What is the Federal Reserve?

Updated: November 20, 2019

The Federal Reserve System is the central banking system of the United States. It was created in 1913 with the passage of The Federal Reserve Act. After subsequent amendments, today’s Federal Reserve, commonly referred to as “The Fed”, has a number of responsibilities including supervising federally chartered banks, facilitating the transfer of money (check clearing and cash wiring), and conducting the nation’s monetary policy. The specific goals of that policy are to increase employment and reduce inflation in the U.S. It is in this last responsibility that the Fed directly affects every citizen and business in the U.S.

What Does the Fed Do?

The Fed isn’t a commercial bank; you can’t walk into one and open a savings or checking account. It acts as the U.S.’s central bank and serves the government as well as financial institutions. The Fed also oversees and regulates banks in the U.S. and influences the economy through interest rates. It doesn’t set the interest rate for loans and credit cards; that’s the prime rate and it’s set by banks and institutions. But the prime rate is based on the U.S. Federal Funds rate, the rate banks charge each other for short-term loans, and that is established by a committee within The Fed, the Federal Open Markets Committee.

What is the Federal Open Markets Committee (FOMC)?

The Federal Open Markets Committee (FOMC), assumes monetary policy responsibilities and operates directly in the marketplace to affect interest rates and the economy. The FOMC is a 12-member committee composed of five of the 12 regional Fed presidents and a seven-member board of governors appointed by the U.S. President and confirmed by the Senate. The committee has a number of tools at their disposal to affect the U.S. economy. Most significant is the targeting, or manipulation of the U.S. Federal Funds rate. By adjusting the amount of cash in the U.S. banking system, The Fed has the ability to manipulate this rate.

How Do Interest Rates Influence the Economy?

High interest rates make it more expensive to borrow money and purchase big ticket items like a car or house. Then again, when interest rates are high you’re making more money on savings and money market accounts. When interest rates are low, your accounts take a ding but it’s easier to borrow money and people tend to spend more, which stimulates the economy. The Fed tries to balance interest rates and aims for a two percent inflation rate for price stability and low unemployment. When a recession hits, The Fed can lower interest rates to encourage people to borrow money and make purchases.

How Does The Fed Regulate Banks and Financial Institutions?

Before The Fed was created, banks would sometimes just run out of money if there was a financial panic or run on the bank, causing devastating losses to their customers. The Fed established a requirement that all commercial banks must maintain a certain amount of “reserve” cash, typically a percentage of their clients’ checking accounts. That ensures that banks will always be able to give you your money when you ask for it. If a bank’s reserve cash drops below that percentage, they can borrow money from another bank or one of the Reserve Banks at the U.S. Federal Funds rate.

Why Do Investors Need to Pay Attention to the Federal Reserve?

Thanks to changes implemented by past FOMC Chairpersons Alan Greenspan, Ben Bernanke and Janet Yellen, The Fed now provides historic transparency as to their actions. When they do effect changes in interest rates, they announce those changes. They also offer insights into their analysis of the economy and make projections as to how they expect the economy to perform in the future. Savvy investors would be very well advised to stay abreast of The Fed’s insights.

Facts About the Federal Reserve

To investors and savers alike, few Institutions are as important--and as misunderstood--as The Fed. Here are some quick facts.

• The Federal Reserve is not a branch of the government, but rather a corporation with shareholders.
• There are four components to the Federal Reserve System: the board of governors, the Federal Open Market Committee, the 12 regional Federal Reserve Banks and member banks holding stock in the regional Federal Reserve Banks.
• The 12 regional Federal Reserve Banks are located in Boston, New York City, Philadelphia, Cleveland, Richmond, VA, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, MO, Dallas and San Francisco. Some of these have branches in other cities within their region.
• Stock in The Fed pays its shareholders a rather attractive dividend of 6 percent.
• Shareholders (owners) in The Fed are federally chartered banks and institutions for which The Fed provides supervision.
• The Fed has been an incredibly profitable enterprise. In 2016 alone, it made over $97 billion in profit, which it transferred to the Treasury Department as mandated.
• The current Federal Reserve is our country’s third effort to establish a central bank.
• The Fed was created with the passage of The Federal Reserve Act in 1913, in part as an attempt to prevent or minimize the occurrence of bank runs.
• The Fed serves as the lender of last resort to banks and institutions that cannot obtain credit elsewhere and the collapse of which would have serious implications for the economy.
• As a bank for banks, The Fed processes and clears approximately 20 billion checks yearly, a service it provides to commercial banks for a fee. It’s one way The Fed funds itself.
• The Fed maintains the checking account for the U.S. government.
• The Fed monitors the condition of currency and either sends it back into circulation or has it destroyed.