Purposes and Functions of the Federal Reserve

Posted on Saturday, December 1st, 2018 MarketBeat Staff

We don’t think about depositors making a “run on the bank” these days. But that wasn’t always the case. In fact, there were times in the first 100+ years of our nation when the baking system was on shaky ground. The old wives tale of storing your cash underneath the mattress was a very practical option for Americans who were concerned about the availability of their cash.

That all changed in 1913 with the creation of the Federal Reserve, commonly referred to as “The Fed”. The Federal Reserve has fundamentally changed our nation’s monetary system. And while most economists would say it’s been for the good, an expanded scope in recent years has some economists questioning whether or not the Federal Reserve’s mandate has become too large.

In this article, we'll explain what the Federal Reserve is and how it shapes U.S. monetary policy. We'll also look at how the changes it makes, particularly regarding interest rates, affects you as an investor and consumer, and look at how the Fed's role has changed throughout history.

What is the Federal Reserve?

Simply put, the Federal Reserve is the central bank of the United States of America. It is the “bank’s bank” and the “lender of last resort”. The Federal Reserve (The Fed) plays an important role in formulating and guiding our nation’s monetary policy.

What are the purposes and functions of the Federal Reserve?

According to the Federal Reserve's website (federalreserve.gov) the primary roles of the Federal Reserve are:

  1. To conduct the United States’ monetary policy “to promote maximum employment, stable prices and moderate long-term interest rates in the U.S. economy”.
    Historically, the Fed tries to promote a Goldilocks economy. They want growth, but they want it to be measured. When the economy starts to grow too fast, they may take actions such as raising interest rates to make borrowing more expensive. Similarly, if the economy is stagnating or in recession, the Fed may lower interest rates to promote borrowing in an effort to "stimulate" the economy. In making interest rate decisions, the Fed not only looks at our Gross Domestic Product (GDP) but also on unemployment claims and the Consumer Price Index. In this way, they are being careful that their policies do not hurt employment or spur inflation.
  2. To “promote the stability and soundness of individual financial institutions and monitor their impact on the financial system as a whole”.
    Perhaps no four words have been associated with the Fed in the last 10 years than “too big to fail”. At the pinnacle of the financial crisis of 2007-2008, the Federal Reserve took unprecedented steps to “bailout” some of our nation’s largest banks to ensure that there was sufficient liquidity in our financial system. This program known as “quantitative easing” increased the nation’s monetary supply to unprecedented levels.
  3. To “promote the safety and soundness of individual financial institutions and monitor their impact on the financial system as a whole”.
    As a condition of the bailouts they received, the nation’s banks were subjected to “stress tests” to ensure that they could perform as viable institutions. These stress tests are ongoing.
  4. To foster a safe and efficient payment and settlement system “through services to the banking industry and the U.S. Government that facilitates U.S. dollar transactions and payments”.
    One of the ways this is done is through the use of the Fed Discount Window and the Federal Reserve Requirement. To ensure the solvency of the banks and that they have adequate liquidity to conduct business, the Fed requires each bank to keep a certain amount of money in reserve. Typically banks will borrow from one another to meet this requirement. However, in some cases, more troubled banks may not be able to find a lender willing to lend funds. These banks can take advantage of the Fed Discount Window to borrow money to meet this requirement.
  5. To "promote 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".
    The Fed works with non-profit organizations and other community organizations to ensure that all members of society can participate in the economy through such things as equal access to credit and fair housing practices.

What is the structure of the Federal Reserve?

The Federal Reserve is an entity of the U.S. Government. It has a seven-member Board of Governors that reside in Washington D.C. The members, including a Chairman and Vice Chairman, are appointed to their position by the sitting President of the United States and require confirmation by the United States Senate. The Federal Reserve is also composed of 12 regional banks in cities throughout the United States. These banks serve an important role of being the “operating arms” of the Federal Reserve and gather critical economic data that the Board of Governors uses to monitor economic conditions so they can make the best decisions regarding U.S. monetary policy.

How does the Federal Reserve determine interest rates?

When it comes to determining interest rates, the Federal Reserve relies on what is known as the Federal Open Market Committee (FOMC). This committee is composed of all seven members of the Federal Reserve Board as well as the President of each of the 12 regional reserve banks.

One of the tools the Federal Reserve uses for guidance in setting interest rates is the LIBOR rate. The LIBOR rate is the lowest rate that banks charge to lend to each other. Historically, the Fed Rate has been virtually identical to the LIBOR rate. However, at the height of the financial crisis in 2007 and 2008, the LIBOR rate was sharply higher as the Federal Reserve was lowering interest rates to an effective rate of 0% in an effort to stimulate growth in the U.S. economy.

Although the monthly meeting of the Federal Reserve typically triggers speculation and can even cause the stock market to rally or decline based on the anticipated news, most of the Federal Reserve’s moves regarding the Federal Funds rate are measured and highly predictable. In this way, they help to give banks a reliable game plan for conducting their business. However, no matter how much input they receive, the decision to raise interest rates is largely a subjective decision. And unfortunately, because the Federal Reserve is a government creation, their decisions are often viewed through a political lens.

Why was the Federal Reserve created?

The Federal Reserve was created as part of the Federal Reserve Act of 1913. Prior to the adoption of this act, the nation's banking system was prone to panic attacks. If the nation was undergoing a financial crisis, such as a recession, it was not uncommon for depositors to make a "run on the bank" in which they would go to their lending institution and withdraw all the money they had deposited. This created two problems. First, since the nature of the banking industry relies on the bank's having an availability of deposits to fund the loans they issue; losing the deposits would literally put the bank out of business. Secondly, a bank run tended to have a psychological effect in which the failure of one bank would lead to a run on another bank.

One of the most notable, and notorious, examples of a banking run occurred in 1907 when one of these panic attacks caused a series of bank runs that had a nearly catastrophic impact on our nation’s banking system which at the time was far more fragile than it is today. The banking crisis and the growing public outcry for government intervention helped elect Woodrow Wilson to President of the United States. One of Wilson’s first large policy initiatives was the establishment of the Federal Reserve Act. One of the offshoots of the act was the establishment of the Federal Reserve System.

The creation of the Federal Reserve had an immediate stabilizing effect on the nation's banking system by providing depositors with a guarantee that their deposits were "insured" by the Federal Government.

How has the Federal Reserve changed over the years?

The structure of the Federal Reserve has remained remarkably consistent. The Federal Reserve operates with nearly full autonomy as it makes the decision on interest rate and government purchases of U.S. Treasuries. However, two important developments in the last 30 years have had a significant impact on how the Fed is managed. First, in 1999, Congress enacted the Gramm-Leich-Bliley Act. This made it legal for banks to conduct retail and investment banking operations. These activities had been kept separate by the 1933 Glass-Steagall Banking Act, which was a response to the stock market crash of 1929. The Gramm-Leich-Bliley Act dramatically increased the scope of the Fed’s operations. Essentially, the Fed was now responsible for ensuring the solvency of the nation’s banks.

However, the ability to conduct both retail and investment operations created an environment of risk-taking among banks. This risk-taking, highlighted by subprime mortgage lending, was one of the triggers for the financial crisis of 2007. This, in turn, created yet another mandate for the Fed. When Congress adopted the Dodd-Frank Act of 2010, the Fed was now empowered to regulate “systemic risk”. This led to the creation of the “stress tests” that banks had to submit to in order to ensure they had sufficient reserves in the case of a future financial crisis. Many of the provisions contained in the Dodd-Frank Act have still not been enacted as of this writing.

The bottom line on the Federal Reserve

The Federal Reserve (or Fed as it is known) has a major influence on the monetary policy of the United States. As the nation’s central bank, it serves a key role in ensuring that our nation’s banks have the necessary liquidity to ensure the integrity of depositor’s funds.

One of the most well-known roles of the Federal Reserve is to provide a monthly report from the Federal Open Market Commission (FOMC). This commission, which is made up of the seven members of the Federal Reserve’s Board of Governors and the President of the 12 regional Federal Reserve Banks, uses this report to announce whether interest rates will increase, decrease or stay the same. Although these moves can have a significant effect on the stock market and the broader economy, the moves are usually very measured and easy for analysts to predict.

The Federal Reserve was created in response to a series of panicked runs in the late 19thand early 20thcentury. Growing populist sentiment in the country led to Congress passing the Federal Reserve Act in 1913, which established the Federal Reserve. Over the years, the Federal Reserve’s mandate has changed to reflect changes to the banking system. Since the financial crisis of 2007, the Federal Reserve is tasked with guarding against “systemic risk” in the banking system.

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