What is the Fed, Anyway?

-- Expert Business Source, 5/6/2008 8:42:00 AM

As the economic consequences of the current credit crunch continue to unfold, an unlikely celebrity has emerged:  The Federal Reserve System, also known as the “Fed.”  The Fed’s Board of Governors and its chairman, Ben Bernanke, have received considerable attention as they repeatedly cut rates. Despite these frequent media appearances, I have observed that many people are unsure about the role of the Fed.

As one client put it, “Exactly what does the Fed do?  I think I slept through that class.”

Sleeping through civics or economics class is one thing, but if you’re participating in our economy as an adult, it is helpful to understand our nation’s banking system.  Therefore, here is a very abridged history of the Federal Reserve System and an equally abbreviated overview of what the Fed does.

An abbreviated history of the Federal Reserve System

The United States’ first attempt to establish a central banking system reaches back to 1791.  After twenty years in existence, that bank became dominated by big business interests and Congress did not renew its charter.  A second failed central bank and a “free banking” era were followed by the establishment of a unified currency for the U.S. for the first time after the Civil War.  Despite having one currency, numerous severe bank panics occurred in the late 1800s and early 1900s, finally leading Americans to realize the necessity of a central banking authority to stabilize the banking system. 

Purpose of the Fed

The purpose of the Federal Reserve System is formally stated in the Federal Reserve Act: "To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States and for other purposes."

Simply put, the Federal Reserve System is the central bank of the United States.  It was created by Congress on December 23, 1913 when President Woodrow Wilson signed the Federal Reserve Act to give American citizens a safer, stable monetary and financial system.  Congress designed the Fed to be somewhat flexible, with a broad perspective on the economy and on economic activity across the United States. The role of the Fed has evolved over time.  According to the Federal Reserve’s own educational website, it is a “classic example of compromise – a decentralized central bank that balanced the competing interests of private banks and populist sentiment.”

Several components

The Fed is composed of several components.  The Board of Governors of the Federal Reserve System in Washington, D.C., is a group which is appointed by the president and confirmed by the Senate. There is also a Federal Open Market Committee, twelve regional Federal Reserve Banks that act as fiscal agents for the U.S. Treasury, and numerous private U.S. member banks. Currently, Ben Bernanke serves as the Chairman of the Board of Governors of the Federal Reserve System.

Monetary policy, credit, stabilizing banking system

Being the bank to the nation is a serious responsibility. The Fed is in charge of setting our monetary policy by influencing money and credit conditions, and also supervises and regulates our larger banking system in order to keep it stable.  The Fed strives to protect the credit rights of consumers and provides financial services to the government, the public, domestic financial institutions and foreign official institutions.
 
Post-war changes

Following the Great Depression, during which over 10,000 banks failed, many blamed the Federal Reserve for failing to prevent the economic devastation.  The Glass-Steagall Act created new reforms in response, which separated commercial and investment banking. Federal Depository Insurance Corporation (FDIC) insurance was also created at that time to provide some protection for consumers.

Since that time the Fed has made many changes.  Among other sweeping reforms, Glass-Steagall was essentially repealed in the 1980s, allowing many banks to offer a variety of financial services including investments.

In the late 1980s, following the market crash of 1987, then-Fed Chairman Alan Greenspan emphasized the role of the Fed in ensuring liquidity for the nation.  This role was a vital one after the terrorist attacks of September 11, 2001, when financial institutions required a great deal of liquidity to provide stability to our economy.

How does monetary policy affect us?

The goals of monetary policy, as the Fed’s educational site offers are to “promote stable economic growth, full employment and stable prices.”  The Fed uses three tools to try and balance these goals:  the discount rate, open market operations and reserve requirements.

What we’ve been hearing about in the news frequently is the discount rate, which is the interest rate that the Fed charges depository institutions (banks) on a short-term basis.  Also in the news has been the Fed’s open market operation, in which the Fed buys and sells U.S. government securities.  This affects the Fed funds rate, which is the rate at which financial institutions borrow reserves from each other.   These actions, which we’ve been hearing so much about recently, are the Fed’s attempts to restore stability to our system through monetary policy.

When and how the economy will recover from its current malaise will be determined by many more forces than the Fed’s actions.  Nevertheless, it is helpful to understand the goals of the Fed and of monetary policy in general in order to understand why various decisions are made.  Next time there is a FOMC meeting, consider how far the U.S. banking system has come since our nation’s founding in its efforts to protect and guide our economy. 

Suzanna de Baca is president of Private Capital Solutions Group. Securities offered through Broker Dealer Financial Services Corp. Member FINRA & SIPC. Investment Advisor Representative of Investment Advisors Corp., A Registered Investment Advisor. Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed reliable, please note that individual situations can vary, therefore the information should be relied upon when coordinated with individual professional advice.