Federal Reserve Summary

  • Last updated on November 10, 2022

As the central bank of the United States, the Federal Reserve is the institution in which the federal government and private banks do their banking. Central banks are responsible for monitoring banks and ensuring they remain solvent. They also control interest rates and thus borrowing costs for consumers and business firms. This, in turn, affects unemployment and inflation, giving the Federal Reserve substantial control over the U.S. economy.

The First Bank of the United States was established by Congress in 1791 through the efforts of Secretary of the Treasury Alexander Hamilton. A bill to renew the bank’s charter was defeated by one vote in 1811. The Second Bank of the United States was authorized by Congress and opened in 1816. However, it was opposed by President Andrew Jackson, and it ceased operation in 1841. These national banks were privately owned and mainly served as the bank for the federal government. Because they competed with other banks and could regulate the amount of currency in the country, private banks opposed the two national banks, which is why their charters did not get renewed.Federal Reserve

Lacking a national bank, the United States was ravaged by a series of financial panics during the late nineteenth and early twentieth centuries. People ran to their banks to withdraw their money, but because banks had lent the money out, they could not pay their depositors. This led to more bank runs and many bankruptcies. After the severe 1907-1908 panic, Congress created a commission to study how future panics might be prevented. When the Democrats swept to power in the 1912 election, they pushed for one key recommendation from the commission–the creation of a central bank. Passage of the Federal Reserve Act in 1913 (mainly along party lines, with Democrats supporting the legislation and Republicans opposing it) created the Federal Reserve, or “the Fed” for short.

Structure

At the bottom of the Federal Reserve System are all the banks and financial institutions in the United States that are subject to regulation and control by the Federal Reserve. Twelve regional Federal Reserve Banks have been established throughout the country to monitor individual banks. These banks are actually owned by the area banks but are not controlled by them. Regional Federal Reserve Banks serve as banks for private banks, doing for them what banks do for people and businesses. Banks deposit their money into regional Federal Reserve Banks, just as people deposit their money into banks. Regional Federal Reserve Banks lend money to banks, just as banks lend to the public; and they cash checks for banks (which is easy as they have all the money), just as each person’s bank cashes that individual’s checks.

Overseeing the entire Federal Reserve System are seven directors or governors. Governors are nominated by the U.S. president and approved by the Senate. They serve fourteen-year terms that are staggered so that one term ends every other year. Lengthy terms mean that governors are not subject to political pressure and do not have to seek reappointment (or reelection) on a regular basis. Staggered terms ensure that people with a good deal of experience will always be on the board of governors. Governors may serve only one full term, but any governor appointed to complete an unexpired term can be reappointed to a full term.

The Federal Reserve governors set U.S. Monetary policymonetary policy by using several tools to control bank lending and interest rates. The chair is the chief executive officer of the board of governors and chief spokesperson for monetary policy. The Federal Reserve chair is regarded as the second most powerful individual in the United States, after the president.

Another important group is the open market committee, which determines the interest rate on overnight loans among banks, or the federal funds rate. This committee consists of the seven governors plus five regional Federal Reserve Bank presidents. The president of the New York Federal Reserve always sits on the open committee, since the hard work of controlling the federal funds rate is done by the New York Federal Reserve Bank in lower Manhattan; four other regional Federal Reserve Bank presidents serve on a rotating basis.

Federal Reserve Powers

The Federal Reserve has both monetary and supervisory powers. In addition, as with the original national banks, the U.S. government uses the Federal Reserve to make deposits and write checks. The Federal Reserve has three main tools to control bank lending and interest rates.

The first tool is through setting the reserve ratio (within some limits set by Congress). Banks typically want to lend out as much of their deposits as possible, because that is how they earn money. However, banks with too little cash are subject to bank runs and panics. The reserve ratio was meant to solve this problem. It requires banks to hold a fraction of their deposits rather than lending them all out. Controlling this ratio lets the central bank control bank lending. At the end of 2007, the reserve ratio was 0 percent on the first $9.3 million of deposits in the bank, 3 percent on total deposits between $9.3 million and $43.9 million, and 10 percent on deposits in excess of $43.9 million. This system of multiple ratios was one of the political compromises made when creating the Federal Reserve. Small banks wanted no restrictions on their lending; larger banks wanted their wealthy depositors to be confident that money would be there for them. Each side got some of what it wanted.

The second is through lending money to private banks at the Discount ratediscount rate, an interest rate set by the board of governors. This lending by the regional Federal Reserve Banks serves two purposes: It helps stem bank runs and panics because it provides money to banks, and discount rate changes allow the Federal Reserve to control bank lending and the interest rates charged by private banks. When the Federal Reserve lowers the discount rate, banks are encouraged to borrow money. With more money to lend out, and with a cheaper source of funds, private banks will lend at lower interest rates. However, with a higher discount rate, banks are less likely to borrow from the central bank and tend to repay any money they borrowed from the Federal Reserve. This means that banks have less money to lend out and therefore will give loans to the highest bidders, which are borrowers willing to pay higher interest rates.

The third method of control is open market operations, which are controlled by the open market committee. These involve the Federal Reserve’s buying and selling government securities or bonds. These are printed up and then sold whenever the government runs a budget deficit and needs to borrow money. Banks own many government securities, which they see as highly liquid (they can be easily sold) and as providing a safe return (the federal government is not likely to go bankrupt). When the Federal Reserve buys securities, it offers higher and higher prices until some bank sells its securities for cash. When the Federal Reserve sells securities, it lowers the price of the securities it owns until it finds a buyer.

These actions enable the Federal Reserve to control the federal funds rate. Overnight loans between banks occur because some banks invariably fail to meet their reserve requirements, and others have extra or excess reserves at the end of the banking day. Overnight lending enables banks to meet their requirements while allowing banks with extra reserves to earn some interest. When the Federal Reserve sells government securities, banks pay for them with cash and therefore have fewer excess reserves to lend out. As a result, the federal funds rate will rise. However, when the Federal Reserve buys securities, it gives cash to banks, which then have more reserves to lend out. With a greater supply of excess reserves, the cost to banks of obtaining funds to meet their reserve requirements will fall.

The Federal Reserve also has many supervisory powers. It sets margin requirements, which limit the use of borrowing to purchase corporate stocks and bonds. It examines the books of private banks to make sure that they are safe and sound, thus protecting depositors. This involves checking to see whether the banks have adequate capital and performing assets (that is, loans that are getting repaid), and have not made risky loans. The Federal Reserve also makes sure that banks do not discriminate in lending or give false or misleading information to borrowers.

A final responsibility of the Federal Reserve is to ensure that the check-clearing system in the United States functions effectively. Because the Federal Reserve holds most bank deposits, it is relatively easy for it to cash checks–basically, it moves money from the pile it is holding for one bank to the pile of another bank.

The most important actions of the Federal Reserve involve lowering the discount rate and the federal funds rate to deal with unemployment problems or financial crises, and raising them when the economy experiences inflationary problems. Lowering these rates make it cheaper for banks to obtain money to lend out. Banks can then lend money at lower interest rates, which encourages borrowing and spending by individuals and business firms. This generates more production, profits, employment, and economic growth. In contrast, higher rates make it more expensive for banks to obtain money, and this means that they will raise interest rates on consumer and business loans. This curtails borrowing and spending in the economy, slows down economic growth, and puts a damper on inflation. The power of the Federal Reserve to control interest rates gives it tremendous control over the performance of the U.S. economy.

Criticisms

Over the years, the Federal Reserve has been criticized by both the left and the right. Free-market economists argue that the market can monitor and control banks better than central bankers can. Milton Friedman criticized the Federal Reserve for supporting a massive stock market bubble during the 1920’s. Then, when the bubble burst, the Federal Reserve did not provide the cash that banks needed after the stock market crashed, leading to the Great Depression.

From the left, the main criticism of the Federal Reserve has been that it protects banks and the U.S. financial system but not average citizens. The Federal Reserve tends to worry more about inflation (which hurts banks, whose loans get repaid in dollars that are worth less) than about unemployment (which hurts the average citizen through job loss and stagnating wages). It also protects financial institutions (for example, bailing out Bear Stearns when it was near default from making bad mortgages) but does little to help individuals unable to make mortgage payments.

Further Reading
  • Eccles, Marriner. Beckoning Frontiers. New York: Alfred Knopf, 1966. This autobiography by the seventh Federal Reserve chair tells of acrimonious political battles with the Department of the Treasury over monetary policy, and how Eccles was essentially forced to resign from his position.
  • Friedman, Milton, and Anna Schwartz. A Monetary History of the United States, 1867-1960. Princeton, N.J.: Princeton University Press, 1963. In this historical account of the creation of the Federal Reserve, Friedman holds the institution responsible for causing the Great Depression and then prolonging it.
  • Galbraith, John Kenneth. Money. Boston: Houghton Mifflin, 1975. A history of money and its regulation in the United States. Galbraith focuses on the politics leading to the creation of the Federal Reserve and its political role.
  • Greenspan, Alan. The Age of Turbulence. New York: Penguin Press, 2007. Autobiography of the thirteenth Federal Reserve chair and an insider’s account of the institution from 1987 to 2002, as it struggled with the Asian financial crisis, stock market booms and busts, and the impact of 9/11.
  • Greider, William. Secrets of the Temple. New York: Simon & Schuster, 1987. A description of the functions and history of the Federal Reserve, focusing on Paul Volcker’s term as chair. Sharply critical of the institution’s secrecy and how it favors Wall Street.
  • Moore, Carl. The Federal Reserve System: A History of the First Seventy-five Years. London: McFarland, 1990. A history of events leading up to the creation of the Federal Reserve, a discussion of the politics involved in passing the Federal Reserve Act, and an account of the changing role of the Federal Reserve in controlling banks and the economy.
  • Wells, Donald. The Federal Reserve System: A History. London: McFarland, 2004. A comprehensive history of the Federal Reserve that emphasizes how it has evolved to become a valued and powerful institution and how it gained independence from political pressures over time.

Bank failures

First Bank of the United States

Second Bank of the United States

Banking

Bond industry

Federal Deposit Insurance Corporation

Alan Greenspan

Inflation

Interest rates

Federal monetary policy

Panic of 1907

Securities and Exchange Commission

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