The Concise Encyclopedia of Economics

Federal Reserve System

by Manuel H. Johnson
About the Author
The Federal Reserve System (the Fed) has been the central bank of the United States since it was created in 1913. The main purpose of a central bank is to regulate the supply of money and credit to the economy. The board of governors, the Fed's principal policy-making organization, plays a key role in this process.

The board has seven members, two of whom serve as chairman and vice chairman. Each governor is appointed to a fourteen-year term, while appointments to the roles of chairman and vice chairman are for four years. The president, with confirmation by the Senate, appoints all seven governors and designates which ones should also be confirmed as chairman and vice chairman. The terms of Federal Reserve governors are long (second only to lifetime appointments of federal judges) to insulate the members from political pressures and foster independent decisions.

The responsibility for regulating the nation's money supply requires the Federal Reserve to influence the amount of reserve funds available to banks and thus the level and direction of short-term interest rates. For example, whether banks and other financial institutions will make loans depends on the profit margin—the difference in the rate of interest they must pay to attract deposits or borrow funds and the interest rate they can charge customers for credit. The greater the profit margin that banks can realize on new loans, the more they will want to lend. To influence interest rates on deposits and interest rates that banks pay to borrow funds, the Fed uses its congressionally granted authority to create money. The Fed creates money in three ways.

First and most important, the Fed can purchase U.S. government securities from financial institutions by simply creating "funds" (credits) on their balance sheets in exchange for the securities. To the extent that these securities are purchased directly from banks, banks have new liquid reserves on their books immediately. When nonbank financial institutions deposit their proceeds from sales of securities, banks will see their reserves increase even more. As some banks become flush with extra reserves, they temporarily lend these funds to other banks overnight to earn interest. The increased supply of reserves relative to demand in the money market pushes down the overnight interest rate (called the federal funds rate). This decline in the cost of credit to banks increases the profitability of new loans to businesses and individuals and provides stronger incentives for banks to expand the amount of credit to the economy.

Fed purchases and sales of government securities to regulate money and credit are referred to as open-market operations. Decisions to conduct open-market operations are made by the Federal Open Market Committee (FOMC), where the board of governors holds a majority of the votes. The FOMC has twelve voting members: the seven members of the board of governors and five of the twelve presidents of the regional Federal Reserve operating banks. (All twelve bank presidents are members of the FOMC, but only five vote at a time. The president of the New York bank always has a vote because of the New York bank's central role as the system's major operating facility.) Each voting member of the FOMC has one vote, and a simple majority is required for a change in policy. FOMC meetings are held roughly every six weeks to decide the appropriate amount of reserves to provide the banking system and the desired level of short-term interest rates.

A second monetary policy tool available to the Federal Reserve is the discount rate, the interest rate the Fed charges on loans it makes to banks. By increasing or decreasing this rate, the Fed can discourage or encourage banks to borrow the funds it creates and, therefore, make more loans to the public. The board of governors (not the FOMC) sets the discount rate by majority vote. In deciding the rate, however, the board does consider the recommendations of the directors from the twelve regional reserve banks.

In the past, discount-rate lending has served a dual purpose: facilitating monetary policy as just described and providing emergency liquidity to troubled banks. The Fed's attempt to accomplish two different missions with the discount rate has prompted a debate over the rate's proper role. To stimulate the growth of credit in the economy via discount-rate lending, the Fed must set the discount rate below other prevailing short-term interest rates. Otherwise, banks have no incentive to borrow from the central bank. But if subsidized credit is also temporarily provided to troubled or failing banks, borrowing from the Fed could become stigmatized, so that normal, healthy banks refrain from seeking discount-rate credit. Such behavior by healthy banks could defeat the overall credit growth objective of Fed monetary policy. This dilemma has led some analysts, both inside and outside the Fed, to recommend that the Fed discontinue use of the discount rate to affect overall credit, and instead, provide discount-rate lending solely to higher-risk banks for emergency liquidity purposes, and only at a penalty rate.

A third way in which the Fed operates monetary policy is by regulating the proportion of liquid reserves that banks must keep on hand. Obviously, the higher the reserve requirement, the less funds there are available to make new loans. The board of governors has the authority to determine reserve requirements above the legal minimum for all federally insured depository institutions. Reserve requirements may be changed by a simple majority vote of the board. In practice, however, reserve requirements are rarely changed because even small adjustments produce rather sweeping impacts on the quantity of required reserves.

The board of governors was not always the dominant policy-making body within the Federal Reserve System. The Federal Reserve Act that created the Fed in 1913 called for a highly decentralized system that empowered the twelve regional banks to conduct somewhat autonomous monetary policy actions based on regional economic considerations. Although the board of directors in Washington was to act in a supervisory capacity, it had limited authority to centrally manage monetary policy. Initially, the board consisted of five internal directors, one of whom served as governor. In addition, the secretary of the Treasury acted as chairman of the board and was an ex officio director along with the comptroller of the currency.

In the early days after the Federal Reserve Act, changes in the discount rate were the principal means of expanding credit growth in the regions. Because each regional reserve bank set its own separate discount rate, there often was no single prevailing Federal Reserve interest rate. As financial markets became more integrated, however, borrowers took advantage of the uneven discount rates by borrowing from the region offering the lowest rate. The ability of private banks to arbitrage between regional reserve bank rates constantly frustrated any attempt by Washington to centrally manage credit growth. This arbitrage eventually forced a standardized policy on the discount rate and brought into question the need for a decentralized Federal Reserve System. Also, during the twenties, Fed open-market operations were expanded into a general strategy for monetary policy under the leadership of Benjamin Strong, head of the Federal Reserve Bank of New York. Strong organized an informal policy committee that was the forerunner of the FOMC.

The Great Depression of the thirties shifted the Fed toward more central management of monetary affairs. Working with Marriner Eccles, a Utah banker, President Franklin Roosevelt fashioned the Banking Act of 1935, which concentrated the authority over monetary policy in Washington with the independent seven-member board of governors, and excluded the secretary of the Treasury and the comptroller of the currency. Eccles was appointed the first chairman of this new board, and a separate building was erected for its use on Constitution Avenue. Benjamin Strong's informal open-market group became a restructured, permanent Federal Open Market Committee in a provision of the banking act.

A trend of increasing board responsibility for the regulation and supervision of the banking system followed the shift in authority over monetary policy. Therefore, in addition to its primary function of managing U.S. monetary policy, today the board is also charged with the regulatory oversight of all bank holding companies, all state chartered banks that are members of the Federal Reserve System, and international activities of all U.S. banks. In addition, the board administers U.S. consumer banking laws and regulates margin requirements in the stock market.

About the Author

Manuel H. Johnson is cochairman of Johnson Smick International, a consulting firm in Washington, D.C. He was vice chairman of the Federal Reserve Board from 1986 to 1990 and, previous to that, was assistant secretary of the Treasury for economic policy.

Further Reading

Board of Governors of the Federal Reserve System. The Federal Reserve System: Purposes and Functions. 1985.

Greider, William. Secrets of the Temple. 1987.

Jones, David M. The Politics of Money: The Fed under Alan Greenspan. 1991.

Kettl, Donald F. Leadership at the Fed. 1986.

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