Federal Reserve

What is the Federal Reserve?

The Federal Reserve (Fed) was created in response to a financial panic in 1907. During this panic, several banks went bankrupt as an attempt to buy all the stock of the United Copper Company failed. The banks who had lent to the scheme were faced with major shortfalls. This led to the third largest trust bank in New York at the time collapsing.

The panic spread to several other New York banks, and after customers started to pull their deposits, financier J.P. Morgan, the founder of the bank of the same name, stepped in. Using his own wealth and encouraging other bank owners to do the same, they stopped the run but shone a light on the weakness of the US banking system.

To avoid this happening again, the US government passed the Federal Reserve Act in 1913, creating the Federal Reserve. The Fed’s purpose was to stabilise the financial system, enact monetary policy, and control the currency of the United States, centralising responsibility.

Today, the Fed’s role goes further and is now a key player in the regulation of commercial banks along with providing services to any depositories.

Structurally, the Fed is led by a Board of Governors, with 12 federal reserve banks underneath them as well as a Federal Market Committee composed of additional members. We’ll touch on that more below.

What does the Federal Reserve do?

In the Federal Reserve Act, the Fed was given three main objectives for its monetary policy: maximise employment, stabilise prices, and regulate interest rates. This has evolved since 1913.

The original act also started the centralisation of the banking system, bringing overall regulation and decision-making under one roof but stopping short of a traditional single central bank.

Instead, the act created 12 regional federal reserve banks. In 1913 the goal was to have them act independently of each other within set guidelines. By 1935, after the great depression began to ease, centralisation progressed further, and the Federal Open Market Committee was created.

Then in 1980, another act was passed by Congress, promoting greater cooperation among all the Reserve banks into today’s model, with agreements in place among each other about services such as pricing.

Nowadays, the Fed follows its five ‘general functions’ to steer the United States’ economy in the public’s interest.

• Monetary policy – the Fed chooses monetary policy to promote employment, stable prices, and regulated interest rates for the US.
• Stability of the financial system – risk management and monitoring of systemic risk in the US and abroad.
• Security of individual financial institutions – monitors banks and other financial institutions within the US to ensure the wider economy’s safety.
• Settlement systems – facilitates payments on behalf of the US government, any US dollar transactions, and the banking industry in the US.
• Consumer protection – manage consumer laws and regulations, monitoring economic developments with this in mind.

Who sets interest rates in the US?

The Federal Open Market Committee (FOMC) is the US equivalent of the Bank of England’s Monetary Policy Committee (MPC). It’s charged with setting interest rates in the US, buying and selling US treasuries, and the federal funds rate (the rate that banks can charge between themselves for loans).

This feels like a lot of jargon and it is, but essentially, the FOMC sets monetary policy for the US at eight regular meetings each year. Their decisions on interest rates have tended to influence most other countries due to the size and scale of the US economy.

The committee consists of the seven members of the Federal Reserve Board of Governors, the President of the New York Fed, and four of the other 11 regional federal reserve banks on a yearly rotation.

The committee is legally required to meet four times a year, but has met eight times a year since 1981 at various intervals. Each meeting will consist of a similar structure with updates on trends in prices or wages, employment data, interest rates, consumer spending, or fiscal policy. This isn’t an exhaustive list, but you get the idea.

Like with the MPC, the FOMC will be briefed by various experts before meeting and then each member will give their own views on the state of the economy and its prospects. At the end of each meeting, a consensus on the direction to take will be agreed and communicated to the Federal Reserve Bank of New York, as it’s in charge of the System Open Market Account (SOMA).

SOMA is what the Fed uses as an indicator of liquidity and as collateral against the value of the US dollar. Think like a mortgage where the house is the collateral, the same principle applies here but without the repayments.

Once this decision is made public, if there were any interest rate changes, this often triggers a chain of events where this trickles down to banks. The banks could then alter their rates, the prices of goods will then change and the consumer will feel the change in their wallets.