Federal Reserve (The Fed)
It is the key economic establishment in the U.S.
Headquartered in Washington D.C, the central banking system of the United States of America, known as the Federal Reserve The Fed, 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 a vastly influential and important financial institution internationally.
The Fed acts in the public interest to encourage financial system stability by adjusting interest rates, money supply, and bank regulations.
The Fed is responsible for administering the Monetary Policy without intervention from legislation, independently from the government.
The Fed is the authority to perform five key functions within the U.S. economy:
Conducting the U.S. Monetary Policy
Promoting Financial System Stability
Promoting Financial Institutional Safety and Soundness
Supervision of Payment Systems
Promoting Customer Protection and Community Building
1. Conducting Monetary policy is a key instrument where the federal funds rate is impacted. The Fed affects the interest rates and spending on capital goods, consumer products, and housing services.
Interest rates have an impact on import and export spending. The Federal Reserve decreases rates to produce 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.
2. Financial stability 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.
3. 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.
4. The Fed monitors and oversees the policies, systems, and operations of depository institutions and other agencies associated with the government, such as the SEC, which is the securities 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.
5. 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.
Debit cards are also issued by the bank, and the FED ensures that transactions are conducted in a fair manner using appropriate fees and resolving errors timely.
6. Lender of Last Resort 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.
The Functions of The Fed
The Fed generates money and currency using OMO. It purchases securities through the market using new currency or by the creation of bank reserves that are 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 two percent.
Long-term economic growth is achieved by using price stability and inflation control. Exceeding 3% of an inflation rate demonstrates a dangerous economic position for the operating economy.
Although the federal reserve of the Fed is not owned by any entity or individual, the Board of Governors directly reports the activities of the Fed to Congress.
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 Fed 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.
Its decisions are protected against intervention. Although the Fed is protected against political pressure, Congress has the power to alternate laws dictating the Fed and its structure.
The Fed also reports to Congress on auditing and monetary policy. Therefore, the Fed's structure is independent of the government. The Fed 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
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 is a persistent increase in the price of goods and services over some time. Therefore it reduces consumer spending and purchasing power. When the money supply rapidly increases over time, inflation occurs.
Its funds come from income from U.S. government security income 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.
The three key instruments optimized in the monetary policy are Open Market Operations, also known as OMO, discount rate, and reserve requirements.
Open market operations mean purchasing and selling government securities and are considered flexible and familiar, and dealers compete on the prices of securities.
The discount rate is the rate of interest charged by the Fed to add a deposit on a depository institution on a short-term loan. Reserve requirements 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 lifespan of money bills has various denominations.
Smaller bills last for six years, whereas larger notes circulate for 15 years. $1, $2, $5, $10, $20, $50 and $100 notes are circulated by the Fed. The largest note to be created was a $10,000 note. However, due to its redundancy and obsoletion, it was discontinued.
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 is causing 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.
It took key actions in response to COVID-19, including lowering the policy rate, stabilizing financial markets, and supporting credit flow in the U.S. economy.
The first step the Fed took was for its FOMC monetary policymaking body to reduce the target for the federal funds rate, FOMC's interest rate, and lower 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 are decreased as the economy evolves from the critical negativity of 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 the Fed 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 carries the authority to lend in crucial circumstances with the approval of the U.S. treasury.
Although COVID-19 is 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
Throughout this article, a wide range of topics have been discussed and analyzed in detail concerning the Federal Reserve.
The Federal Reserve is defined, the role of the Fed is understood, and the historical context of the Fed's introduction and establishment in 1913 was seen.
The structure, independence, operational mechanism, and ownership of the Fed were also critically summarized in this article.
Finally, an explanation of the monetary policy, its impact, and its implementation were provided, along with an understanding of the Fed's response to COVID-19.
The Federal Reserve System has foreseen several transitions since its establishment in 1913.
Its prominence and strong power over the global financial system have made it a powerful force in promoting the stability of the U.S. economy, with objectives it continues to meet amid a widespread COVID-19 pandemic.
Everything You Need To Master Financial Statement Modeling
To Help You Thrive in the Most Prestigious Jobs on Wall Street.
Researched by Haniya Ahmad Wasim I Linkedin
Free Resources
To continue learning and advancing your career, check out these additional helpful WSO resources:
or Want to Sign up with your social account?