What Does The Federal Reserve Do?

The news is full of references to the U.S. Federal Reserve. Will the price of gold go up due to Federal Reserve actions? Will inflation remain in check or soar out of control because the Federal Reserve does not act? Where are interest rates going and how is the Federal Reserve responsible? Just what does the Federal Reserve do to gain this much attention?

What Is the Federal Reserve?

Founded in 1913 the Federal Reserve is the central bank of the United States. According to FederalReserveEducation.org congress founded the Federal Reserve System to provide the nation with a safer, more flexible, and more stable monetary and financial system.

The Board of Governors, also known as the Federal Reserve Board, is the national component of the Federal Reserve System. The board consists of the seven governors, appointed by the president and confirmed by the Senate. Governors serve 14-year, staggered terms to ensure stability and continuity over time. The chairman and vice-chairman are appointed to four-year terms and may be reappointed subject to term limitations.

Among the responsibilities of the Board of Governors are to guide monetary policy action, to analyze domestic and international economic and financial conditions, and to lead committees that study current issues, such as consumer banking laws and electronic commerce.

The Board also exercises broad supervisory control over the financial services industry, administers certain consumer protection regulations, and oversees the nation’s payments system. The Board oversees the activities of Reserve Banks, approving the appointments of their presidents and some members of their boards of directors. The Board sets reserve requirements for depository institutions and approves changes in discount rates recommended by Reserve Banks.

The most important responsibility of the board is its participation in the Federal Open Market Committee (FOMC) which sets U.S. monetary policy. The seven board members are the majority with reserve bank presidents having 5 votes.

The Federal Reserve pays for its operation by assessments of Federal Reserve Banks and does not receive appropriations from congress. The system has 12 Federal Reserve banks and 24 branches all under the oversight of the Board of Governors.

Monetary Policy

The Federal Reserve Bank of Richmond explains how the Fed affects monetary policy. The Fed uses three tools: open market operations, the discount rate and reserve requirements.

Open market operations-purchases and sales of U.S. Treasury and federal agency securities-are the Federal Reserve’s principal tool for implementing monetary policy.

The second major monetary policy implementation tool is the discount rate.

The third major monetary policy implementation tool is reserve requirements.

By buying or selling U.S. Treasuries the Fed influences interest rates. When it raises or lowers the discount rate it is changing the rate set for lending to other banks thus affecting their operations and the rates charged to customers. And when the Fed raises or lowers reserve requirements its either removes or add money to the current money supply.

The FOMC and the Federal Funds Rate

A tool of the Federal Open Market Committee is the federal funds rate. This is the overnight rate of interest between one depository institution and another on money held as deposits by these institutions in the Federal Reserve. What the Federal Reserve does by raising or lowering this rate is stimulate economic growth by lowering the rate and slowing growth and inflation by raising the rate.