4 Things You Need to Know About the Federal Reserve

By Damian Davila on 25 May 2016 0 comments

The mention of the Federal Reserve brings to many Americans the image of a super powerful organization in charge of keeping the economy operating smoothly. And to a certain extent that isn't too far from reality: The Fed develops and implements economic and monetary policies that affect not only U.S. citizens, but also individuals around the world.

Let's take a closer at what is the Fed, what it does, and how those actions impact people everyday.

What Is the Fed?

Created by the U.S. Congress on December 23, 1913, the Federal Reserve System became the first formal organization to study and implement monetary policy. In other words, it is the central bank of the United States.

Currently there are 12 regional Federal Reserve Banks located throughout the nation in major cities, including Boston, Dallas, and San Francisco. Each one of these locations serves a district formed by entire or portions of several U.S. states and territories. For example, the St. Louis Federal Reserve Bank serves the Eighth Federal Reserve District, which consists of Arkansas and portions of six other states: Missouri, Mississippi, Tennessee, Kentucky, Indiana, and Illinois.

Who Makes Up the Fed?

While the most well-known figure of the Fed is the chairman of the Board, currently Janet L. Yellen, the Fed is headed by a Board of Governors. Each one of the seven members of the Board of Governors is appointed by the president and serves for a 14-year term. The board is led by a chairman and a vice chairman, both also appointed by the President but approved by the Senate for four-year terms.

Some interesting facts about the Fed's chairmen:

  • While Alan Greenspan is often thought to be the longest-serving chairman, that title goes to William M. Martin with 18 years and 9 months, from 1951 to 1970. (See also: 3 Pearls of Financial Wisdom From Alan Greenspan)
     
  • The current vice chairman, Stanley Fischer, is the author of many classic economic textbooks, which you may have used (or are currently using) in college.
     
  • On February 3, 2014, Janet Yellen became the first female chair of the board of governors. She was also the first female vice chairman during her 2010–2014 appointment.
     
  • The only former Fed chairman on social media is Ben Bernanke, who you can follow at @benbernanke on Twitter.
     
  • While a chairman is appointed for four years, some resign before their full term. For example, Roy Young resigned in the middle of his last four-year term.

The Fed chairman has less unilateral power than the title might suggest. The chair counts as just one vote among the total seven votes of the board. Additionally, the chairman doesn't automatically become the chairman of the Federal Open Market Committee (FOMC), which is the Fed's monetary policymaking body formed by the seven members of the board and five Reserve Bank presidents on a rotating basis. The FOMC controls the federal funds rate, the primary lever of U.S. monetary policy. The Fed chair also only counts as one vote in the FOMC.

What Does the Fed Do and How Does It Affect You?

All of the responsibilities of the Fed fall under four general areas and they all have an effect on your financial activities.

1. Influence money and credit conditions in the U.S. economy in pursuit of full employment and stable prices.

By setting the target federal funds rate, the Fed establishes a benchmark for many short-term interest rates and, consequently, influences credit conditions throughout the economy. Through open market operations (the purchase and sale of U.S. government securities), setting the discount rate (usually lower than the federal funds rate and used for short-term loans from a Federal Reserve Bank to a regular bank), and minimum reserve requirements that banks must adhere to, the Fed aims to maintain its announced target federal funds rate.

The Fed's monetary policy affects the supply of reserves in the U.S. banking system, indirectly affecting longer term interest rates, such as mortgages, and ultimately aiming to achieve full employment and low inflation.

How It Affects You: For good reason, economists keep a close eye on the target federal funds rate. It affects all forms of credit. For example, the interest rate on 30-year mortgage loans are highly correlated to the yield of a the U.S. Treasury 10-year bond, which depends on the Fed's target rate. Another example is that banks set the interest rates on their loans and deposit accounts based on the federal funds and discount rates. (See also: 6 Important Things You Need to Know About the Housing Market in 2016)

2. Supervise and regulate banks and other important financial institutions to ensure the safety of the nation's banking and financial system.

The Fed shares banking supervisory authority with other agencies, including the Office of the Comptroller of the Currency (OCC) in the U.S. Treasury Department. All nationally chartered banks have to be members of the Federal Reserve System and are subject to on-site examinations and off-site monitoring by their assigned Federal Reserve Bank. An example of an examination is the stress test, which requires financial institutions to have enough deposits on hand to withstand potentially large losses.

How It Affects You: The Fed establishes minimum requirements for banks to have cash on hand so that you can actually withdraw your money. If there were no minimum requirements, an unscrupulous bank could hold all deposits hostage by lending them all out. At the same time, it prevents banks from closing shop for the day for not having enough cash after a very large withdrawal.

3. Maintain the stability of the financial system by containing systemic risk.

No matter how much you diversify your portfolio, you can never get rid of systemic risk — the risk of collapse on the entire financial system. The Fed seeks to minimize that systemic risk as much as possible.

The Fed can act as a "lender of last resort" to provide liquidity to the banking system during emergency situations. For example, on the day after 9/11 the Reserve Banks provided loans directly to depository institutions to restore confidence in the U.S. financial system and allow those institutions to meet their short-term obligations.

Under the 2010 Dodd-Frank Act, the Fed has authority to subject systemically important nonbank financial institutions, such as bank holding companies with over $50 billion in assets, to heightened supervisory standards.

How It Affects You: You're willing to put your money in banks and invest in the stock market because you trust that the financial system is here to stay. The Fed plays a key role in maintaining that trust by by enabling banks to make payments even in the event of emergencies and regulating activities of key financial institutions.

4. Provide certain financial services to the U.S. government and other major official institutions and operate the nation's payment systems.

The Fed distributes all bills printed by the U.S. Bureau of Engraving and Printing in Washington, D.C., and Fort Worth, Texas, and all coins produced by the U.S. Mints in Philadelphia and Denver to its 12 Federal Reserve Banks. In turn, these 12 banks distribute all bills and coins to depository institutions throughout the U.S. to meet public demand.

The Fed's Automated Clearinghouse (ACH) processes about three fourths of the nation's electronic transactions, which include direct payroll deposits, Social Security benefit payments, and tax refunds. Additionally, the Federal Reserve Banks handle a wide variety of financial transactions for U.S. agencies, including processing of food stamps and handling of postal money orders.

How It Affects You: The Fed makes sure that your payroll deposit and tax refund arrives in a timely manner to your checking account. The Federal Reserve Banks virtually touch almost any payment that you send out or any deposit that you receive through a bank.

What do you think is the most important role of the Fed?

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Guest

The discount rate is set higher than the federal funds rate. The Fed wants to encourage banks to lend to each other. But the Fed will be the lender of last resort to a bank (at the discount rate) if no other bank will lend to a bank (at the federal funds rate).