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The Workings Of The Fed
by Cleveland Federal Reserve Board
Welcome to the Drawing Board.

The Federal Reserve has been in the news a lot recently, and we thought it might be helpful to look at what the Fed is, what it does, and why it is structured the way it is.

First let's take a look at what are arguably the Fed's six biggest jobs-- 1) It oversees and regulates all bank holding companies and about 800 state chartered banks that have chosen to join the Federal Reserve System. The Fed employs supervisors and examiners who check on those institutions to check on those institutions to make sure they are healthy.

2) The Fed acts as a bankers bank. So when the banks borrow from each other or when you write a check from your bank for purchases from a company that uses another bank and that check needs to be withdrawn from you bank's account and transferred to the other bank's account, it's the Federal Reserve that settles many of those transactions.  

3) The Fed acts as the government's bank, which means it processes checks written by the government and holds government deposits.

4) When the government wants to issue securities like treasury bills, bonds or notes to raise cash, it turns to the Fed to get the job done.

5) The Fed loans to bank's directly through its discount window and bank's usually don't go to the discount window unless they are having trouble finding a loan elsewhere because the discount rate is generally higher than market rates-- and that is intentional-- it's kept higher to encourage banks to borrow in the markets which keeps the markets healthy.  

6) Participants in the Fed's Open Market Committee formulate and execute monetary policy.

Now what does that mean? Let's clear it up with a story-- A good story needs characters and our story has 19 characters called the participants or the Federal Open Market Committee ('FOMC").

And who are they? The first member, you probably know, Ben Bernanke-- the chairman of the Federal Reserve Board.

Next, are the other 6 member's of the Federal Reserve Board of Governors who reside in Washington with Ben, and like Ben, are nominated by the President of the United States and confirmed by the Senate. Each board member is an independent policy maker with an independent voice.

Next, are the twelve presidents of the twelve independent banks scattered across the country-- from San Francisco, to Cleveland, to New York.

So there is our cast of characters. Now what do these people do? A lot of things, but in terms of formulating and executing monetary policy, it is this-- Each member is constantly gathering a bunch of data about how the economy is performing in general, and in his or her part of the country if they are one of those district bank presidents.  

For instance, in our case at the Federal Reserve Bank of Cleveland, our President is constantly pouring over economic data with our researchers, meeting with business people and others throughout the region and she collects all that information, insight and analysis. And she and a few of her colleagues bring it all with them to Washington DC eight times a year. All of the district presidents do the very same thing and when they get together with Ben Bernanke, and the rest of the board of governors in Washington, they present everything they have-- this representation of the economic picture from across the land, and it's used by voting members of the FOMC to formulate and execute monetary policy.

Voting members-- not everyone who participates in the FOMC meeting, votes at every meeting. All members provide input, but the only ones voting are the Federal Reserve chairman, Ben Bernanke, the other members of the board of governors, the president of the New York Federal Reserve bank, and four of the remaining eleven eleven district Federal Reserve presidents.

The district presidents outside of New York are on rotating terms, so they all get to vote eventually.

OK, we keep talking about formulating and executing monetary policy. Let's explain what that involves-- setting monetary policy begins with the goal that any action the FOMC might take, should help keep the purchasing power of the dollar stable over time and help make sure jobs are plentiful. Until the economic crisis hit, the main tool the FOMC used to conduct monetary policy was adjusting the Federal Funds Rate, which is the interest rate at which banks can borrow from one another.

There are three options really-- keep the rate the same, lower it or raise it. Lowering the rate generally makes it easier and more attractive for banks to borrow money. Imagine your bank where you can borrow money at 5%. And then the rate gets lowered to 4%. Since it costs you less now to borrow money, you can offer lower rates to consumers that are looking to borrow money to buy a new car or a house or a college education. Or you can make loans to businesses looking to buy equipment or raw materials or buildings and all of this activity tends to heat up the economy.

Here is how-- when interest rates are low, people tend to buy more things. And when there are more people buying more things, businesses that want to keep up with the increased demand may have to hire more workers. When you raise the Federal Funds Rate, banks now have to pay more for borrowed money. Let's say they were able to borrow money at 4% and now the rate goes up to 5%. To make a profit, banks would have to loan money out at a rate higher than 5%. And people may decide they don't want to borrow at those higher rates, so overall borrowing goes down. And if borrowing goes down, that generally means people are spending less money. And if people spend less, demand for products and services tends to go down. And if demand goes down, the general price of goods and services tends to rise more slowly, and that keeps inflation at bay-- since inflation is a measure of a rise in the general price of goods and services.

Until very recently this raising and lowering of the Federal Funds Rate was the Fed's main tool for implementing monetary policy. But when the financial crisis hit, and the economy continued to falter, even after the Fed Funds Rate was dropped to essentially zero. The Fed responded by creating a number of temporary problems. Some were designed to make short term loans available to financial institutions that couldn't find loans in the markets or who didn't want to borrow at the Fed's discount window as they were afraid that going to the window would make them appear weak.

Other programs allows the Fed to buy those mortgage backed securities you've heard so much about. And that brought down mortgage rates for reasons we don't have time to explain here.

The Fed also used its emergency lending powers by extending credit to some large companies that were on the brink of failure and whose failure could've had dire consequences for our already severely weakened economy.

So the combination of these special programs and the raising or lowering of the Fed Funds Rates, all have the intention of keeping prices stable and people employed-- that's what is meant by formulating and executing monetary policy-- and it's no easy task.

Complicating matters is it takes some time for these actions to have an effect on the economy especially a rate change.

Change the Fed Funds Rate today, and it might be 12-18 months before a change works its way through the system and affects the economy. And that's why the Federal Reserve is setup to be independent-- part of the government, but separate from it too. Why?

Monetary decisions by nature are long term decisions. And it helps when making long term decisions to be free from pressure from the here and now. Let's say the decision of whether to heat or cool the economy was unduly influenced by elected or even non-elected officials-- or anyone else who might be tempted to manipulate the economy to say set off a boom to get re-elected, or finance ambitious social programs, or pay off government debt.

All of these things may be popular in the short term, but in the long term they could lead to high inflation. So the Federal Reserve is setup to provide some checks and balances so long term monetary policy decisions are made by people who have a long term view. That's why board members have 14 year terms and can't serve in the position after they are through serving.

We also want the people making these important long term decisions that affect the economy to be accountable to the government and its people which is why the Federal Reserve chairman and each member of the board of governors, is appointed by the President and confirmed by the Senate, and why presidents of the Reserve Bank have to be approved by the board. Independent and accountable both at the same time. That's the goal and it's one reason for having an independent Fed.

Another reason is an independent Federal Reserve is flexible enough to act quickly to provide a backstop in times of crisis that can help the economy from falling off the cliff.

If there were no Fed, the only backstop would be whatever financial support the banks or government could provide and in a crisis, neither may be in a position to provide support. The banks might be in need of support of their own and the government might not want to take on more debt or it might become stuck in a political stalemate into how to resolve the problem.

Before the Fed came into being, when economic trouble hit, many banks crashed and they took a lot of businesses down with them. Also, having 12 independent Federal Reserve banks located from coast to coast ensures that the economic realities from all across the land are represented when monetary policy is being considered.

It also guards against to much power being concentrated in a single location in a single city.

However you feel about the Fed and its role in monetary policy, it's probably good to know how the Fed works and why it is setup the way it is. Something to think about-- until the next time, on the Drawing Board.