The Federal Reserve
The Federal Reserve
The Federal Reserve System, also known as the Fed or the U.S. central banking system, is the single most powerful economic institution in America and possibly the world. Since its establishment in December of 1913, the Federal Reserve’s primary role has been to provide the United States with a secure, stable, and flexible financial and monetary system. The Fed was created in response to a financial crisis in the U.S. in 1907 and has remained a last-resort lending institution in times of economic problems. Before its creation, America was the only financial power without a central bank. However, its role in the country’s economy has expanded since then.
Understanding the Importance of the Central Banking System in the USA
Central banks are financial institutions that have exclusive influence over the production and distribution of money or credit for a country or a group of countries. They prevent panic and economic disruptions in a country by regulating banks, providing financial services, conducting monetary policies, and maintaining economic stability.
The central banking system was established during the 1910s to resolve the economic vulnerability issues brought about by bank runs and financial panics. Its role in the economy was better demonstrated during the 2008 economic meltdown and the COVID-19 Pandemic in 2020. Their response to the economic crisis of 2008 was to institute a variety of initiatives intended to support the ability of financial institutions to attain liquidity and encourage improved conditions in the financial market. They also helped solve the economic crash brought about by the lockdown on 2020 by purchasing debt securities in large amounts.
The Federal Reserve conducts its monetary policy via the Federal Open Market Committee (FOMC) and manages the country’s money supply by changing the interest rates and controlling the inflation levels. Their ability to decide on how much banks should charge as interest is why the Fed has so much influence over the economy.
The Effect of the Federal Reserve System on the Stock Market
When the Board of Governors that constitute the Federal Open Market Committee sit down for a meeting, they plan on a set value for the federal funds rate. This decision typically affects the rate at which banks can borrow and lend money from each other overnight. As a result, any change in the interest rates in the United States has an immediate impact on the stock market. Other markets might take anywhere between several months to a year to witness a significant impact.
In order to control inflation, the Federal Reserve affects the federal funds rate. They have an implied target inflation rate of 2 %. The basic concept behind inflation targeting is founded on the conviction that long-term growth in an economy is better accomplished by implementing a monetary policy that is achieved by controlling inflation.
Inflation rates of 1 % to 2 % per year are typically considered acceptable, while more than 3 % rates depict a risky economic position that could lead to currency depreciation. The Taylor rule is an econometric model that states that the Federal Reserve must raise interest rates when inflation or GDP growth rates are higher than desired.
When the Federal Reserve increases the federal funds rate, it seeks to limit the quantity of money in circulation and available for purchase. As a result, money becomes more expensive to acquire, causing certain stocks to rise. When the federal funds rate is reduced, the money supply expands. This incentivizes spending by making borrowing more affordable.
While a change in interest rates usually takes at least a year to have a widespread economic impact, the stock market’s reaction to a change is frequently more immediate. Markets often attempt to price in future expectations of rate hikes and anticipate the FOMC’s actions before they become official.
The Structure of the Federal Reserve
The Federal Reserve has a unique structure in its organization because it is both a private and public institution. The Fed is described as an independent body within the government. The government does not fund the Federal Reserve System. It derives its executive power from the Federal Reserve Act, which Congress approved in 1913 and is susceptible to an adjustment or repeal by Congress.
The founders deliberately opposed the idea of a single central bank during its creation. Instead, they envisioned a consolidated banking system with the following features:
- The Board of Governors comprised of seven members
- The Federal Open Market Committee (FOMC)
- A decentralized system of 12 regional Federal Reserve Banks
- Twenty-four branches across the United States
Although this structure closely resembles that of a private sector entity, the Federal Reserve was established to benefit the interests of the public. These organizations collaborate to develop policies that affect the state and stability of the American economy.
The Board of Governors is a government institution that performs business oversight by overseeing national banks. It has seven members appointed by the U.S. President and approved by the Senate. However, as of June 2022, the Federal Reserve has only six members who govern it. They supervise the 12 District Reserve Banks and regulate the national monetary policy. It also oversees and is responsible for regulating the entire financial system in the United States.
Members chosen to be on the board serve a staggered 14-year term. However, if a member serves a full term, they cannot be nominated a second time, which begins every two years on February first of even-numbered years. After their terms of office expire, members of the board continue to serve until their successors are appointed and qualified.
The President appoints the chairman and vice chair from the current list of actively serving governors. They each serve a four-year term on the board and can be reappointed multiple times until their terms as governors expire. During holidays, they are usually closed and will be available on the next business day.
The Functions of the Federal Reserve
The Federal Reserve has a monetary policy with one main objective; to promote economic growth. This helps to stabilize the price of commodities in the market and ensure a maximum number of sustainable jobs. This would mean an unemployment rate that does not exceed 4 or 5%.
Their goals can be further divided into the following.
- The Federal Reserve’s monetary policy objectives are twofold: To foster economic conditions that result in stable prices and maximum sustainable employment.
- Conduct a monetary policy for the country by controlling the direction of money and credit in the economy to achieve maximum work opportunities and low inflation.
- Overseeing and restricting the activities of banks and other major financial establishments to guarantee the safety and stability of the country’s banking and monetary system and preserve consumers’ credit rights.
- Sustaining the financial system’s stability and containing systemic risk in the financial markets.
- Provides certain banking services to the United States government, financial institutions in the United States, and foreign government entities, as well as playing a significant role in the operation and oversight of the nation’s payment systems.
The Role of the Federal Reserve System During the Great Recession
During the Great Recession, like all other central banks worldwide, the Federal Reserve reduced its interest rates to encourage lending and other economic activities. Its rates had dropped to near zero by the end of 2008, remaining until 2015. However, they engaged in another unconventional policy known as quantitative easing, or Q.E., which pertains to the large-scale purchase of fixed assets such as treasury bonds, home loan securities, and other debts. The news of this move caused a lot of concern among economists who thought that this kind of increase in the money supply would result in an inflation rate that would be hard to control.
The Federal Reserve is an independent organization within the United States government. Despite its governors receiving an appointment by the President, the Fed has the right to make independent decisions uninfluenced by the federal government’s decision.
The Federal Reserve System (Fed) provides the country with a secure, stable, and flexible financial and monetary system. The Federal Reserve’s primary responsibilities include regulating banks, providing financial services, conducting monetary policies, and maintaining economic stability. They undertake monetary policy for the country by affecting the availability of money and credit the economy to achieve job employment and secured commodity prices.
No one owns the Federal Reserve. The Federal Reserve Act of 1913 established the Federal Reserve as the central bank of the United States. However, according to the Federal Reserve Act of 1913, each of the twelve regional banks of the Federal Reserve System is owned by the member banks that provided the initial capital to keep them running.
The Board of Governors. They are a group of seven members appointed by the U.S. President and approved by the Senator.