What is
the Federal Reserve?
What is its stated purpose?
The Federal Reserve
A lot of our daily commentary and RateWatch involves
talking about the Federal Reserve and surmising its
intentions.
The Nations Bank
The original Federal Reserve System was established
by the Congress in 1913. The intention was to set up a
network of "reserve banks" that were to smooth out
problems with bank reserves in each region. If Bank "A"
was a bit short of its reserve requirements on Monday
night it could borrow a few bucks from Bank "B" or from
the Fed. The regional Federal Reserve Banks were to act
on the advisement of the member banks, not on their own
notions. The Federal Reserve system was not intended to
replace the gold standard.
The Banking Act of 1935 gave power to the Federal
Reserve to create money by purchasing government
securities, and it added the authority that allowed them
to specify within limits the reserve requirements for
the member commercial banks. Indeed, it is these two
things that give the Fed their present power.
Put most simply, the Federal Reserve System is the
central bank of the United States. It has the
responsibilities of fostering a sound banking system and
a healthy economy. If you take a dollar out of your
wallet you will notice that it is issued by one of the
12 Federal Reserve Banks.
Each of the twelve Federal Reserve Banks is organized
into a corporation whose shares are sold mostly to the
commercial banks and thrifts operating within the Bank's
district.
Money is produced by the Treasury department through
the Bureau of the Mint and Bureau of Engraving and
Printing and distributed through the Federal Reserve
Banks.
The Federal Reserve is the Federal government's
banker. It also serves as a "banker's bank". It
regulates banks. It helps banks with day-to-day
liquidity problems and it also is in the check
processing business. The check processing is really a
"side business" which the Fed should no longer be
involved with. Other people can do it cheaper.
In 1995 the Federal Reserve had net income totaling
$23.9 billion, which, if it were a single firm, would
qualify it as one of the most profitable companies in
the world. By law, nearly all of the its annual earnings
($23.4 billion) were paid to the U.S. Treasury.
Like any respectable business nowadays the Fed has
lots of WWW sites. A good starting place is:
http://www.frbchi.org/frinfo/frinfo.html This is
part of the WWW site of the Federal Reserve Bank of
Chicago and an excellent gateway into the other Fed
sites.
The Economy In addition to providing support for
banks the Fed is charged with keeping the economy
healthy. This involves the ever delicate process of
expanding the economy without causing unacceptable
inflation.
The Tools
The Fed had 3 tools to control money and the economy.
1) it can change reserve requirements. This enables
banks to either takes money out of reserve and pump it
into the economy or forces them to put more into reserve
and curtail lending.
2) the discount rate. This is what the Federal
Reserve charges banks that have to borrow money to cover
short term liquidity problems. An increase in the
discount rate discourages borrowing and slows the
economy. A reduction in the discount rate encourages
borrowing and spending and expands the economy.
The discount rate is, thus, the basis for all rates,
including mortgages.
3) The Open Market. This is the key. When the Fed
wants to encourage business it can pump money into the
system by buying securities on the open market. If the
Fed sells securities it takes money out of the system
and slows the economy. The direction of the "open
market" activity is set by the FOMC, the Fed Open Market
Committee.
This idea of "open market" is extremely important.
The Fed can open up its checkbook (the magic one with
the near infinite overdraft protection) and inject money
into the economy by buying government notes and bonds.
BUT, it must do so on the open market. Congress'
sovereignty over expenditure is maintained by forcing
the Fed to buy from private holders of government debt.
If the Treasury Department ran the show, Congress would
have succumbed to the executive branch.
Setting the target for the discount rate, and then
following through with open market activity is the
biggest tool the Fed has in regulating the economy. The
Fed also needs the rate to be accepted by the market.
The present discount rate is 5.5%. In 1981, the most
recent time of runaway inflation, the discount rate was
14%. In 1958 it was as low as 1.75%. By exchanging cash
for debt or vice versa, the Fed controls the money
supply. The notions as to how this should be done are
the backbone of the realization of Keynesian and
Monetarist economic policy |
