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How the Fed Works

From the September/October 2007 Issue

The Federal Open Market Committee meets today and is expected to slash interest rates. KEVIN HASSETT, a former Fed economist, offers an inside look at how America’s central bankers operate.

Fed Compared to Top U.S. Companies1) What is the Federal Reserve?

For 94 years, the Fed has been the central bank of the United States. Its primary duties are conducting the nation’s monetary policy, supervising and regulating banks, and providing financial services and liquidity (that is, ready cash) to depository institutions and the federal government.

Providing liquidity sometimes means being a lender of last resort. A lender of last resort can save a bank during a run by providing cash to the embattled financial institution. Throughout the early history of the United States, there was no official lender of last resort. Following a severe bank panic in 1907, the worst of four panics over a 34-year period, Congress appointed a commission to study the issue. The result was the Federal Reserve Act of 1913, which established the Federal Reserve System.

In 2006, after accounting for its expenses, the Fed returned $29 billion in profits to the U.S. Treasury.

The Fed is widely dispersed around the country. It has three major parts: the Washington-based Board of Governors, 12 regional Federal Reserve banks, and the Federal Open Market Committee (FOMC).

It is the FOMC, whose members include all of the governors, the president of the New York Fed, and four regional bank presidents in rotation, that has the high-visibility job of directing the operations that determine interest rates.


2) Who owns the Fed?

The Fed as a whole is a government organization that is not really owned by anyone, but each regional Federal Reserve bank is technically owned by the private commercial banks in its district.

Each of the regional Fed banks has its own board of governors and issues stock to commercial banks, which are required to purchase shares equal in value to 6 percent of their capital. The regional Fed bank actually holds only half of that money, the rest being “subject to call” by the governors in case of an extreme liquidity crisis. Owning stock, however, does not grant authority, much less control. Member commercial banks do receive a 6 percent dividend on their paid-in stock, but they cannot sell the stock or use it as collateral for loans. In addition, the Fed’s Board of Governors in Washington—not the boards of the regional Reserve banks—is responsible for regulatory functions.

3) Where does the Fed get its money?

The Fed has its own source of funds, so Congress cannot guide monetary policy through withholding or bestowing appropriations.

The main source of income is seigniorage revenue. Whenever the Fed increases the amount of money in circulation, it purchases new currency from the U.S. Treasury for cents on the dollar. For example, if a member bank needs an extra million dollars, it calls the Fed to order currency, and the Fed asks the Treasury to print the amount. The Fed gives the money to the bank, and debits the bank’s reserve account. The Fed then invests the reserves in government securities as collateral, and profits from the interest that accrues to its own account. In 2006, after accounting for expenses, the Fed returned $29 billion in profits to the U.S. Treasury (Figure 1).

4) Do Congress and the President influence the Fed?

The founders of the Federal Reserve understood that sound monetary policy requires central bankers to make unpopular decisions. As a result, the 1913 law gave the Fed a much higher degree of independence than other government agencies. The Fed has its own source of funds, so Congress cannot guide monetary policy through withholding or bestowing appropriations. Governors are appointed for 14-year terms, tenure that is second in length only to the lifetime appointments of federal judges.

But the independence has boundaries. Each member of the seven-person Board of Governors is appointed by the President and confirmed by the Senate. The Federal Reserve must report annually to the Speaker of the House and twice annually to the banking committees of Congress. Of course, Congress can pass new laws affecting the Fed at any time. And Fed bankers read the newspapers. They aren’t completely insulated from politics.

5) Is the Fed’s job to boost the economy, or is it just to preserve the value of the currency?

Both. The Humphrey-Hawkins Act of 1978 requires the Fed to maintain long-run growth while minimizing inflation and pursuing price stability. So the Fed is supposed to fight inflation, but not so much that its actions undermine growth. Since Paul Volcker became chairman of the Fed during Jimmy Carter’s term, the Fed has generally avoided cutting rates in an effort simply to rev up the economy. The Fed’s strategy is that low inflation, even if it needs to be achieved through raising interest rates, is an important prerequisite for long-term economic growth.

Fed Funds Rate6) How does the Fed influence the economy?

Member banks maintain reserves that they deposit at the Fed. A bank that is short on reserves can borrow the money from other member banks at what is called the “federal funds rate”—or “overnight rate,” since the loans are extremely short-term. The federal funds rate is critical to the economy, and it feeds through to other rates.

The overnight rate is one of only two rates that the Federal Reserve controls. When inflation fears are aroused, the Fed increases the fed funds rate (called a “tightening”) in order to slow activity in sectors of the economy, such as housing and automobiles, that are particularly sensitive to interest rates. When the economy slows, the Fed reduces the fed funds rate in order to stimulate activity (“loosening”).

The Fed also controls what is called the “discount rate”—which is what the Fed charges banks for loans it makes directly to them. The discount rate is usually close to the fed funds rate.

7) How does the Fed decide whether to tighten or loosen monetary policy?

A recent study by two economists, Meredith Beechey of the Fed and Pär Österholm of Uppsala University in Sweden, showed that the Fed generally has acted as if it has a target inflation rate. That target, however, has varied considerably depending on who was running the Fed.

When Alan Greenspan was chairman, the Fed acted as if it had a target inflation rate of about 2.9 percent for the overall Consumer Price Index (CPI). If inflation topped 2.9 percent, the Fed usually tightened; if inflation was below 2.9 percent, it tended to loosen. Under the current Fed chairman, Ben Bernanke, the target rate may be a bit lower, perhaps around 2.5 percent, although it has yet to be formally estimated. The Fed does not announce a target in advance.

8) How does the Fed set rates?

Through its operations in the open market, the Fed adds or subtracts money to hit its rate target (Figure 2). If the Fed wants to raise rates by one-quarter of a point, for example, it can sell Treasury securities to banks in its system. The banks get the securities, and, in payment, they send the Fed money that had previously been used to meet reserve requirements. The banks now need to borrow from other banks to replenish their reserves. This demand for credit drives up interest rates. The open-market process may sound convoluted, but it works. If the Fed wants to lower rates, it can buy securities from banks, which receive money that lets them reduce their demand for reserves.

9) Does the Fed also affect long-term rates, like those for mortgages?

The Fed is supposed to fight inflation, but not so much that its actions undermine long-term economic growth.

Only indirectly. Long-term rates are set in the bond market and depend on buyers’ and sellers’ expectations of inflation and economic growth. If short-term rates are expected to be on an upward trajectory, long-term rates will generally be higher than short-term and will rise roughly in tandem, since investors usually demand more interest when they put their money to work for a longer time.

Sometimes, however, investors will react to rising short-term rates by lowering long-term rates. The reason is that high short-term rates can choke off economic growth in the future. Investors reckon that, under such a scenario, rates farther out will level off or fall because the Fed will be forced to reduce the fed funds rate in the future. When long-term rates are below short-term rates, the yield curve is said to be “inverted.” Market participants often see an inversion as a harbinger of a recession.

10) How important is the Fed chairman?

At times, Alan Greenspan seemed to have dictatorial power over monetary decisions. The FOMC, however, has 12 independent members, and each has one vote. If Greenspan did have sway over the votes of the others, it can only be because he was able to persuade them that his views were correct.

 

Map of Federal Reserve banks11) Why is there only one Federal Reserve bank on the West Coast?

The locations of Federal Reserve banks and the boundaries of Federal Reserve districts (Figure 3) were based on the distribution of population and banking in 1913, and on political forces that were peculiar to that year. As the nation’s population shifted, the Federal Reserve responded by adding branches of the Reserve banks, but these branches do not increase a region’s representation on the FOMC. For example, the Federal Reserve Bank of San Francisco, the only one on the West Coast, has branches in Los Angeles, Salt Lake City, Seattle, and Portland.

12) Why are there two Federal Reserve banks in Missouri?

Senator James A. Reed was rewarded by the Senate for breaking a deadlock in committee and permitting the 1913 law to pass. Kansas City, of which he was formerly mayor, was awarded a bank, and St. Louis, one of America’s great commercial hubs at the time, got one too.

13) Are all regional Fed banks created equal?

The New York Fed conducts open-market operations, intervenes in foreign exchange markets, and stores monetary gold. Its president is generally considered the second most important Fed official.

No. The Federal Reserve Bank of New York plays a unique role within the Federal Reserve System. In addition to the usual duties of a Fed bank, it conducts open-market operations, intervenes in foreign exchange markets, and stores monetary gold. Also, while the presidents of the other 11 banks rotate on and off the FOMC, the president of the New York Fed is a permanent voting member and serves as its vice chairman. As a result, the presidency of the New York Fed is viewed as the second most important post in the system.

14) Did a secret meeting of Wall Street bankers produce the Fed?

The Fed is often the subject of elaborate, fanciful conspiracy theories. This one, however, has some truth. In 1910, Senator Nelson Aldrich of Rhode Island met off the coast of Georgia to discuss banking reform and plans for a new central bank. Wary that, if word got out, they would appear to be manipulative masterminds, participants kept the meeting secret. The Aldrich Plan that they devised was defeated in the House, but it served as a foundation for the Federal Reserve Act.

Kevin Hassett, director of economic policy studies at the American Enterprise Institute, was formerly a senior economist at the Federal Reserve.

Image credit: Chart illustrations by MacNeill & MacIntosh.

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