One of the more mysterious areas of the economy is the role
of the Fed. Formally known as the Federal Reserve, the
Fed is the gatekeeper of the U.S. economy. It is the central
bank of the United States -- it is the bank of banks and the
bank of the U.S. government. The Fed regulates financial
institutions, manages the nation's money and influences the
economy. By raising and lowering interest rates, creating
money and using a few other tricks, the Fed can either
stimulate or slow down the economy. This manipulation helps
maintain low inflation, high employment rates, and
In this edition of HowStuffWorks,
we'll visit the mystical world of the Fed and talk about terms
like monetary policy, discount rates, and open market
operation. We'll find out just what kinds of tasks fill Alan
Greenspan's day, and see how his and the Federal Reserve
Board's decisions affect our everyday lives.
Why do we need the Fed? Sometimes, in order
to understand why you need something, it helps to find out
what it was like before that "something" was created. Before
the Federal Reserve was created in 1913, there were over
30,000 different currencies floating around in the
United States. Currency could be issued by almost anyone --
even drug stores issued their own notes. There were many
problems that stemmed from this, including the fact that some
currencies were worth more than others. Some currencies were
backed by silver or gold, and others by government bonds.
There were even times when banks didn't have enough money to
honor withdrawals by customers. Imagine going to the bank to
withdraw money from your savings account and being told you
couldn't because they didn't have your money! Before the Fed
was created, banks were collapsing and the economy swung
wildly from one extreme to the next. The faith Americans had
in the banking system was not very strong. This is why the Fed
The Fed's original job was to organize, standardize and
stabilize the monetary system in the United States. It had to
set up a method that could create "liquidity" in the
money supply -- in other words, make sure banks could honor
withdrawals for customers. It also needed to come up with a
way to create an "elastic currency," meaning it had to
control inflation by making sure prices didn't climb too
quickly, and it needed a way of increasing or
decreasing the country's supply of currency in order to
prevent inflation and recession.
Inflation Inflation is
not a good thing because it slows down economic growth.
For example, when inflation is high, things cost more and
people spend less. They also do less long-term planning that
involves spending money, such as building
houses and investing.
Businesses are affected in the same ways. When inflation is
high, it tends to fluctuate quite a bit. This uncertainty
makes people wary of spending money for fear that inflation
will increase even more and they won't be able to pay their
High inflation also adds additional costs to long-term
interest rates. These costs are to offset the risk associated
with inflation. The additional costs make borrowing money less
attractive. When people don't buy things (when demand is
down), then the supply of goods gets too high, production has
to decrease, and unemployment increases -- in other words,
When prices are stable (when inflation is low), consumers
make more purchases, investments, etc., production output is
maintained and employment remains high.
Recession When recession
hits, the Fed can lower interest rates in order to
encourage people to borrow money and make purchases. This
works in the short run, but it has to be handled carefully so
that inflation isn't impacted in the long run.
The Fed has to carefully balance the short term goals of
increasing output and employment with the long term goals of
maintaining low inflation.
What does the Fed do? The Fed regulates
financial institutions, acts as the U.S. government's bank,
acts as a bank's bank, and is responsible for managing the
nation's money. The Fed has two divisions: One group, the
Board of Governors, is responsible for setting monetary
policy and managing the nation's money; the other group, the
12 regional Reserve Banks, acts as the service division
that carries out the policy and oversees financial
institutions. The regional Reserve Banks represent the private
sector. Both of these groups have the same goals.
employment doesn't necessarily mean that everyone is
working. Economists have a "natural rate" of
unemployment that is ultimately the goal. If the
unemployment rate is pushed too low -- below 5% or so --
inflation rises because more money is in the economy,
and that goes against the long-term Fed goal of stable
In its role as
money manager, the Fed has two primary goals:
Maintain stable prices (control inflation)
Ensure maximum employment and production output
It achieves these goals indirectly by raising or
lowering short-term interest rates. Although these are two
separate goals, the outcome of each is the same -- a stable
Monetary Policy Monetary
policy refers to the actions the Fed takes to influence
financial conditions in order to achieve its goals.
The Fed's primary control is in the raising and lowering of
short-term interest rates. In doing this, the Fed can
indirectly influence demand, which then influences the
economy. For example, if interest rates are lowered, borrowing
money to make purchases becomes less expensive, and people are
more motivated to spend money because they can get a better
deal on the loan. Spending money, in turn, stimulates economic
growth, which is what the Fed is trying to do in that
instance. If there is too much money in the economy, however,
people spend more money and demand increases at a faster rate
than supply can match. Prices rise too quickly because of the
shortage of products, and inflation results. If there is too
little money in the economy, people don't have excess spending
money, and there is little economic growth.
The Fed watches economic indicators closely to determine in
which the direction the economy is going. By forecasting
increases in inflation or slow-downs in the economy, the Fed
knows whether to raise or lower interest rates or increase the
supply of money.
Influencing inflation takes a long time and has to be
looked at as a long-term goal. Influencing employment and
output, however, can be done more quickly and therefore is a
short-term goal. Finding the balance between the two is key.
The lags in the effects that monetary policy has on the
economy are significant. This is why the Fed has to make
forecasts of inflation prior to it actually happening -- one,
two or even three years in advance. If the Fed waited until
inflation were apparent, then it would be extremely difficult
to catch up and get it back under control. We'll talk about
the economic indicators shortly.
Regulator As a regulator for financial institutions,
the Fed establishes the rules of conduct that these
institutions must follow. The regional Reserve Banks then
carry out the supervision and enforcement of these
regulations. These regional banks monitor the activities of
banks within their regions and ensure that they are operating
The Federal Reserve also watches out for the public
interest by monitoring banks that are seeking to merge with
other banks or holding companies. The Fed rules on these
requests according to the impact the merger will have on the
local community and general public interest.
A Bank's Bank Just as
banks serve their customers, the Fed acts as a bank for banks.
The Fed keeps the pipeline of transactions flowing. It processes
and clears one-third of all the checks processed in the
country -- that's about 20 billion checks per year. The
regional Reserve Banks provide these services to the banks
within their regions. The transactions are done on a fee
basis, which is part of how the Federal Reserve supports
itself. Banks are not required to use the Reserve Banks; they
can choose to use a private competitor. This helps to ensure
that the processing fees being charged are kept under control.
The Government's Bank The
Fed maintains the checking account of the U.S.
Treasury. As the largest bank customer in the country, the
U.S. government does quite a bit of business and performs a
lot of financial transactions, all of which are handled by the
Fed. These transactions amount to trillions of dollars and
include all of the tax deposits and withdrawals for U.S.
citizens. It also includes securities such as savings bonds,
Treasury bills, notes, and bonds that are bought by and for
the U.S. government.
Photo courtesy U.S. Treasury Treasury Secretary Lawrence H. Summers and
Treasurer Mary Ellen Withrow unveil the new five and 10
dollar bills in November
The Fed also monitors the condition of currency and either
sends it back into circulation or has it destroyed. Because
there are times during the year when people need more cash,
currency is stored at Reserve Banks so that banks can order
more paper money as they need it. These "orders" are paid for
with funds from the bank's reserve account balance held
with the Fed.
The Fed Tool Box The most important job the
Fed has is to manage the nation's money and the overall
economy. Controlling the inflation rate and maintaining
employment and production aren't easy tasks. The Fed has to
have some pretty hefty tools up its sleeve in order to
influence the economy of an entire country -- especially one
the size of the United States. The Fed has to be able to
affect the rate at which consumer banks and financial
institutions create "checkbook" money for customers through
the loans they grant and investments they offer. They do this
by influencing short-term interest rates and the amount of
money in circulation.
But how does it do that? The Fed uses three tools:
The reserve requirement
The discount rate
Open market operations
The Reserve Requirement In order to combat
the problems of insufficient cash reserves (and the inability
to pay depositors) that were faced before the creation of the
Federal Reserve System, banks now have to set aside a certain
amount of cash in "reserve." The reserve balance that banks
must maintain is typically a percentage of their total
interest-bearing and non-interest-bearing checking account
deposits (currently 3% to 10%). In other words, the amount of
a bank's required reserves will fluctuate depending on their
account totals. The reserve is very important because it helps
to ensure that the bank will always be able to give you your
money when you ask for it.
How do loans "create"
When banks loan
money, that money is spent on goods or services. These
goods or services create income for the people providing
them, which they in turn spend on other good and
services. When lots of loans are made, even more
spending is done and more money is pumping through the
When the Fed sees that too much money is going
through the economy and prices are rising too quickly
(inflation), they put the brakes on by selling
securities. This reduces the amount of reserves
available to banks, causing interest rates to rise, and
banks will not make as many loans because it costs more
for consumers to borrow. Ultimately, the economy slows
down and inflation slows down with it.
This percentage of
required reserves directly affects how much money they can
"create" in their local economies through loans and
investments. It is this connection between the required
reserve amount and the amount of money a bank can lend that
allows the Fed to influence the economy. If the reserve
requirement is raised, then banks have less money to loan and
this will have a restraining effect on the money supply. If
the reserve requirement is lowered, then banks have more money
Reserve money is used to process check and
electronic payments through the Federal Reserve and to meet
unexpected cash outflows. These reserves can be held as "cash
on hand," as a reserve balance at a regional Reserve Bank, or
Although the Fed has the power to do so, changing the
amount of reserve cash a bank has to have can have dramatic
effects on the economy; for this reason, this tool is rarely
used. The Fed more often alters the supply of reserves
available by buying and selling securities. When the Fed sells
securities, it reduces the banks' supply of reserves. This
makes interest rates go up. When the Fed buys securities, it
increases the banks' supply of reserves. This makes interest
rates go down.
All of this buying and selling is referred to as open
market operations (discussed below).
In the event that a bank's money supply drops below the
required reserve amount, that bank can borrow either from
another bank or from a Reserve Bank. If it borrows from
another bank's excess reserves, then the loan takes place in a
private financial market called the federal funds
market. The federal funds market interest rate, called the
funds rate, adjusts according to the supply of and
demand for reserves.
If a bank chooses to borrow emergency reserve funds from a
Reserve Bank, then it pays an interest rate called the
The Discount Rate The
"discount rate" is the interest rate that a regional Reserve
Bank charges banks and financial institutions when they borrow
funds on a short-term basis. The Fed discourages banks from
borrowing except for occasional, short-term emergency needs.
The discount rate often plays a larger role in the overall
monetary policy than would be expected because it is a visible
announcement of change in the Fed's monetary policy.
Typically, higher discount rates indicate that more
restrictive monetary policies are in store, while a lower rate
might signal a less restrictive move.
Changes in the discount rate can affect:
Lending rates (by making it either more or less
expensive for banks to get money to lend or hold in reserve)
Other open market interest rates in the economy (because
of its "announcement effect")
Operations The most effective tool the Fed has, and
the one it uses most often, is the buying and selling of
government securities in its open market operations.
Government securities include treasury bonds, notes, and
bills. The Fed buys securities when it wants to
increase the flow of money and credit, and sells
securities when it wants to reduce the flow.
Here's how it works. The Fed purchases securities from a
bank (or securities dealer) and pays for the securities by
adding a credit to the bank's reserve (or to the dealer's
account) for the amount purchased. The bank has to keep a
percentage of these new funds in reserve, but can lend the
excess money to another bank in the federal funds market. This
increases the amount of money in the banking system and lowers
the federal funds rate. This ultimately stimulates the economy
by increasing business and consumer spending because banks
have more money to lend and interest rates are lowered.
When the Fed wants to decrease the money supply, it sells
securities. That transaction deducts the purchase amount from
the bank's reserve (or the dealer's account). This reduces the
amount of money the bank has to lend in the federal funds
market and increases the federal funds rate. This move
ultimately slows the economy down by decreasing the amount of
money banks have to loan, which increases interest rates and
typically reduces consumer and business spending.
These decisions are made by the Federal Open Market
Committee (FOMC), which consists of the seven members of
the Board of Governors, the president of the Federal Reserve
Bank of New York, and four rotating members from the other
eleven Reserve Banks. This committee has eight meetings per
year to discuss and direct the monetary policy. Additional
emergency meetings are called when needed. The FOMC specifies
either a quantity of reserves to be purchased or sold or a
specific change in the federal funds rate. (The federal funds
rate is the interest rate at which banks lend reserves to
How is the Fed set up? The Federal Reserve
System was established in 1913 when Congress passed the
Federal Reserve Act. Although the Fed is independent of
the government, it is ultimately accountable to Congress
because Congress can amend the Federal Reserve Act at any
time. Its actions, however, do not require any kind of
approval from the government.
The Fed is called a "decentralized" central bank,
which in itself seems to be a contradiction. It works,
however, because the Fed is uniquely structured to eliminate
government control but still remains accountable to both the
government and the public. The Board represents the interests
on the government side, and the regional Reserve Banks (whose
boards of directors consist of local citizens) represent the
interests of the private side. In order to operate
independently of the government, the Fed finances its own
The Board of
Governors The Fed has a seven-member Board of
Governors and 12 regional Reserve Banks. The U.S. president
appoints (and the Senate confirms) the seven Governors, whose
14-year terms are staggered to prevent a single president from
being able to appoint too many governors. The chairman of the
Federal Reserve, who serves a four-year term, is also
appointed by the president.
Member Banks of the
Any national bank
that is chartered by the federal government is
automatically a member of the Federal Reserve System.
State banks have to meet specific standards that the
Board of Governors sets in order to become members.
Member banks are required to buy stock
in their regional Reserve Banks. This stock doesn't give
the bank any kind of voting privileges and cannot be
sold or used as collateral for loans. What the banks do
get is a six percent dividend on the stock and the
ability to vote for the Class A and Class B directors of
the Reserve Bank.
Each of the 12
Reserve Banks has nine directors on its board. The directors
are responsible for the overall operations of their banks and
report to the Board of Governors. The directors are divided
into three groups that represent a cross-section of ideas and
interests for the region. These groups are called Class A,
Class B and Class C. Class A represents commercial banks that
are members of the Federal Reserve System. These member banks
elect both the Class A and Class B directors. Class B and C
directors do not come from the banking industry. They
represent the economic interests of the local district,
including agriculture, manufacturing, labor, consumers and
nonprofits, and are elected by the Board of Governors. This
allows both the private sector and the government/public
sector to have representation.
Banks Each regional Reserve Bank president is
appointed to a five-year term by the bank's Board of
Directors, but the Board of Governors gets the final say-so in
FOMC The Federal Open
Market Committee (FOMC) consists of the seven members of the
Board of Governors, the president of the Federal Reserve Bank
of New York, who acts as vice chairman, and four members from
the other eleven Reserve Banks that rotate at the end of each
Economic Indicators In order to develop the
nation's monetary policy, the FOMC looks at many economic
indicators. This gives the FOMC a feel for what the economy is
doing and what direction it may be taking. It also looks to
the The Beige Book, which is a report that summarizes
comments received from businesses and other contacts outside
of the Federal Reserve. This, in addition to economic
indicators, forms the basis for the FOMC's monetary policy.
The Federal Reserve chairman accesses data about the
economy every half hour or so when things in the economy are
calm, and every 15 minutes when things aren't. This is simply
to make sure nothing is happening in the economy that the
chairman doesn't know about. The chairman can also tap into a
network of business contacts that provide insight into a wide
range of businesses, revealing who is buying what and in what
amounts. By staying on top of where the economy is right now
and where it is going, the Fed can project future changes and
Here are the economic indicators examined by the Fed:
Consumer Price Index (CPI) - This indicates the
change in price for a fixed set of merchandise and services
intended to represent what a typical consumer might purchase
over a given period. It is compiled monthly by the U.S.
Department of Labor's Bureau of Labor Statistics. By keeping
track of the rate of change in the CPI, the Fed can get an
accurate measure of inflation.
Real Gross Domestic Product (GDP) - The GDP is
the total of all of the goods produced in the United States,
regardless of who owns them or the nationality of the
producers. The measurement is produced quarterly and
accurately represents national output, meaning it uses real
terms so inflation doesn't distort the numbers. It is used
as an indicator of the performance and growth of the
Housing Starts - Because housing is very
sensitive to interest rates, this indicator is tells the
FOMC how financial changes are affecting consumers. Housing
starts are an estimate of the number of housing units that
started construction in a given period. The report is
Nonfarm Payroll Employment - This measurement
includes the total number of payroll jobs that are not in
the farming business. It is produced each month by the U.S.
Department of Labor's Bureau of Labor Statistics and also
includes information about the total number of hours worked
and hourly wages earned by workers. It is helpful to the
FOMC as an economic indicator because it indicates the pace
(or changes in the pace) of economic growth. The average
hourly earnings number also shows trends in supply and
S&P Stock Index - The Standard & Poor
Index shows the FOMC the changes in price in a very wide
variety of stock. S&P compiles the index daily. The
value of watching this index as an indicator of the economy
is that it often indicates the confidence consumers and
businesses have in the economy. If the market is rising,
then investments and spending will rise; if the market is
low or falling, then investments and spending will also slow
Industrial Production/Capacity Utilization - This
measures industrial output both by product and by industry.
It is compiled by the Board of Governors each month and is
useful because it tells the FOMC about the current growth of
the Gross Domestic Product. By understanding the level of
capacity utilization, the FOMC can understand how well
resources are being utilized. All of this can indicate
future changes in the rate of inflation.
Retail Sales - This is a total of all merchandise
sold by retail merchants in the United States. The numbers
are presented in dollar amounts, and are adjusted for
seasonality but not for inflation. The U.S Department of
Commerce produces this report each month. This measurement
tells the FOMC how much consumers are buying. This is called
the personal consumption expenditure and indicates
future growth or lags in the economy.
Business Sales and Inventories - This is a
measurement of the total sales and inventories for the
manufacturing, wholesale, and retail sectors. This report is
compiled monthly by the U.S. Department of Commerce and can
be a good indicator of growth or slow downs in the economy
because it shows the level of inventory and whether it is
moving or not. Inventory that isn't moving indicates a
future slow down; inventory that is moving may indicate an
increase in future production.
Light-Weight Vehicle Sales - Because changes in
car sales can account for a large portion of the change in
the GDP from quarter to quarter, this measurement has to be
taken into account. The report is compiled by Ward's
Automotive Reports and the American Automobile
Manufacturer's Association, and seasonally adjusted numbers
are generated by the U.S. Department of Commerce and the
Bureau of Economic Affairs.
Yield on 10-year Treasury Bond - This is simply
the current market rate for U.S. Treasury bonds that will be
maturing in 10 years. This is good as an indicator because
mortgage rates tend to follow it. Changes in mortgage rates,
in turn, indicate future changes in the housing industry.
categorizes money based on its liquidity. It is
divided into three categories:
M1 - The actual cash money supply,
spending money, checking accounts and currency
M2 - A larger category that includes M1,
small savings accounts and time deposits at banks,
and money market mutual funds
M3 - Larger and less liquid, including
corporate CDs, etc.
M2 - Because there is often a link between the
supply of money and the growth of the GDP, this measurement
is yet another indicator that the FOMC looks to when making
decisions about monetary policy. The report is produced by
the Board of Governors weekly and monthly.
Lagging Economic indicators are categorized as
leading, coincident, or lagging. Leading indicators
anticipate the direction in which the economy is going.
Coincident indicators tell the Fed about the economy's
current status. Lagging indicators help the Fed
determine how long a downturn or upturn in the economy will
last because these indicators are affected months after an
upturn or downturn has begun.
By studying the indicators as they fall into these
categories, the Fed can determine the phase of the business
cycle that the economy is in at the time. The four phases of
the business cycle are:
Expansion or recovery
Contraction or recession
The categories of "leading,"
"coincident," and "lagging" indicate the turning points of the
economy relative to the business cycle. As the economy moves
from one phase to the next, these indicators change.
For more detailed information about how economic indicators
work, check out this
section of the Fed 101 Web site.
How does the Fed support itself? In order to
remain independent of the U.S. government, the Federal Reserve
totally supports itself. It generates its income for the most
part from interest. This interest comes from many
Government securities that it acquires through open
Foreign currency investments
Bank/depository institution loans that the Fed makes
using the discount rate
The Fed is also paid
fees for services it provides such as funds transfers
processing, and automated clearinghouse (ACH) operations.
(ACH options are electronic alternatives to the paper-based
check system. Examples include automatic payroll deposits and
electronic bill paying.)
Any money the Fed has left over after it pays all of its
expenses are sent to the U.S. Treasury. Since the Federal
Reserve System began in 1914, about 95 percent of the Reserve
Banks' net earnings have ended up being paid into the
Information about the income and expenses of the Federal
Reserve Board can be found in the Board of Governor's Annual
Checks and Balances The structure of the
Federal Reserve was carefully laid out to incorporate a strong
system of checks and balances. Its decentralized status and
broad range of participants eliminates the chances of any one
group having too much control.
Each of the Fed's tools is under the authority of a
different group within the system. For example, the Board of
Governors has the authority to change bank reserve
requirements; the boards of directors for the individual
Reserve Banks can initiate changes to the discount rate (which
then has to be approved by the Board of Governors); and the
open market operations (the most important tool) is controlled
by the FOMC, which represents both groups.
These checks and balances, along with the overall structure
of the Federal Reserve, make sure that partisan interests
don't have too much control and ensure that the Fed's
decisions represent the broad interests and needs of the
entire United States.
For more information, check out the links on the next page.