The Federal Reserve is the central bank for the United States. Its decisions affect the U.S. economy and, therefore, the world. This position makes it the most powerful actor in the global economy. It is not a company or a government agency. Its leader is not an elected official, which makes it seem highly suspicious to many people, because it is not subject to either voters or shareholders.
Learn how the Federal Reserve works, who actually owns it, and how they are held accountable.
Who Owns the Federal Reserve?
The Federal Reserve is an independent entity established by the Federal Reserve Act of 1913. At that time, President Woodrow Wilson wanted a government-appointed central board, but Congress wanted the Fed to have 12 regional banks to represent America's diverse regions. The compromise meant that the Fed has both.
Congress and the Fed
The president and Congress must approve all members of the Federal Reserve Board of Governors, but the board members' terms deliberately don't coincide with those of elected officials. The president appoints the Federal Reserve chair, currently Jerome Powell. Congress must approve the president's appointment. The chair must report on the Fed's actions to Congress.
Congress can alter the statutes governing the Fed. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act limited the Fed's powers. It required the Government Accountability Office (GAO) to audit the emergency loans the Fed made during the 2008 financial crisis. It also required the Fed to make public the names of banks that received any emergency loans or TARP funds. The Fed must get Treasury Department approval before making emergency loans, as it did with Bear Stearns and AIG.
The Fed's Board is an independent agency of the federal government, but its decisions don't have to be approved by the president, legislators, or any elected official.
Equally as important, the Fed does not receive its funding from Congress. Instead, its funds come from its investments. It receives interest from U.S. Treasury notes it acquired as part of open market operations. It receives interest on its foreign currency investments. Its banks receive fees for services provided to commercial banks. These include check clearing, funds transfers, and automated clearinghouse operations.
The Fed also receives interest on loans it makes to its member banks. It uses these funds to pay its bills, then turns any "profit" over to the U.S. Treasury Department.
The 12 regional Federal Reserve banks are set up similarly to private banks. They store currency, process checks, and make loans to the private banks within their area that they regulate. These banks are also members of the Federal Reserve banking system. As such, they must maintain reserve requirements. In return, they can borrow from each other at the fed funds rate when needed. As a last resort, they can also borrow from the Fed's discount window at the discount rate.
To be a member of the Federal Reserve system, commercial banks must own shares of stock in the 12 regional Federal Reserve banks. But owning Federal Reserve bank stock is nothing like owning stock in a private company. It can't be traded and doesn't give the member banks voting rights. These pay out dividends, mandated by law to be 6%. But the banks must return all profits, after paying expenses, to the U.S. Treasury.
Why the Fed Must Remain Independent
The Fed's monetary policy can do its job better when it is shielded from short-term political influence. It must be free to set expectations, especially about inflation. It cannot do that when its leaders are worried about being fired by an elected official.
Fed chairs are predominantly well-respected academic economists. Their expertise is in public policy, finance, and central banking. They are valued for that expertise, not for charisma, a large fan base, or public speaking skills. They are accustomed to an environment where ideas are rationally discussed, debated, and evaluated.
How the Fed Is Held Accountable
Although it is independent, the Fed is still accountable to the public and to Congress. The Fed can best guide expectations if it is transparent about its actions. It must also clearly communicate its reasons for its actions.
The Fed communicates through frequent and detailed reports. First, the Fed chair and other board members testify frequently before Congress. Second, the Fed submits to Congress a detailed Monetary Policy Report twice per year. Third, the Federal Open Market Committee (FOMC) publishes a statement after each meeting. It also provides detailed meeting minutes three weeks later. Verbatim transcripts are available five years later.
How the Fed Works
The Fed's primary function has been to manage inflation. It has a variety of tools to accomplish that.
During the financial crisis of 2008, it created innovative tools to avert a depression. Since the recession, it also pledged to reduce unemployment and spur economic growth.
Monetary Policy Tools
The Fed works by using its monetary policy tools.
Setting low-interest rates is called "expansionary monetary policy." That makes the economy grow faster. If the economy grows too fast, it triggers inflation.
Increasing interest rates is called "contractionary monetary policy." It slows economic growth by making loans and other forms of credit more expensive. That restricts the money supply. As demand falls, businesses lower prices. This creates deflation. That further lowers demand, because consumers delay buying while waiting for prices to fall further.
How does the Fed cut interest rates? It lowers the target for the fed funds rate. Banks usually follow the Fed's lead, cutting benchmark rates such as the prime rate. The Fed can also use its other tools, such as lowering the discount rate that banks use to borrow funds directly from the Fed's discount window.
To combat the financial crisis of 2008, the Fed got creative. It bought mortgage-backed securities from banks directly as a way to pump liquidity into the financial system. It also started buying Treasuries. Both purchases became known as "quantitative easing."
Critics worried that the Fed's policies would create hyperinflation. They argued that the Fed was just printing money. But banks weren't lending, so the money supply wasn't growing quickly enough to cause inflation. Instead, they hoarded cash to write down a steady stream of housing foreclosures. The situation didn't improve until 2011. By then, the Fed had cut back on quantitative easing.
Frequently Asked Questions (FAQs)
Which chair of the Federal Reserve was named "Person of the Year" by Time Magazine in 2009?
Federal Reserve Chairman Ben Bernanke was named "Person of the Year" by Time Magazine in 2009.
What does the Federal Reserve do?
The Federal Reserve is the central bank of the U.S., and it's tasked with promoting the effective operation of the U.S. economy. It does this through monetary policy, monitoring the safety of financial institutions, facilitating payment and settlement systems, as well as promoting risk management, consumer protection, and community development.