the financial system.

The pandemic has caused global economic difficulty. COVID-19 has had a massive outbreak and negative impact on the functionality of the American economy. It has disrupted business lending, borrowing, and consumer spending and created high levels of unemployment.

The first step the Fed took was for its FOMC to reduce the target for the federal funds rate, lowering it to almost 0. It is expected to remain the same until the economy recovers from the disruption and normalizes to meet the Fed’s objectives. 

Borrowing costs are therefore reduced for firms and households, and spending and investment decrease as the economy grapples with the challenges posed by the economic crisis. 

The next step for the Fed was to stabilize the financial market and encourage smooth operations. Trading of securities was relaxed as its volatility in the financial market was hard for buyers and sellers. 

Fed’s purchases of securities have allowed markets to operate in a market of difficulty where assets are hard to exchange and sell. Purchases generate cash in the economy and demonstrate that the Fed is a strong supporter and backer of the U.S. financial system.  

The last step taken by the Federal Reserve was introducing temporary funding and lending facilities, which are financial assistance programs that the Fed offers to help borrowers meet their funding needs.

The Fed has the authority to lend in crucial circumstances with the approval of the U.S. Treasury.  Although COVID-19 was a health crisis, it has impacted the U.S. economy and financial markets significantly. 

However, the Fed has responded effectively and made key changes to follow the dual mandate and meet its objectives. The actions have minimized economic harm and established a strong foundation for economic recovery amid a public health crisis. 

Summary

The Federal Reserve (The Fed), headquartered in Washington D.C., is the cornerstone of the U.S. economy, influencing interest rates and financial regulations. Established in 1913, it operates independently, executing monetary policy and ensuring financial stability.

Some of the key functions include conducting monetary policy, overseeing payment systems, and acting as a lender of last resort. Structured with the Board of Governors and twelve Federal Reserve Banks, the Fed utilizes tools like open market operations and discount rates.

In response to the COVID-19 pandemic, it swiftly lowered interest rates, stabilized markets, and supported credit flow, showcasing its commitment to stability and employment in the face of economic challenges.

Researched by Haniya Ahmad Wasim I LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Commercial Bank
• Fed Balance Sheet
• Federal Discount Rate
• Federal Funds Rate
• Federal Open Market Committee (FOMC)