What is the Fed?
The Federal Reserve System was created on December 23, 1913, when President Woodrow Wilson signed the Federal Reserve Act into law. The system is composed of a central, independent governmental agency–the Board of Governors–in Washington, D.C., and 12 regional Federal Reserve Banks, located in major cities throughout the nation.
Today, the Federal Reserve sets the nation’s monetary policy, supervises and regulates banking institutions, maintains the stability of the financial system, and provides financial services to depository institutions, the U.S. government, and foreign official institutions.
What does the Federal Reserve Do Specifically?
The Federal Reserve performs five main functions for the country.
- conducts the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy;
- promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad;
- promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole;
- fosters payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments; and
- promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.
***All this information is courtesy of the federalreserve.gov site.
Now let us talk about each of these points and how they accomplish what it is they are trying to do.
Point #1 Federal Open Market Committee (or FOMC)
The term “monetary policy” refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.
The Federal Reserve controls the three tools of monetary policy–open market operations, the discount rate, and reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.
To accomplish this, the Fed has many tools at its fingertips. Here is a link that will take you to some of the tools that are used. https://www.federalreserve.gov/monetarypolicy/policytools.htm
Point #2 Use of Forms to Collect Data
The Federal Reserve uses reporting forms to collect data from bank holding companies, depository institutions, other financial and nonfinancial entities, and consumers. The use of the forms is required in some cases, voluntary in others. Some data are collected periodically, others only occasionally.
Point #3 Community & Regional Financial Institutions
Community banks serve businesses and consumers throughout the country. The Federal Reserve defines community banking organizations as those with less than $10 billion in assets, and regional banking organizations as those with total assets between $10 billion and $100 billion. Regional and community banking organizations constitute the largest number of banking organizations supervised by the Federal Reserve. In supervising community banks, the Federal Reserve follows a risk-focused approach that aims to target examination resources to higher-risk areas of each bank’s operations and to ensure that banks maintain risk-management capabilities appropriate to their size and complexity.
The nine economic indicators that the Federal Reserve uses to forecast the upcoming changes in the country’s economy.
OUTPUT. The total output of goods and services is a key indicator of economic activity and serves as a gauge of the economy’s ability to provide products and services to people. Over the long run, people’s standard of living rises when output grows faster than the population. One of the goals of the Federal Reserve’s monetary policy is to achieve maximum sustainable growth of output.
CONSUMER SPENDING. Consumer spending accounts for about 2/3 of total spending in the economy, so monitoring its pace is a key ingredient in tracking the overall economy. Fortunately, consumer spending usually grows at a fairly stable rate, helping to smooth fluctuations in the overall economy.
HOUSING STARTS. Housing starts are an estimate of the number of new housing units that builders begin to construct each month. Housing starts are used to monitor movements in the economy because housing activity is very sensitive to changes in interest rates and tends to be very cyclical. Such starts are typically low during periods of slow economic growth or recessions and are high during periods of strong economic growth.
UNEMPLOYMENT. The unemployment rate measures the number of people looking for jobs as a percentage of the total number of people who are either working or looking for work. Payroll employment measures the number of jobs in the economy. One of the goals of the Federal Reserve’s monetary policy is to maintain high employment that keeps the unemployment rate low. FEDERAL BUDGET SURPLUS OR DEFICIT. The federal government runs a budget surplus when its revenues exceed its expenditures; it has a budget deficit when its revenues fall short of its spending. When the federal government runs a deficit, it borrows (by selling Treasury bills, notes, and bonds) to pay its expenses. When it has a surplus, it repays previously issued debt. Changes in taxes or government spending enacted by Congress (referred to as fiscal policy) will alter the size of the budget surplus or deficit and can also affect the level of economic activity.
TRADE BALANCE. The trade balance is the difference between the amount of goods and services exported and the amount imported. A country has a trade surplus (i.e., a positive trade balance) when it exports more then it imports; it has a trade deficit (i.e., a negative trade balance) when it imports more then it exports. The trade balance reflects a variety of factors, including the strength or weakness of the dollar against other currencies. When U.S. economic growth is more rapid than economic growth abroad, the U.S. trade deficit also tends to increase.
INFLATION. Inflation occurs when the average level of the prices of the products and services we buy increases. When the average level of prices declines, this is called deflation. Significant inflation or deflation distorts economic incentives because it alters the purchasing power of people’s money. For example, a 5 percent annual rate of inflation means that the income you earn this year will buy 5 percent less next year. One of the goals of the Federal Reserve’s monetary policy is to achieve price stability — that is, no significant inflation or deflation.
INTEREST RATES. Interest rates determine consumers’ and businesses’ costs of borrowing credit and therefore affect their spending. The Federal Reserve uses one interest rate, the federal funds rate (the interest rate on overnight loans between banks), as its primary instrument for implementing monetary policy. Other interest rates tend to rise and fall with the federal funds rate (although rarely by exactly the same amount). Thus, changes in the federal funds rate are closely monitored for signals about current monetary policy.
STOCK MARKET. Stock market movements are one of the leading
indicators of economic activity and are also generally viewed as an indicator of business and consumer confidence in the economy. Changes in stock prices reflect investors’ expectations about changes in economic conditions that will affect companies’ future earnings. The stock market is an important source of funds for many companies and therefore influences their ability to expand. In addition, stock holdings are an important part of many people’s wealth; therefore, persistent changes in stock prices influence their willingness to spend (although changes in their incomes matter more).
***All this information is courtesy of the federalreserve.gov site.***
For more information about the origin and regulation of the Federal reserve, here is a link to the establishment of the Federal Reserve System we are now using.