The Federal Reserve System

Introduction to the Federal Reserve

The Federal Reserve System is the central banking system of the United States, which conducts the nation’s monetary policy.

Learning Objectives

Describe the primary function and objectives of the Federal Reserve System

Key Takeaways

Key Points

  • By changing the money supply through buying or selling government bonds, the Fed can alter the short-term interest rates. This lowers interest rates, which can stimulate borrowing, spending, and investment, in theory.
  • The Fed also supervises and regulates banking institutions, maintains the stability of the financial system, and provides financial services to depository institutions, the government, and foreign institutions.
  • The Congress established three key objectives for monetary policy —maximum employment, stable prices, and moderate long-term interest rates.
  • The Fed acts independently; it does not have to answer to the president or Congress.

Key Terms

  • Federal Reserve System: the central banking system in the United States
  • monetary policy: The process by which the government, central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.
  • depression: a period of major economic contraction

What is the Federal Reserve ?

The Federal Reserve System (also known as the Federal Reserve, or the “Fed”) is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics. Over time, the roles and responsibilities of the Federal Reserve System have expanded, and its structure has evolved. Events, such as the Great Depression, were major factors leading to changes in the system.

Congress established three key objectives for monetary policy—maximum employment, stable prices, and moderate long-term interest rates—in the Federal Reserve Act. Its duties have expanded over the years, and today, according to official Federal Reserve documentation, include conducting the nation’s monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system, and providing financial services to depository institutions, the U.S. government, and foreign official institutions.

The Fed is independent within government in that “its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government. ” Its authority is derived from statutes enacted by the U.S. Congress, and the system is subject to congressional oversight. The members of the board of governors, including its chairman and vice-chairman, are chosen by the president and confirmed by the Senate.

Since the inflation of the 1970s, Federal Reserve monetary policy has emphasized preventing rapid escalation of general price levels. When the general price level is rising too fast, the Federal Reserve acts to slow economic expansion by reducing the money supply, thus raising short-term interest rates.

When the economy is slowing down too fast or contracting, the Federal Reserve increases the money supply, thus lowering short-term interest rates. The most common way it effects these changes in interest rates, called “open-market operations,” is by buying and selling government securities among a small group of major banks and bond dealers.

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Monthly changes in the currency component of the U.S. money supply as reported by the Federal Reserve

Banking Crises and Centralized Reserve Enforcements

One of the Federal Reserve’s duties is to regulate financial institutions, such as bank-holding companies and state member banks.

Learning Objectives

Discuss the Federal Reserve’s powers for enforcing actions due to violations

Key Takeaways

Key Points

  • Generally, the Federal Reserve takes formal enforcement actions against banks for violations of laws, rules, or regulations, unsafe or unsound practices, breaches of fiduciary duty, and violations of final orders.
  • Formal enforcement actions include cease and desist orders, written agreements, removal and prohibition orders, and orders assessing civil money penalties.
  • The Federal Reserve supervises certain entities and has the statutory authority to take formal enforcement actions against them.

Key Terms

  • Federal Reserve: the central banking system of the United States

The Federal Reserve supervises certain entities and has the statutory authority to take formal enforcement actions against them, including state member banks, bank holding companies, nonbank subsidiaries of bank holding companies, branches and agencies of foreign banking organizations operating in the United States and their parent banks, and officers, directors, employees, and certain other categories of individuals associated with the above banks, companies, and organizations.

Generally, the Federal Reserve takes formal enforcement actions against the above entities for violations of laws, rules, or regulations, unsafe or unsound practices, breaches of fiduciary duty, and violations of final orders. Formal enforcement actions include cease and desist orders, written agreements, removal and prohibition orders, and orders assessing civil money penalties.

Enforcement

If the Federal Reserve determines that a state member bank or bank holding company has problems that affect the institution’s safety and soundness or is not in compliance with laws and regulations, it may take a supervisory action to ensure that the institution undertakes corrective measures. Typically, such findings are communicated to the management and directors of a banking organization in a written report. The management and directors are then asked to address all identified problems voluntarily and to take measures to ensure that the problems are corrected and will not recur.

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Bank failure: If the Federal Reserve determines that a state member bank or bank holding company has problems that affect the institution’s safety and soundness or is not in compliance with laws and regulations, it may take a supervisory action to ensure that the institution undertakes corrective measures.

Most problems are resolved promptly after they are brought to the attention of an institution’s management and directors. In some situations, however, the Federal Reserve may need to take an informal supervisory action, requesting that an institution adopt a board resolution or agree to the provisions of a memorandum of understanding to address the problem. If necessary, the Federal Reserve may take formal enforcement actions to compel the management and directors of a troubled banking organization, or persons associated with it, to address the organization’s problems. For example, if an institution has significant deficiencies or fails to comply with an informal action, the Federal Reserve may enter into a written agreement with the troubled institution or may issue a cease-and-desist order against the institution or against an individual associated with the institution, such as an officer or director. The Federal Reserve may also assess a fine, remove an officer or director from office and permanently bar him or her from the banking industry, or both.

The Lender of Last Resort

The U.S. Federal Reserve as the “lender of last resort” extends credit to financial institutions unable to obtain credit elsewhere.

Learning Objectives

Explain why the Federal Reserve serves as the “lender of last resort”

Key Takeaways

Key Points

  • There has been some criticism of this particular Fed function, as it shifts responsibility away from lenders and borrowers and adversely affects other parties in the form of inflation.
  • Through its discount and credit operations, Reserve Banks provide liquidity to banks to meet short-term needs stemming from seasonal fluctuations in deposits or unexpected withdrawals.
  • The rate the Fed charges banks for these loans is the discount rate (officially the primary credit rate).

Key Terms

  • liquidity: An asset’s ability to become solvent without affecting its value; the degree to which it can be easily converted into cash.

In the United States, the Federal Reserve serves as the lender of last resort to those institutions that cannot obtain credit elsewhere and the collapse of which would have serious implications for the economy. It took over this role from the private sector “clearing houses” which operated during the Free Banking Era; whether public or private, the availability of liquidity was intended to prevent bank runs.

According to the Federal Reserve Bank of Minneapolis, “the Federal Reserve has the authority and financial resources to act as ‘lender of last resort’ by extending credit to depository institutions or to other entities in unusual circumstances involving a national or regional emergency, where failure to obtain credit would have a severe adverse impact on the economy. ” Through its discount and credit operations, Reserve Banks provide liquidity to banks to meet short-term needs stemming from seasonal fluctuations in deposits or unexpected withdrawals. Longer term liquidity may also be provided in exceptional circumstances. The rate the Fed charges banks for these loans is the discount rate (officially the primary credit rate).

By making these loans, the Fed serves as a buffer against unexpected day-to-day fluctuations in reserve demand and supply. This contributes to the effective functioning of the banking system, alleviates pressure in the reserves market and reduces the extent of unexpected movements in the interest rates. For example, on September 16, 2008, the Federal Reserve Board authorized an $85 billion loan to stave off the bankruptcy of international insurance giant American International Group (AIG).

The Federal Reserve System ‘s role as lender of last resort has been criticized because it shifts the risk and responsibility away from lenders and borrowers and places it on others in the form of inflation.

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The Market for Balances at the Federal Reserve

The Fed as a Check Clearer

The Fed created a nationwide check-clearing system that provided an efficient and stable way of transferring funds between institutions.

Learning Objectives

Explain why a check clearing system was created under the Federal Reserve system

Key Takeaways

Key Points

  • The government of the United States of America is the federal government of the constitutional republic of 50 states that constitute the United States, as well as one capitol district and several other territories.
  • A check-clearing system was created in the Federal Reserve system after banks refused to clear checks from certain others during times of economic uncertainty.
  • The system, then, was to provide not only an elastic currency —that is, a currency that would expand or shrink in amount as economic conditions warranted—but also an efficient and equitable check-collection system.

Key Terms

  • Check-clearing: The movement of a check from the depository institution at which it was deposited back to the institution on which it was written; the movement of funds in the opposite direction and the corresponding credit and debit to the accounts involved.

The Fed as a Check Clearer

The government of the United States of America is the federal government of the constitutional republic of 50 states that constitute the United States, as well as one capitol district, and several other territories. The federal government is composed of three distinct branches: legislative, executive, and judicial, with powers vested by the U.S. Constitution in the Congress, the President, and the federal courts, including the Supreme Court, respectively; the powers and duties of these branches are further defined by acts of Congress, including the creation of executive departments and courts inferior to the Supreme Court.

Check clearing is defined as “the movement of a check from the depository institution at which it was deposited back to the institution on which it was written, the movement of funds in the opposite direction, and the corresponding credit and debit to the accounts involved. Check clearing also encompasses the return of a check (for insufficient funds, for example) from the bank on which it was written to the bank at which it was deposited, and the corresponding movement of funds. ”

Because some banks refused to clear checks from certain others during times of economic uncertainty, a check-clearing system was created in the Federal Reserve system. By creating the Fed, Congress intended to eliminate the severe financial crises that had periodically swept the nation, especially the sort of financial panic that occurred in 1907. During that episode, payments were disrupted throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other banks, a practice that contributed to the failure of otherwise solvent banks. To address these problems, Congress gave the Federal Reserve System the authority to establish a nationwide check-clearing system. The system, then, was to provide not only an elastic currency—that is, a currency that would expand or shrink in amount as economic conditions warranted—but also an efficient and equitable check-collection system.

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Measures of Aggregate Balances, 2001-2004: Billions of dollars

The Reserve Requirement

The Federal Reserve is in charge of setting reserve requirements for all depository institutions in the country.

Learning Objectives

Discuss what happens when the Fed increases or decreases the reserve requirement

Key Takeaways

Key Points

  • Reserve requirements are the amount of assets against liabilities that depository institutions must hold in reserve.
  • A bank’s liabilities are their financial obligations; for instance, if a customer deposits $100 in the bank, that is a liability because the bank must have that $100 to give back if the customer decides to withdraw their money.
  • Requiring depository institutions to hold a certain fraction of their deposits in reserve (either as cash in their vaults or as non- interest -bearing balances at the Federal Reserve ) directly affects availability of credit.
  • An increase in the reserve requirement reduces the amount banks are free to lend out, so this is a contraction in credit that leads to an increase in interest rates. The opposite is true if there is a decrease in the reserve requirement.

Key Terms

  • reserve requirement: The amount of funds that a depository institution must hold in reserve against specified deposit liabilities.
  • liabilities: An amount of money in a company that is owed to someone and has to be paid in the future, such as tax, debt, interest, and mortgage payments.

Reserve requirements have long been a part of the United States banking history. Depository institutions maintain a fraction of certain liabilities in reserve in specified assets. The Federal Reserve can adjust reserve requirements by changing required reserve ratios, the liabilities to which the ratios apply, or both. Changes in reserve requirements can have profound effects on the money stock and on the cost to banks of extending credit and are also costly to administer; therefore, reserve requirements are not adjusted frequently. Nonetheless, reserve requirements play a useful role in the conduct of open market operations by helping to ensure a predictable demand for Federal Reserve balances and thus enhancing the Federal Reserve’s control over the federal funds rate.

Requiring depository institutions to hold a certain fraction of their deposits in reserve, either as cash in their vaults or as non-interest-bearing balances at the Federal Reserve, does impose a cost on the private sector. The cost is equal to the amount of forgone interest on these funds—or at least on the portion of these funds that depository institutions hold only because of legal requirements and not to meet their customers’ needs.

Changes in reserve requirements can affect the money stock, by altering the volume of deposits that can be supported by a given level of reserves, and bank funding costs. Unless it is accompanied by an increase in the supply of Federal Reserve balances, an increase in reserve requirements (through an increase in the required reserve ratio, for example) reduces excess reserves, induces a contraction in bank credit and deposit levels, and raises interest rates. It also pushes up bank funding costs by increasing the amount of non-interest-bearing assets that must be held in reserve. Conversely, a decrease in reserve requirements, unless accompanied by a reduction in Federal Reserve balances, initially leaves depository institutions with excess reserves, which can encourage an expansion of bank credit and deposit levels and reduce interest rates.

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Reserve Requirement: Reserve Requirement Ratios, 2004

The Discount Rate

The Fed makes loans to depository institutions and charges different discount rates for each of discount windows.

Learning Objectives

Describe the Fed’s primary credit, secondary credit, and seasonal credit lending programs

Key Takeaways

Key Points

  • The Fed offers three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.
  • The discount rate charged for primary credit (the primary credit rate) is set above the usual level of short-term market interest rates.
  • The discount rate on secondary credit is above the rate on primary credit.
  • The discount rate for seasonal credit is an average of selected market rates.

Key Terms

  • discount rate: The interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility.
  • Discount window: The discount window is an instrument of monetary policy (usually controlled by central banks) that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions.

The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from the Fed’s lending facility, the discount window. The Fed offers three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.

Under the primary credit program, loans are extended for a very short term (usually overnight) to depository institutions in generally sound financial condition. Depository institutions that are not eligible for primary credit may apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. Seasonal credit is extended to relatively small depository institutions that have recurring intra-year fluctuations in funding needs, such as banks in agricultural or seasonal resort communities.

The discount rate charged for primary credit (the primary credit rate) is set above the usual level of short-term market interest rates. (Because primary credit is the Federal Reserve ‘s main discount window program, the Federal Reserve, at times, uses the term “discount rate” to mean the primary credit rate. ) The discount rate on secondary credit is above the rate on primary credit. The discount rate for seasonal credit is an average of selected market rates. Discount rates are established by each reserve bank’s board of directors, subject to the review and determination of the Federal Reserve System ‘s Board of Governors. The discount rates for the three lending programs are the same across all reserve banks except on days around a change in the rate.

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Discount rate: Effective Federal funds rate and discount rate, 1955-2004

Open Market Operations

Open market operations (OMO) refer to a central bank’s selling or buying of government bonds on the open market.

Learning Objectives

Define the role and function of an open market operation (OMO)

Key Takeaways

Key Points

  • The Fed’s primary tool in conducting monetary policy is open market operations, which involves the Fed buying or selling securities (usually U.S. treasury bonds ) on the open market.
  • The Fed’s open market account (their securities holdings associated with open market operations) is composed mostly of U.S. Treasury securities with remaining maturities of one year or less. This allows the Fed to change the composition of its assets quickly, if necessary.
  • Buying or selling the bonds changes the supply of base money in the economy, affecting the interest rates.
  • The Federal Open Market Committee (FOMC) oversees open market operations.
  • In theory, the Federal Reserve could conduct open market operations by purchasing or selling any type of asset. In practice, however, most assets cannot be traded readily enough to accommodate open market operations.

Key Terms

  • Open Market Operation: an activity by a central bank to buy or sell government bonds on the open market.
  • monetary policy: The process by which the government, central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

Open Market Operation

An open market operation (also known as OMO) is an activity by a central bank (in the U.S. it is the Fed) to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy. The usual aim of open market operations is to control the short term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.

In theory, the Federal Reserve could conduct open market operations by purchasing or selling any type of asset. In practice, however, most assets cannot be traded readily enough to accommodate open market operations. For open market operations to work effectively, the Federal Reserve must be able to buy and sell quickly, at its own convenience, in whatever volume may be needed to keep the federal funds rate at the target level. These conditions require that the instrument it buys or sells be traded in a broad, highly active market that can accommodate the transactions without distortions or disruptions to the market itself. The market for U.S. Treasury securities satisfies these conditions. The U.S. Treasury securities market is the broadest and most active of U.S. financial markets. Transactions are handled over the counter, not on an organized exchange. Although most of the trading occurs in New York City, telephone and computer connections link dealers, brokers, and customers—regardless of their location—to form a global market.

Composition of the Federal Reserve’s Portfolio

The overall size of the Federal Reserve’s holdings of Treasury securities depends principally on the growth of Federal Reserve notes; however, the amounts and maturities of the individual securities held depends on the FOMC’s preferences for liquidity. A sizable share of the Federal Reserve’s holdings is held in Treasury securities with remaining maturities of one year or less. This structure provides the Federal Reserve with the ability to alter the composition of its assets quickly when developments warrant. At the end of 2004, the Federal Reserve’s holdings of Treasury securities were about evenly weighted between those with maturities of one year or less and those with maturities greater than one year.

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U.S. Treasury securities held in the Federal Reserve’s open market account, December 31, 2004: In billions of dollars.