Federal Reserve System: Its 4 Functions and How It Works

Is the Fed a "Secret Society" That Controls Your Money?

Janet Yellen
Federal Reserve Board Chair Janet Yellen testifies before the Senate Banking, Housing and Urban Affairs Committee February 14, 2017 in Washington, DC. Photo by Win McNamee/Getty Images

Definition: The Federal Reserve System is America's central bank. That makes it the most powerful single actor in the U.S. economy and thus the world. It is so complicated that some consider it a "secret society" that controls the world's money. They are right about its function, but there is nothing secret about it.

Four Functions of the Federal Reserve System

The Federal Reserve's most critical and visible function is to conduct monetary policy.

It does this to manage inflation and maintain stable prices. To do that the Fed sets a 2.0 percent inflation target for the core inflation rate.

The Fed also pursues maximum employment. Its goal is the natural rate of unemployment of 4.7-5.8 percent. The Fed moderates long-term interest rates through open market operations and the Fed funds rate. The goal of monetary policy is healthy economic growth. That target is 2-3 percent growth rate for gross domestic product.

Second, the Fed supervises and regulates many of the nation’s banks to protect consumers.

Third, it maintains the stability of the financial markets and constrains the potential crises.

Fourth, it provides banking services to other banks, the U.S. government and foreign banks. (Source: "What Is the Purpose of the Federal Reserve System?" Board of Governors of the Federal Reserve.)

Structure

To understand how the Fed works, you must know its structure.

The Federal Reserve System has three components. The Board of Governors directs monetary policy. Its seven members are responsible for setting the discount rate and the reserve requirement for member banks. Staff economists provide all analyses. They include the monthly Beige Book and the semi-annual Monetary Report to Congress

The Federal Open Market Committee oversees open market operations. That includes setting the target for the fed funds rate that guides interest rates. The Board members and four of the twelve bank presidents are members. The FOMC meets eight times a year.

The Federal Reserve Banks supervise commercial banks and implement policy. They work with the Board to supervise commercial banks. There is one located in each of their twelve districts. 

1. How It Manages Inflation

The Federal Reserve controls inflation by managing credit, the largest component of the money supply. This is why people say the Fed prints money. The Fed restricts credit by raising interest rates and making credit more expensive. That reduces the money supply, which curbs inflation. Why is managing inflation so important? Ongoing inflation is like insidious cancer that destroys any benefits of growth.

When there is no risk of inflation, the Fed makes credit cheap by lowering interest rates. This increased liquidity spurs business growth, and ultimately reduces unemployment. The Fed monitors inflation through the core inflation rate, as measured by the Personal Consumer Expenditures Price Index. It strips out volatile food and gas prices.

They typically rise in the summer and fall in the winter. That's too fast for the Fed to manage.

The Federal Reserves uses expansionary monetary policy when it lowers interest rates. That expands credit and liquidity, which makes the economy grow faster and creates jobs. If the economy grows too much, it triggers inflation. At this point, the Federal Reserve uses contractionary monetary policy and raises interest rates. High-interest rates make borrowing expensive, which slows growth and makes it less likely that businesses will raise prices.  For examples, see Who Are the Major Players in the Fight Against Inflation?

The Federal Reserve sets the reserve requirement for the nation's banks. It states that banks must hold 10 percent (less for smaller banks) of their deposits on hand each night.

The rest can be lent out. If a bank doesn't have enough cash on hand at the end of the day, it borrows what it needs from other banks. That amount is called the fed funds. Banks charge each other the fed funds rate.

The FOMC sets the target for the fed funds rate at its monthly meetings. To keep the fed funds rate near its target, the Fed uses open market operations to buy or sell securities from its member banks. It creates the credit out of thin air to buy these securities. It's the same effect as printing money. That adds to the reserves the banks can lend, thus lowering the Fed funds rate. Here's the Current Fed Funds Rate.

2. How It Supervises the Banking System

The Federal Reserve oversees roughly 5,000 bank holding companies and any foreign banks operating in the United States. It also regulates 850 state bank members of the Federal Reserve Banking System  That's a network of 12 Federal Reserve banks. They both supervise and serve as banks for all the commercial banks in their region.

The 12 banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco. The Reserve Banks serve the Department of the U.S. Treasury. They handle its payments and sell government securities. They also assist with its cash management and investment activities. Reserve banks conduct valuable research on economic issues. (Source: "The Structure of the Federal Reserve System," Federal Reserve Education.)

The Dodd-Frank Wall Street Reform Act strengthened the Fed's power over banks. If any bank becomes too big to fail, it can be turned over to Federal Reserve supervision. The Fed will require it to maintain a higher reserve requirement to protect against any losses.

Dodd-Frank also gave the Fed the mandate to supervise "systematically important institutions." In 2015, the Fed created the Large Institution Supervision Coordinating Committee. It regulates the 16 largest banks.

Most important, it is responsible for the annual stress test of 31 banks. These tests determine whether the banks have enough capital to continue making loans even if the system falls apart as it did in October 2008. (Source: Jon Hilsenrath, "Washington Strips New York Fed's Power," Wall Street Journal, March 4, 2015.)

3. How the Fed Maintains the Stability of the Financial System

The Federal Reserve worked closely with the Treasury Department to prevent global economic collapse during the financial crisis of 2008. It created many new tools. They include the Term Auction Facility, the Money Market Investor Lending Facility, and quantitative easing. For a blow-by-blow description of everything that happened, while it was going on, see Federal Intervention in the 2007 Banking Crisis.

Two decades earlier, the Federal Reserve intervened in the Long Term Capital Management Crisis. Federal Reserve actions worsened the Great Depression of 1929 by tightening the money supply to defend the gold standard.

4. How It Provides Banking Services

The Fed buys U.S. Treasuries from the federal government. That's called monetizing the debt. That's because the Fed creates the money it uses to buy the Treasuries. It adds that much capital to the money supply. During the financial crisis, it quadrupled its holdings. It now holds $4 billion in Treasuries and other securities. For more, see Is the Federal Reserve Printing Money?

The Fed is called the "bankers' bank."  That is because each Reserve bank stores currency and processes checks. Most important, it loans funds to its members if needed to make their reserve requirement.

These loans are made through the discount window. The Fed charges the discount rate, also set at the FOMC meeting. This rate is higher than the fed funds rate but lower than LIBOR. Most banks avoid using the discount window because there is a stigma attached. It is assumed the bank can't get loans from other banks. That's why the Federal Reserve is known as the bank of last resort. (Source: "Why Does the Fed Lend Money to Banks?" Board of Governors of the Federal Reserve System.)

History

The Panic of 1907 spurred Congress to create the Federal Reserve System. It established a National Monetary Commission to evaluate the best response to prevent ongoing financial panics, bank failures, and business bankruptcies. Congress passed the Federal Reserve Act of 1913 on December 23 of that year.  

Congress originally designed the Fed to "provide for the establishment of Federal
reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."  Since then, Congress has enacted legislation to amend the Fed's powers and purpose. 

Who Owns the Fed?

The Federal Reserve is an independent bank. The Board and FOMC make their decisions based on research, not political reasons. The president, U.S. Treasury Department and Congress don't ratify its decisions.

But the Board members are selected by the president and approved by Congress. That gives elected officials oversight over the Fed's long-term direction. For more, see Who Owns the Federal Reserve?   

Some elected officials are so suspicious of the Fed and its ownership that they want to end it all together. Senator Rand Paul wants to control it by auditing it more thoroughly. His father, former Congressman Ron Paul, wanted to shut it down. For more, see End the Fed.

Chairman

The Fed's Chair sets the direction and tone of the Federal Reserve Board and FOMC. The current chair is Janet Yellen (2014 - 2018). Her biggest concern is unemployment, which is also her academic specialty. That makes her "dovish." Ironically, she's the chair when the economy requires restrictive monetary policy

The former chair was Ben Bernanke (2006 - 2014). He was an expert on the Fed's role during the Great Depression. That was very fortunate. He knew the steps to take to end the Great Recession and keep it from turning into a depression.

How the Fed Affects You

The financial press scrutinizes the Fed for clues as to how the economy is performing, and what the FOMC and Board will do about it. Therefore, the Fed directly affects your stock and bond mutual funds and your loan rates. By having such an influence on the economy, the Fed also indirectly affects your home's value and even the possibility that you may get laid off or rehired.