Understanding the Federal Reserve System

By Diana Palmieri

“You're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house...right next to yours….and in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can.”

- George Bailey, It’s A Wonderful Life

 
Most can remember this very emotional scene from It’s A Wonderful Life. Most of Bedford Falls storms into the old Bailey Building & Loan demanding their money be paid back immediately. Poor George and Mary used their honeymoon funds to satisfy some of their depositors in the bank and avoid collapse. Financial panic similar to what George Bailey experienced plagued the nation back in the 19th and early 20th centuries. These events led to constant bank failures and bankruptcies which disrupted the economy. 

The Federal Reserve System was founded by Congress on December 23, 1913. It was enacted to stabilize and create flexibility within our monetary and financial system. The Federal Reserve is the central bank of the United States.

Over the years, the role of the Fed has expanded.  These roles are generally as follows:

  • Conducting the nation’s monetary policy by influencing monetary and credit conditions.
  • Supervising and regulating banks to ensure the safety and soundness of the nation’s financial system.
  • Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
  • Providing financial services to depository institutions, the U.S. government, and foreign official institutions.

The Board of Governors

The Board plays a major role in the supervision and regulation of the Federal Reserve Banking System. The Board is a federal government agency composed of seven members who are appointed by the President and confirmed by Congress. Each Board member has a term of 14 years and cannot be reappointed after that term ends. The Chairman (currently Ben Bernanke) and Vice Chair are also appointed by the President and confirmed by the Senate and their terms last four years. 

The Reserve Banks

The operational component of the Federal Reserve System, Reserve Banks have several functions, which follow:

  • Collect and process millions of checks daily.
  • Process federal fund wires and automated clearing house (ACHs/direct deposits).
  • Move currency and coin in and out of circulation.
  • Hold the cash reserves of depository institutions and make loans to them.
  • Supervise and examine member banks for safety and soundness.
  • Issue and redeem government securities.

The Reserve Banks are divided into 12 districts: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. They operate under the general supervision of the Board of Governors, and function somewhat independently. 

The Federal Open Market Committee (FOMC)

The FOMC is the branch of the Federal Reserve Board that actually determines monetary policy. This committee meets eight times a year to determine and set key interest rates (such as the discount rate). They will also determine, based on economic conditions, whether money supply will be increased or decreased. They accomplish this by buying or selling US government securities in the open market. If they sell more securities in the open market, they are tightening up money supply. If they buy more securities, they are loosening up the money supply. These meetings are secret, and Wall Street usually goes nuts trying to determine what the Fed will do next. The FOMC is comprised of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four other Reserve bank presidents, who serve one year terms on a rotating basis. 

Following are two terms that you most likely have heard about or see often and what they mean to you and your pocketbook. 

  • The Discount Rate. The interest rate that financial institutions pay on short term loans from the Federal Reserve. This can affect how much financial institutions charge people that borrow money from them.  This affects you in the respect of how high or low your interest rate will be on a loan. 
  • Reserve Requirements. This is the amount of physical funds a financial institution must hold in reserve against deposits in customer accounts. So, yes, this determines how much money financial institutions can loan to customers. The MORE the reserve requirement, the less the bank can lend to you.

It’s important to understand that the actions the Fed takes today influence the economy and the inflation rate for some time to come. Consequently, policymakers must be forward-looking and must take preemptive action to head off inflation before it gathers momentum. There is a lot of controversy going on about the Fed’s policies and how it has been affecting monetary policy within the United States for these past few years. Because this is your money we are talking about, you should have a general understanding of just how these policies can affect you and your wallet. 

This article is a very general summary so I encourage you to visit the Federal Reserve Board’s website for more information at www.federalreserve.gov

 

The information contained in this article is not intended to constitute legal, accounting, tax, investment, consulting or other professional advice or services. For specific information that applies to your circumstances you should consult a qualified tax advisor or independent professional advisory. Diversification of your overall investment portfolio does not assure a profit or protect against a loss in a declining markets. 

Diana Palmieri is dually registered with Vanderbilt Securities LLC and H Beck Inc., which are unaffiliated. Securities offered through Vanderbilt Securities LLC, member SIPC/FINRA/MSRB. 
 

Buyers Guide Featured Companies



More Buyer's Guide >

Fire Dynamics

Survival Zone

Extrication Zone

Tech Zone