Federal Reserve 101

Banks, Investing & Retiring

Financial news is filled with references to the Federal Reserve, especially given the recent interest rate hike and the hundreds of articles on the effect of the Fed’s actions. But do you know what the Fed really is and how it came to be?

The Federal Reserve is the federal government’s central banking system. Created by the Federal Reserve Act in 1913, the Fed opened for business in late 1914. The Fed comprises of twelve regional banks. They are spread out across America – although the locations skew a bit east due to population distribution at the time the law was passed.

The twelve locations are St. Louis, San Francisco, Atlanta, Boston, Kansas City, Minneapolis, New York, Philadelphia, Richmond, Cleveland, Chicago, and Dallas. These banks added branches to adjust to population growth over time. The twelve regional banks are collectively in charge of setting monetary policy, which is delivered through the Federal Reserve Board in Washington, DC.

The best way to think of the Fed is as the bank of banks. They maintain reserves to lend to banks (at the baseline interest rate so often referenced) and keep liquidity in the market during runs on banks. At the time of its creation, there was no mechanism to stop literal runs on banks. During an economic panic, people would literally go to the bank and withdraw their cash until the bank ran out of money. At that point, credit becomes impossible and commerce comes to a halt. Imagine such a system on Black Monday in 1987 — or the stock market crash of 1929 that led to the Great Depression.

At the beginning of the 1900s, the U.S. was the only developed country without a central banking system, due to fierce resistance on centralized government control (which exists to a certain extent today). Multiple past efforts to establish a central bank failed. During the panic in 1907, Wall Street tycoon J.P. Morgan effectively acted as a central bank by gathering his fellow bankers and deciding which banks should be saved. Morgan made loans available to those banks, while others were cast adrift to fail.

Morgan realized that having one individual in charge of such an important task was filled with risk, and that a systematic approach was required. Congress followed up on this approach by creating the Fed as an independent manager of fiscal policy.

Since they are charging interest to banks, the Fed actually makes money — but some of this money is redirected toward the member banks and the federal government. The regional Fed banks pay dividends to the banks within their region. The collective bank profits are capped at 6% and profits above that level are returned to the federal government. This creates a balance between the private and governmental take of the profits.

Note that the Fed truly is an independent entity. Employees of the Federal Reserve Banks are not government employees. The Fed tends to act cooperatively with government, because the interests generally converge. For example, the recent interest rate hike is not welcomed by all in government, as there is a risk of slowing the economy in an election year. The Fed’s actions should remain above politics.

The Fed has more functions than just setting monetary policy and lending money to banks. They also control the input of new currency and coins and the withdrawal of older ones, along with the issuance and redemption of Treasury securities. The Fed is also the effective checking account for the government, processing millions of checks on a daily basis. Finally, they also serve as oversight for banks with respect to sound practices.

In a way, the Federal Reserve is like the grease of the economy. They adjust monetary policy to keep the economy running as smoothly as possible. It is always a challenge to find the right amount of economic “grease” to apply. Too much or too little influence and the economy does not run properly. This is why economists have been unnerved by the near zero interest rates of the last seven years, and why the Fed has been moving deliberately to bring the U.S. economy back into the proper balance.

Photo ©iStock.com/Veni

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