Understanding the Federal Reserve System

Early last week, big news was made when the “Fed” announced that interest rates would be cut by half of a percentage point, but few individuals really understand the inner workings of the Fed and why it seemingly has so much power over money in the U.S. Read on for a basic overview of this rather complex system.

Popularly coined the Fed, the Federal Reserve System is headquartered in Washington, D.C., and is charged with overseeing and regulating money and the financial market in the United States. While its role in maintaining nationwide financial livelihood is crucial and closely entwined with the federal government, the Federal Reserve System actually is not an official government department -- a fact that comes as quite a surprise to many people.

Officially, the Federal Reserve System as a whole is an independent agency of the federal government, while the different parts of which it is comprised are more or less connected to the government as well. In practice, the Fed is like a hybrid between a government agency and a private company. However you cut it, this system is the central banking system in the United States.

The Federal Reserve System has been in effect since 1913, when it fist was established through the Federal Reserve Act. Also through this act came the creation of Federal Reserve Notes, or “paper money”, the regulation of which remains under the authority of the Fed to this day. This is just one of many important duties of the Fed.

The duties of the Federal Reserve System

In general, the Fed is charged with three broad responsibilities: (1) open market operations, (2) discount rates, and (3) reserve requirements.

Open Market Operations -- Open market operations are designed to control the U.S. monetary market, and involve the buying and selling of government and U.S. treasury securities.

Discount Rates -- A discount rate is the rate charged by the Fed to a financial institution for use of a loan. Discounts rates may be one of three different types: primary credit (very short-term loans provided to relatively flourishing institutions), secondary credit (like primary credit but for those institutions that cannot obtain the prime interest rate), and seasonal credit (provided to institutions based on yearly fluctuations in need).

Reserve Requirements -- Reserve requirements are standards designated by the Fed over the amount of available money that financial institutions must have on hand in relation to their deposits.


The organization of the Federal Reserve System

The Fed is comprised of several different parts, each of which has its own responsibilities: the Board of Governors, the Federal Open Market Committee, the Federal Reserve Banks, and private member banks.

Board of Governors -- The Board is made up of seven members (“governors”) who have been nominated by the president of the United States and approved by the U.S. Senate. They are appointed to 14-year terms of service, and each governor may not serve more than one full term. Once appointed, the governors work quite independently of the government, though the Board is funded by Congress.

Included in the seven governors are the Chairman (currently Dr. Ben Bernanke) and Vice Chairman of the Federal Reserve. The chair and vice chair are nominated by the president and approved by the Senate to serve 4-year terms.

The Board of Governors is in charge of regulating reserve requirements. It also is charged with supervising the functions the private member banks. Furthermore, the Board is responsible for developing and regulating the monetary and credit standards that translate into law, such as the Truth in Lending Act.

Federal Open Market Committee -- The Board of Governors, along with five presidents of the Federal Reserve Banks, make up the Federal Open Market Committee (FOMC). The FOMC is in charge of open market operations, making the crucial decisions that affect credit -- including the recent drop in the interest rate. Put broadly, the FOMC attempts to manipulate and regulate the financial market according to national economic prerogatives.

Federal Reserve Banks -- The Federal Reserve Banks provide the loans to other financial institutions via the discount window program. There is one regional federal reserve bank per reserve district, the locations of which are as follows:

District -- Reserve Bank Location
1 -- Boston
2 -- New York City
3 -- Philadelphia
4 -- Cleveland
5 -- Richmond
6 -- Atlanta
7 -- Chicago
8 -- St. Louis
9 -- Minneapolis
10 -- Kansas City
11 -- Dallas
12 -- San Francisco

Concerning the Board of Governors, not more than one member from a particular reserve district is allowed.

Private Member Banks -- Private member banks of the Federal Reserve System lawfully include all national banks, and many other financial institutions as well.