Know your Fed: A description of the Federal Reserve

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The Federal Reserve Board has the power to drive up borrower loan payments, cost savers thousands of dollars and send tens of thousands of Americans to the unemployment line. But just what exactly is it?

To help those who don’t know the Federal Reserve Board from the “American Idol” judges, we’ve whipped up a primer that can help.

“The power of the Fed represents the sum of conscious and not-so-conscious choices that the government and society have made about who’s going to be in the driver’s seat of economic policy, and over time, things have evolved such that the Fed has taken over the driver’s seat,” says Tom Schlesinger, executive director of the Financial Markets Center. The Philomont, Va., group studies and publishes articles about the Fed’s structure and interest rate policies.

“Their ability to influence credit market conditions and the supply of money has enormous influence on the overall direction of the economy, over who gets a job or a pink slip and over who has success in their business or is looking at bankruptcy.”

While it has become much more visible in recent years, the Fed has been a force in American economics for almost a century. Created by the Federal Reserve Act of 1913, the “Fed” is actually made up of a couple of different parts.

The first is the Federal Reserve Bank system. There are 12 regional Fed banks, which are quasi-independent institutions located in major U.S. cities. They do many things, such as supervise banks in their regions and distribute currency to them. Each Fed bank has a board of directors and a president.

The power brokers
But unless you’re fascinated by the intricate details of how a dollar makes its way from the Bureau of Engraving and Printing to the regional Fed banks and into your pocket, you care more about the Federal Reserve Board of Governors than the regional Fed banks. After all, it’s the board that holds most of the power when it comes to interest rate policy.

The president appoints and Congress confirms seven members to the Washington-based federal agency. Members serve 14-year terms that are staggered to prevent the entire board from changing all at once. The president also appoints a chairman (currently Ben Bernanke) and vice chairman, who are either already board members or become so in conjunction with their appointments, to four-year terms. Because of early resignations and other reasons, the board sometimes operates with vacancies.

In addition to their other responsibilities, board members all sit on the Federal Open Market Committee, or FOMC. They are joined by the president of the Federal Reserve Bank of New York and a rotating combination of four other regional bank presidents. The group gathers eight times a year to discuss the economy and decide how to proceed with regard to interest rates. If circumstances change between these meetings, which are usually five to eight weeks apart, members can teleconference or otherwise convene and make emergency rate changes.

The FOMC controls only two rates directly — the federal funds rate and the federal discount rate. To understand what those rates are, people first have to understand that banks are required to maintain a certain percentage of the money deposited with them by customers on reserve at the Fed. On any given day, some banks will find they have extra money on reserve while some will find they don’t have enough.

— Updated: Sept. 14, 2006

Those lacking reserves can borrow money to meet reserve requirements either directly from the Fed or from each other. When banks borrow from the Fed, they pay interest at the discount rate. That doesn’t happen very often, though, because discount rate borrowing is supposed to be used as somewhat of a last resort. For that reason, the discount rate isn’t all that important.

But financial institutions borrow from each other all the time. When they do so, the borrowing bank pays interest to the lending bank at the federal funds rate. Banks are more than willing to lend out their excess reserves, too, because they don’t earn any interest on the money they have to keep deposited with the Fed.

Keeping the rates on target
The actual funds rate fluctuates all the time depending on market conditions. But the Federal Reserve Bank of New York can keep the rate near the target spelled out by policymakers at the last FOMC meeting by trading securities with private-market institutions. If the Fed wants to drive the funds rate lower, it increases the supply of available reserves in the marketplace by buying securities.

When that happens, banks can obtain money to lend out more cheaply. They pass at least some of the lower cost of operating through to their customers. Whenever the funds rate falls, for instance, banks lower their prime rates. That, in turn, lowers the rates on products whose rates are tied to prime, including home equity lines of credit and credit cards. Banks also lower their rates on certificates of deposit, car loans, personal loans and the like.

So what impact does that have? The lower cost of financing a new car prompts consumers like you to go out and replace their hulking, $60-a-fillup SUVs with shiny new subcompacts. Dealerships start running out of cars and order more from their factories. Managers who fired workers months ago when demand slowed suddenly find they can’t keep the assembly lines running. They start placing “Help Wanted” ads on the Web and hire more workers, who suddenly find themselves with money to spend, too.

Meanwhile, investors who got wind of the improved car sales outlook start buying the stock of XYZ Motors and all of its suppliers. That makes the monthly mutual fund statements of Americans everywhere look better than they have in a long time, boosting consumer confidence and wealth. The cycle continues, the economy improves and FOMC members bask in the warm glow that comes from knowing they saved us all from destruction.

So there you have it. While predicting whether and by how much Fed policymakers will cut rates is a difficult task, at least now you know how they do it!

— Updated: Sept. 14, 2006