To understand the Federal Reserve, also known as the Fed, it is important to know its primary objective: to keep prices stable and allow for sustainable long-term economic growth. To do this the Federal Reserve, as a central bank, was given a dual mandate: to keep employment high and to keep inflation low. It primarily does this by controlling the cost of borrowing money.

The Role of the Fed

The Fed is both a bank for banks, and a bank for the government. As a bank for banks, it collects checks, transfers funds and is a receiver and distributor for cash and coin. In addition, the Federal Reserve lends banks money. As a bank for government, the Fed acts as fiscal agent by selling and redeeming government securities such as savings bonds and Treasury bills.

The Federal Reserve has three primary tools to control the cost of borrowing in the US economy:

- The Discount Rate – This is the interest rate the Federal Reserve charges banks for borrowing from the U.S. government

- Open Market Operations – This consists of purchases or sales of government securities for the purpose of increasing or decreasing the money available for bank reserves

- Required Reserve Ratio – This adjusts reserve requirements all member banks must hold against their accounts. Usually banks must hold a reserve of 10% of all transaction accounts. 

The Fed’s Structure

The Fed consists of a Board of Governors. There are seven members, including the chairperson and vice-chairperson. They are located in Washington, D.C. The President with Senate approval appoints all members.

Each member of the Board of Governors serves fourteen-year staggered terms, with the exception of the chair and vice-chair who serve four-year terms. The Board of Governors serves at the request of the President, but are non-partisan appointments.

In addition to the Board of Governors, there are 12 district Reserve Banks, with 25 branches located throughout the United States. Each district bank has a Board of Directors, with nine members each. The banking industry chooses six members and the Board of Governors in Washington, D.C. chooses three of them.

Policy of the Fed

The Federal Open Market Committee (FOMC) is the Fed’s monetary policy-making body. It regulates the Open Market Operations and is considered the most important tool of the Fed. It consists of seven members of the Board of Governors plus four voting Reserve Bank presidents. It meets eight times per year. Within five to six weeks of each meeting, it publishes The Record of Policy Actions.

The Federal Reserve adjusts its policy according to the needs of the economy. If there is an economic downturn, the Fed decreases interest rates, making it easier to borrow money. In this way, there is an availability of cash and credit to stimulate growth.

If there is an economic boom (upturn) the Fed increases interest rates. The cost of borrowing becomes higher, slows the amount of cash available in the economy, and slows growth.

Economic Indicators

Twice yearly, the chairperson of the Federal Reserve gives testimony to the U.S. Congress. The chair gives insight into current Fed concerns. By writing to the public information department at the Board of Governors of the Federal Reserve, any U.S. citizen can obtain both congressional testimony and The Record of Policy Actions.

The balance between stimulating the economy by controlling interest rates and keeping inflation low is a task that requires observation of certain economic indicators. There are a number of other economic indicators; such as Gross Domestic Product (GDP), Consumer Price Index (CPI), Producing Price Index (PPI), the unemployment rate and jobless claims, in addition to Durable Goods Orders and Index of Industrial Production.

Limitations of the Federal Reserve

The role of the Fed is complicated by several factors. The globalization of the world economy makes it more difficult for the Fed to control the U.S. economy. The Fed only has jurisdiction over the United States and cannot control foreign banks or governments from injecting or reducing U.S. dollars into the U.S. economy. In addition, certain capital market innovations, such as mortgage securities, have made it more difficult for the Fed to create policy that impacts the economy.

For example, if the Fed lowers interest rates the cost of borrowing can go up, the opposite of what Fed policy intended.  This action is called “pushing on a string.” The cost of borrowing can sometimes only begin to drop by intervention of the U.S. Department of the Treasury to guarantee all inter-bank loans.

However, the Fed remains the most important and effective government policy making body that directly affects all citizens. By fulfilling its mandate of high employment and low inflation, the role of the Federal Reserve remains a requirement for economic stability in the United States. Despite changes in the global economy, the Fed continues to be the most important economic tool for sustaining U.S. long-term growth.

Additional information:

• Board of Governors Federal Reserve:                www.federalreserve.gov
• Federal Reserve Education:                               www.federalreserveeducation.org
• Federal Reserve:                                               www.federalreserveonline.org