The Federal Reserve System is the central bank of the United States. It was created in 1913 to provide central banking activities for the country and to build a more stable and secure financial system after a series of bank failures.
Federal Reserve Tasks
The Federal Reserve has five tasks
- Conducting the nation’s monetary policy
- Promoting the stability of the financial system to minimise systemic risks
- Promoting the safety and soundness of individual financial institutions
- Providing services to the banking industry to ensure strong functioning of the settlement and payment systems
- Promotion of consumer protection and community development
Federal Bank System
The Federal Reserve operates under a Federal system with 12 regional Fed districts under a decentralised system, with each regional bank operating independently.
The 12 Federal Reserve districts are:
- New York
- St Louis
- Kansas City
- San Francisco
Is the Federal Reserve Independent?
The Federal Reserve has full operational independence surrounding its decision-making. It is, however, responsible to Congress. The Federal Reserve Chair is required to testify to both house of Congress on a regular basis and other Federal Reserve members also testify on occasion both on monetary policy and regulatory matters.
The Administration and Congress could decide on a change to the mandate and there has been discussion of a formal inflation target, although this would inevitably be very contentious. The Government Accountability Office (GAO) has authority to review and audit Federal Reserve activities.
Federal Reserve Objectives
The Federal Reserve has a statutory mandate from Congress to promoting maximum employment, stable prices and moderate long-term interest rates.
There is not a specific inflation target laid down in the mandate, but the Fed’s judgement is that an inflation rate of 2%, as measured by the personal consumption expenditure (PCE) price index, is consistent with the mandate. It is important to note that the primary target is not consumer prices, although this obviously also has an important impact in determining inflation trends.
There is also no fixed goal in terms of an unemployment rate given the changes in labour-market dynamics and difficulties in defining maximum employment.
Federal Reserve Board
The Federal Reserve Board is the governing body and guides the operation of the Federal Reserve System to promote the goals and fulfil its responsibilities.
There are seven people who sit on the Board. The President nominates these members and these nominations have to be ratified by the Senate. These appointments are often embroiled in partisan politics given the power to block nominations. The process can be delayed indefinitely and it is often the case that there are less than seven people actually serving on the Board at any one time. The board members are appointed to serve a term of 14 years.
The chair is appointed with an initial term of four years, which can be extended. The nomination of the Chair by the President also has to be ratified by the Senate.
Fed’s Monetary Policy Operation
The Federal Reserve adjusts monetary policy in order to achieve its targets of maximum employment and 2% inflation. This can be achieved by adjusting the level of interest rates or, following the financial crash, engaging in quantitative easing through the purchase of government bonds, which inflates the balance sheet. Interest rate policy works by changing the target for the Federal Funds interest rate and managing this rate through open-market operations, which then sets a base for interest rates in the economy.
Federal Reserve Open Market Committee (FOMC)
Any changes in policy are agreed through the Federal Reserve Open Market Committee (FOMC), which meets eight times per year.
The FOMC is comprised of the Federal Reserve Board and the Presidents of the 12 regional Federal Reserve banks. All regional Presidents take part in the policy discussion and the New York Federal Reserve President has a permanent vote on the committee.
There are four other voting members from the regional banks, with the voters determined by a policy of annual rotation. Overall, there should be 12 voting members at each FOMC meeting if there is a full complement of board members in place.
Following the meeting, the policy decision and statement are released with details of the economic assessment and votes. The committee may also provide guidance on expected policy action at subsequent meetings.
At every other meeting, the FOMC releases the latest economic forecasts for the economy as well as individual projections of interest rates from the FOMC members. At these meetings, the Fed Chair also holds a media press conference.
The FOMC also sets the discount rate. Requests for a change in the discount rate can be submitted by the individual District banks, which are then discussed by the FOMC.
FOMC Meeting Minutes
The minutes of the meeting are released roughly three weeks after the meeting has taken place. The minutes provide a more detailed record of the discussions that took place and describe the thoughts of the committee. The minutes are useful in determining potential future policy actions.
Fed Beige Book
The Beige Book is an informal review of current economic conditions by the Federal Reserve Banks and is the basis for discussion on economic trends in the FOMC meetings. Staff members also provide internal projections and forecasts for the Board.
Federal Reserve Speeches
Members of the Federal Reserve Board and the regional Federal Reserve Presidents often make speeches during their time in office. These are important in setting out their thoughts on the economy and potential trends in interest rates, especially as prepared comments are often followed by a Q&A session.
These remarks are often significant in moving markets, with the speeches from the Fed Chair notably important, especially when the Chair is looking to signal a change in policy direction or make a specific point over policy.
The Federal Reserve produces a number of economic data releases relating to credit, money and economic trends. The Fed provides the latest data on industrial production, money supply and consumer credit, although they are not the most important data releases; crucial labour-market data, for example, produced by the Bureau of Labor Statistics. The Fed also produces a survey on behaviour by loan offices, which gives insight into credit conditions within the economy.
Bank Stress Tests
The Federal Reserve runs stress tests every year in order to test the resilience of commercial banks. Various simulations are used to illustrate a severe and extreme financial shock to the economy such as a deep recession, severe decline in equity markets or a crash in the housing sector. Simulations then determine the extent to which bank capital is depleted and whether the banks would remain solvent. If the banks are deemed to be vulnerable, they are ordered to strengthen their capital base.
The Federal Reserve can demand improvements in risk controls within the banks.
Federal Reserve’s Global Responsibility
The Federal Reserve needs to ensure there is sufficient liquidity in the financial system and will co-operate with other global central banks to ensure liquidity is maintained. There will also be frequent discussions with heads of other global central banks to boost co-operation, especially when financial markets are extremely volatile.
This is an extremely important role for the Fed given that the dollar remains the dominant global reserve currency. Policy actions by the FOMC therefore have a big role in overseas economic developments and the global financial system and the Fed is mindful of the international consequences of policy changes.