What is the Fed?

The Federal Reserve System, popularly known as "the Fed," is an unusual federal agency created in 1913 to give the government some control over banking, which at that time was mostly unregulated.

There's a central Board of Governors in Washington, D.C. and 12 regional Federal Reserve Banks. There's also the Federal Open Market Committee, which gets all the attention as it changes a few key interest rates.

The Board of Governors is made up of seven members, each appointed by the president, confirmed by the Senate and serving a 14-year term. The board is led by a chairman and a vice chairman, each appointed by the president for four-year terms.

Most of the work of the Fed is done by the regional Federal Reserve Banks, which regulate and audit banks and similar institutions, hold reserves for national and state banks, operate as banks for the federal government, distribute currency to banks and similar institutions, clear checks for member banks and administer laws pertaining to consumer credit protection.

The Fed's "member" banks include all national banks and state-chartered banks that choose to join the Federal Reserve System.

Why is the Fed important?

The real power of the Fed is its influence over monetary policy. The Federal Open Markets Committee meets eight times a year to make decisions on short-term interest rates, especially what's known as the federal funds rate. By law, the Fed is supposed to "promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

How does the Fed work?

The Fed has three main tools to do this job. The most important is to set the federal funds rate, which is what banks pay each other for overnight loans. The committee sets a target for this rate, but not the actual rate itself. When the news media report that the Fed changed interest rates, it's the federal funds rate that is being referred to.

The second tool is the discount rate, which is what banks pay to borrow money from a Federal Reserve Bank. This is usually lower than the federal funds rate, but the two are closely tied.

The third tool is the reserve requirement. This is a percentage of deposits that all banks must hold in reserve and cannot loan out. This rate is usually around 10 percent, but it can change from time to time. This is a very powerful tool, but it is rarely used. So this power is mostly theoretical, held in reserve, so to speak.

Why should anybody care except banks?

The federal funds rate might not seem like a very big deal, but it is powerful. Banks borrow from and lend to each other routinely in order to make sure they meet their reserve requirements. When the Fed changes the federal funds rate, it makes those loans among banks more or less expensive. And over time that can impact just about every interest rate that banks charge their customers.

If If the Federal Open Market Committee, sometimes known as the FOMC, is concerned about inflation and wants to cool down the economy, it does so by increasing the federal funds rate. This eventually makes it more expensive for businesses and consumers to borrow money and thus slows down economic activity. If instead the Fed wants to stimulate the economy, it does so by reducing the federal funds rate, making it easier for banks to lend money and for consumers and businesses to borrow.
Changes in the federal funds rate have a ripple effect on other rates. Interest rates influence each other. Long-term rates tend to go up and down together, and short-term rates tend to go up and down together. So when banks suddenly have to pay less for very-short-term money, as in overnight loans, they generally pass the savings on to their customers in the form of lower short-term rates. Conversely, when the federal funds rate goes up, banks quickly pass the added cost on to their customers.

This is why banks' prime rate, which is a benchmark for many loans, usually moves up or down quickly after changes in the federal funds rate. The changes gradually work their way into longer-term rates such as for car loans and fixed-rate mortgages and corporate bonds. Because of the time this takes, many economists believe federal funds rate changes don't work their way through the economy for about six months.

What are "basis points?"

When the Fed changes interest rates, the news is often reported by measuring the change in something called "basis points." This may sound confusing, but it's really very simple if you remember that one basis point is equal to one-hundredth of 1 percent. That means that 25 basis points is one quarter of a percent, 50 basis points is half a percent, etc.

Who is Alan Greenspan?

Alan Greenspan is chairman of the Federal Reserve Board and arguably one of the most powerful individuals in the United States. Greenspan has demonstrated a sharp intellect along with an unusual ability to keep his independence while still following the trends of political power in Washington, D.C.

He was born in New York City in 1926, son of a stockbroker and a saleswoman. He showed early signs of mathematical genius, yet after high school chose to attend the Julliard School of music and later played clarinet and saxophone in a traveling swing band in the mid 1940s.

He abandoned a music career to obtain bachelor's and master's degrees in economics from New York University and begin doctoral studies at Columbia University. He left Columbia when he ran out of money and took a job later as an economist for the National Industrial Conference Board. (He eventually got his Ph.D. from New York University in 1977.)

In the 1950s, Greenspan became a dedicated follower of Ayn Rand, whose philosophy of "enlightened selfishness" appealed to Greenspan more than the free-market skepticism of John Maynard Keynes and many other economists of his generation. However, Greenspan took a more pragmatic and politically aware route than many of the uncompromising heroes of Rand's novels.

Greenspan later started a consulting company that offered economic forecasts to large companies and financial institutions, at a time when few corporations had their own professional staff economists. In the 1960s, Greenspan was a director of policy research for Richard Nixon but did not come to Washington until the 1970s, when he became chairman of the Council of Economic Advisors under President Gerald Ford.

In this job, during a decade that saw wage and price controls, a major oil crisis and the Watergate scandal that led to Nixon's resignation, Greenspan got his first taste of experience being grilled before angry senators and congressmen. Undoubtedly that was valuable training for parts of his present job.

Greenspan returned to private life and resumed his economic consulting practice after the election of President Jimmy Carter, though he was chairman of the nonpartisan Social Security Commission in the early 1980s. In 1987, he was appointed chairman of the Federal Reserve Board by President Ronald Reagan and has served since then under both Republican and Democratic administrations.

Several books have been written about Greenspan, including "Maestro: Greenspan's Fed and the American Boom" by Bob Woodward and "Greenspan: The Man Behind the Money" by Justin Martin.

 

 

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