What Is The Federal Reserve And What Are Its Functions?
Understanding what the Federal Reserve (informally known as the Fed) is, what its functions are, and why its policies matter so much in global markets, as well as to businesses and consumers, is vital to understanding the workings of the American economy. Any trader (trader in the stock market, currencies, cryptocurrency markets, and other speculative markets) should understand the operation of this entity and take into account what is decided in it to make a fundamental analysis of the markets as accurate as possible.
The Federal Reserve System (also known as the Federal Reserve or simply the Fed) is the banking system or central bank of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics (particularly the panic of 1907) led to a desire for central control of the monetary system to alleviate financial crises. Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System.
The United States Congress established three key goals for monetary policy in the Federal Reserve Act:
1. Maximize employment,
2. Stabilize prices and
3. Moderate long-term interest rates.
The first two goals are sometimes called the Federal Reserve’s dual mandate. Its functions have expanded over the years and now also include the supervision and regulation of banks, maintaining the stability of the financial system, and providing financial services to depository institutions, the US government, and foreign official institutions.
The Fed also researches the economy and provides numerous publications, such as the Beige Book and the FRED database.
Federal Reserve Organization
The Federal Reserve System is made up of several layers.
It is governed by the board of governors appointed by the president of the Federal Reserve Board (FRB).
Twelve regional Federal Reserve Banks, located in cities across the country, regulate and supervise privately owned commercial banks. Nationally chartered commercial banks are required to hold stock and may elect some of the Federal Reserve Bank board members for their region.
The Federal Open Market Committee (FOMC) sets monetary policy. It consists of the seven members of the board of governors and the twelve regional presidents of the Federal Reserve Bank, although only five bank presidents vote at a time (the president of the New York Federal Reserve and four others who rotate for terms of office). one-year vote). There are also several advisory councils. Therefore, the Federal Reserve System has public and private components. It has a unique structure among central banks and is also unusual in that the US Treasury Department, an entity outside of the central bank, prints the currency used.
The federal government sets the salaries of the seven governors of the board and receives all the annual profits of the system after dividends are paid on the capital investments of member banks and an account surplus is maintained. In 2015, the Federal Reserve had a net income of USD 100.2 billion and transferred USD. 97.7 billion to the US Treasury.
Although it is an instrument of the United States government, the Federal Reserve System considers itself “an independent central bank because its monetary policy decisions do not have to be approved by the president or anyone else in the executive branches.” or legislative branch of government, does not receive funding from Congress, and the terms of the members of the board of governors span multiple presidential and congressional terms
The first attempt to create a national currency was during the American Revolutionary War.
In 1775, the Continental Congress, as well as the states, began issuing paper money, calling the bills “continentals.” Continentals were backed only by future tax revenue and were used to help finance the Revolutionary War. Overprinting, as well as British forgery, caused the value of the Continental to decline rapidly. This experience with paper money led the United States to strip Congress and the states of the power to issue letters of credit (paper money) in a draft of the new Constitution on August 16, 1787, in addition to prohibiting such issuance by states and limit states’ ability to make anything other than legal tender gold or silver coins.
In 1791, the government gave the First Bank of the United States a charter to operate as the central bank of the United States until 1811. The First Bank of the United States came to an end under President Madison because Congress refused to renew its status. The Second Bank of the United States was established in 1816 and lost its authority to be the central bank of the United States twenty years later under President Jackson when its charter expired. Both banks were based on the Bank of England. Ultimately, a third national bank, known as the Federal Reserve, was established in 1913 and still exists to this day.
First Central Bank, 1791 And Second Central Bank, 1816
The first American institution with central banking responsibilities was the First Bank of the United States, chartered by Congress and signed into law by President George Washington on February 25, 1791, at the urging of Alexander Hamilton. This was done despite strong opposition from Thomas Jefferson and James Madison, among many others. The operating charter was in effect for twenty years and expired in 1811 under President Madison because Congress refused to renew it.
In 1816, however, Madison revived it in the form of the Second Bank of the United States. Years later, the early renewal of the bank’s charter became the main issue in the re-election of Chairman Andrew Jackson. After Jackson, who opposed the central bank, was re-elected, he withdrew government funds from the bank. Jackson was the only president to pay off the federal government’s debt in full. The statutes of the second central bank were not renewed in 1836.
From 1837 to 1862, in the era of free banking, there was no formal central bank. From 1846 to 1921, an independent treasury system governed.
From 1863 to 1913, the National Banking Act of 1863 instituted a system of national banks during which a series of bank runs occurred in 1873, 1893, and 1907.
Creation Of The Third Central Bank, 1907-1913
The main motivation for the third central banking system came from the panic of 1907, which caused a renewed desire among legislators, economists, and bankers for a reform of the monetary system.
During the last quarter of the 19th and early 20th centuries, the US economy went through a series of financial panics. According to many economists, the previous national banking system had two main weaknesses: an inelastic currency and a lack of liquidity.
In 1908, Congress enacted the Aldrich-Vreeland Act, which provided for an emergency currency and established the National Monetary Commission to study banking and currency reform. The National Monetary Commission came back with recommendations that were repeatedly rejected by Congress. A review crafted during a secret meeting on Jekyll Island by Senator Aldrich and representatives of the nation’s leading industrial and financial groups later became the basis for the Federal Reserve Act. The House voted on December 22, 1913, with 298 voting in favor and 60 against. The Senate voted 43-25 on December 23, 1913. President Woodrow Wilson signed the Federal Reserve Bill that same day.
Reserve Act Of 1913
The head of the bipartisan National Monetary Commission was financial expert and Senate Republican leader Nelson Aldrich. Aldrich created two commissions: one to study in-depth the American monetary system and the other, headed by Aldrich himself, to study and report on the European central banking systems.
In early November 1910, Aldrich met with five well-known members of the New York banking community to devise a central banking bill. Paul Warburg, a meeting attendee and long-time advocate of central banking in the US, later wrote that Aldrich was “baffled by all he had absorbed abroad and was faced with the difficult task of drafting a highly technical bill while being harassed by the daily grind of his parliamentary duties. After ten days of deliberations, the bill, later to be called the “Aldrich Plan,” was passed. The plan had several key components, including a central bank with a headquarters in Washington and fifteen branches located throughout the United States in geographically strategic locations, and a uniform elastic currency based on gold and commercial paper.
Nelson Aldrich believed that a central banking system without political involvement was best, but Warburg convinced him that a plan without public control was not politically feasible. The commitment implied the representation of the public sector in the Board of Directors.
Aldrich’s bill met with much opposition from politicians. Critics accused Aldrich of being biased because of his close ties to wealthy bankers like JP Morgan and John D. Rockefeller Jr., Aldrich’s son-in-law. Most Republicans favored the Aldrich Plan, but it lacked enough support in Congress to pass it because rural and Western states viewed it as a pro-“Eastern establishment.” In contrast, progressive Democrats favored a government-owned and -operated reservation system; they believed that public ownership of the central bank would end Wall Street’s control over the supply of US currency. Conservative Democrats fought for a privately owned, albeit decentralized, reservation system.
The original Aldrich Plan was dealt a fatal blow in 1912 when Democrats won the White House and Congress. However, President Woodrow Wilson believed that Aldrich’s plan would suffice with some modifications. The plan became the basis for the Federal Reserve Act, which was proposed by Senator Robert Owen in May 1913. The main difference between the two bills was the transfer of control from the Board of Directors (called the Federal Committee Reserve Open Market Act) to the government. Therefore, with the modifications to the Aldrich project, the Fed was born as an entity controlled by the Government, not as an independent central bank as we know it today. The bill passed Congress on December 23, 1913, on a largely partisan basis, with most Democrats voting “yes” and most Republicans voting “no.”
From 1913 To The Present Day
Woodrow Wilson appointed Paul Warburg and other prominent experts to lead the new system, which began operations in 1915 and played a major role in financing the American and Allied war efforts in World War I. Warburg at first refused the appointment, citing US opposition to a “Wall Street man”, but when World War I broke out he accepted. He was the only Fed chairman appointee to be asked to appear before the Senate, where members questioned him about his interests in the central bank and his ties to Kuhn, Loeb & Co.’s “money trusts.” Paul Warburg was therefore the first president of the Federal Reserve System.
1951 agreement between the Federal Reserve and the Department of the Treasury
The 1951 Accord, also known simply as the Accord, was an agreement between the United States Department of the Treasury and the Federal Reserve that restored the independence of the Fed.
During World War II, the Federal Reserve agreed to keep the interest rate on Treasury bills fixed at 0.375 percent. The entity continued to support government borrowing after the war ended, even though the Consumer Price Index rose 14% in 1947 and 8% in 1948, and the economy was in recession. President Harry S. Truman in 1948 replaced then-Federal Reserve Chairman Marriner Eccles with Thomas B. McCabe for opposing debt policy, although Eccles’ tenure on the board continued for three more years. The reluctance of the Federal Reserve to continue financing the deficit became so great that, in 1951, President Truman invited the entire Federal Open Market Committee to the White House to settle their differences. William McChesney Martin, then undersecretary of the Treasury, was the main mediator. Three weeks later, he was named chairman of the Federal Reserve, succeeding McCabe.
Post -Bretton-Woods Conference era :
In July 1979, President Jimmy Carter nominated Paul Volcker as Chairman of the Federal Reserve Board amid raging inflation. Volcker tightened the money supply and by 1986, inflation had fallen sharply. In October 1979, the Federal Reserve announced a policy of “targeting” monetary aggregates and bank reserves in its fight against double-digit inflation.
In January 1987, with inflation running at just 1%, the Federal Reserve announced that it would no longer use money supply aggregates, such as, or guidelines to control inflation, although this method had been used since 1979, apparently with great success. Before 1980, interest rates were used as guidelines; but inflation was severe. The Fed complained that the aggregates were confusing. Paul Volcker was chairman until August 1987, after which Alan Greenspan took over, seven months after the aggregate monetary policy changed.
The recession from 2001 to present:
From early 2001 to mid-2003, the Federal Reserve lowered its interest rates 13 times, from 6.25% to 1.00%, to combat the recession. In November 2002, rates were lowered to 1.75% and many rates fell below the rate of inflation. On June 25, 2003, the fed funds rate was lowered to 1.00%, its lowest nominal rate since July 1958, when the overnight rate averaged 0.68%. Beginning in late June 2004, the Federal Reserve System raised the target interest rate and then continued to do so 17 more times.
In February 2006, President George W. Bush appointed Ben Bernanke as Chairman of the Federal Reserve.
In March 2006, the Federal Reserve stopped making M3 public (M0 to MZM, going through M3, M2, and M1 is how the money supply is measured in the economy*) because the costs of collecting this data exceeded the Benefits. M3 includes all of M2 (which includes M1) plus large-denomination time deposits ($100,000 and up), balances in institutional money market funds, repurchase liabilities issued by depository institutions, and Eurodollars held by US residents in foreign branches of US banks, as well as all banks in the UK and Canada.
Due to a credit crunch caused by the subprime mortgage crisis in September 2007, the Federal Reserve began cutting the fed funds rate. The Fed cut rates by 0.25% after its December 11, 2007 meeting, disappointing many investors who had expected a larger cut; the dow jones industrial average fell nearly 300 points that day. The Fed cut the rate by 0.75% in an emergency action on January 22, 2008, to help reverse a significant market decline influenced by weakening international markets. The Dow Jones Industrial Average initially fell nearly 4% (465 points) at the start of trading and then recovered to a 1.06% (128 points) loss. On January 30, 2008, eight days after the 0.75% drop, the Fed lowered its rate again, this time by 0.50%.
On August 25, 2009, President Barack Obama announced that he would nominate Ben Bernanke for a second term as Chairman of the Federal Reserve. In October 2013, he nominated Janet Yellen to succeed Bernanke.
In December 2015, the Fed raised its benchmark interest rates by a quarter of a percentage point between 0.25% and 0.50%, after nine years without changing them.
In 2020, in response to the economic crisis caused by the coronavirus, which forced the closure of businesses and forced layoffs throughout the United States, the Federal Reserve acted aggressively again, lowering its interest rates and leaving them close to 0, to stimulate the economy and provide relief to the government, which at the time required high levels of debt to be able to finance social assistance programs in response to unemployment and the closure of companies generated by the pandemic. At the time of the coronavirus crisis, the chairman of the Federal Reserve was Jerome Powell. Powell warned in September 2020 that the US economy was going to need constant support and that the intervention of the Fed, through monetary policy, was not going to be enough to overcome the crisis, tax policy.
Independence Of The Federal Reserve
Theoretically, the Fed is an independent body from government policies, which has not made it exempt from pressure from state agents and from the regulation that requires it to submit reports to Congress (reports that are reviewed by both chambers). . Even with this, the Federal Reserve has enough independence to maintain interest rates as it sees fit, if this were not the case, the government could lower the interest rate as it wishes to have control over its own debts and be able to spend at will.
The Functions Of The Federal Reserve.
Within the functions of this organization we have:
1. Issue the currency of current use for public use.
2. Establish the monetary policy of the United States, keeping inflation levels stable (with increases in interest rates when required) and generating monetary liquidity in times of recession, which means lowering interest rates and providing quantitative relief, buying government debt bonds to stimulate aggregate demand.
3. Help generate economic stability and boost GDP growth and the nation’s aggregate demand.
4. Lend money to commercial and financial banks when they require it.
5. To serve as a depositary of the funds of the banks and the savings reserves of the States and the Federal Government.
6. Establish regulations for consumer protection, specifically to implement housing grant laws, truth lending law, women’s business ownership law, equal credit opportunity law, cost disclosure law consumer finance.
Role Of The Federal Reserve In Financial Crises
The Fed has played a controversial role in the financial crises that have occurred in the United States, serving as a trigger for crises and also as the saving instrument to turn to when these crises cannot be contained.
It is claimed that the Fed underestimated the 2008 financial crisis and initially did little to counter its damaging effects on the economy. Not even legendary figures like Alan Greenspan saw the 2008 crisis coming.
After the 2008 crisis, the Fed had to act as a lender of last resort, providing liquidity to banks so that they could continue to operate normally and avoid a collapse of the economy.
With the intervention of the Federal Reserve in the 2008 crisis to rescue investment banks, and under George Bush, the State once again played an active role in the economy, which was known as a return to the positions Keynesian economics thought to be dead and buried.
Federal Reserve Chairmen
Paul Warburg (1913-1914)
Charles Sumner Hamlin (1914-1916)
William P.G. Harding (1916-1922)
Daniel Crisinger (1923-1927)
Roy Young (1927-1930)
Eugene Mayer (1933-1934)
Mariner Eccles (1934-1948)
Thomas McCabe (1948-1951)
William M. Martin (1951-1970)
Arthur F. Burns (1970-1978)
William Miller (1978-1979)
Paul Volcker (1979-1987)
Alan Greenspan (1987- 2006, who has lasted the longest in office and was long considered an oracle about the direction the economy was going to take. Greenspan was unable to see the financial crisis of 2008 as a consequence of the housing bubble that he helped create with his inability to act on the banking system)
Ben Bernanke (2006 -2014) was considered by Forbes magazine to be one of the most powerful people in the world when he had to face the subprime mortgage crisis. He lasted eight years in office.
Janet Yellen (2014- 2018) was in charge of the economic recovery period. She maintained the economic expansion policies of her predecessor Ben Bernanke.
Jerome Powell (2018 – currently in office). Because of the economic recovery achieved during the presidency of his predecessors at the Fed, he has maintained a policy of moderately high-interest rates. He has been under pressure from the Trump administration to lower interest rates amid the trade war with China.