What is the Federal Reserve and what does it do?

Periodically, I hear about the Federal Reserve raising interest rates or lowering interest rates. But what is the Federal Reserve? Is it a governmental body or a private one? Does it just set interest rates or does do other things?

The Federal Reserve is considered an independent central bank. It is independent since its decisions do not have to be ratified by the President or Congress. The Federal Reserve System was created by Congress in 1913 "to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."

While the Federal Reserve is an independent institution, it is still accountable to Congress. The Constitution gives Congress the power to coin money and set its value. Congress delegated this power to the Federal Reserve in the 1913 Federal Reserve Act, but still maintains oversight authority. Under the Humphrey-Hawkins Act of 1978, the Federal Reserve must submit a report on the economy to Congress by February 20 and July 20 of each year. Alan Greenspan, the current Chairman of the Federal Reserve Board of Governors, is called to testify on the report before Senate and House Committees.

The Federal Reserve System is made up of a Board of Governors and twelve regional Federal Reserve Banks located in major cities throughout the country. There are seven members that sit on the Board of Governors. Each member must be nominated by the President of the United States and confirmed by the Senate. Members are appointed to serve 14-year nonrenewable terms. The President also nominates members of the Board to serve as Chair and Vice Chair for four-year renewable terms. These appointments must also be confirmed by the Senate.

The most important policy making body of the Federal Reserve System is the Federal Open Market Committee (FOMC). It is composed of the seven Governors, the president of the Federal Reserve Bank of New York, and four other Reserve Bank presidents that serve on a rotating basis. The FOMC can effect monetary policy through the use of three tools:

  1. Open market operations--the buying and selling of U.S. government securities.
  2. Altering reserve requirements--the amount of funds that commercial banks must hold in reserve against deposits.
  3. Adjusting the discount rate--the interest rate charged to commercial banks.

These tools can be used to tighten or expand the money supply. For example, if the FOMC wanted to control inflation, it could restrict the nation's money supply by selling government securities and raising the amount of money that banks need to set aside for reserve requirements. Both of these actions would take money out of circulation. In theory, a smaller supply of money would lead to less spending which would lead to lower prices. The FOMC can also raise interest rates to help control inflation. By making money more expensive to borrow, consumers would be more likely to save money rather than spend it. This could also lead to lower prices.

The FOMC meets eight times during the year to consider economic developments and to vote on policy. In the past 12 months, Federal Reserve officials have raised interest rates six times. During the FMC's last meeting on May 16, the committee voted to raise short-term interest rates by half of a percentage point to 6.5%, the highest level since 1991. This was done in an effort to slow the pace of the U.S. economy and keep inflation at a low, manageable level.

Since the FOMC meeting in May, many observers have speculated about the Federal Reserve's likely actions when it next meets on June 27-28. One good indicator of the Fed's likely actions is the "Beige Book" it releases two weeks before each of its policy meetings. The Beige Book is a survey of economic conditions across the country and is used as a reference for Fed officials when considering monetary policies, such as interest rate hikes. The Federal Reserve is primarily concerned about inflation and many speculate that higher inflation may lead to another increase in interest rates.

The Fed's latest report was released June 14 and showed a leveling off of the Consumer Price Index (a broad measure of the prices of goods in the economy) for the month of May. However, the report also showed that long-term inflation, measured over a 12-month period, was up from last year. Furthermore, many expect that rising gasoline costs will contribute to a higher Consumer Price Index for the month of June. Most indications point to a boost in interest rates when the Fed convenes later this month.

Contributing Author: Prof. Shad Satterthwaite, The University of Oklahoma

Other Resources

Board of Governors of the Federal Reserve Board Official Site
The Federal Open Market Committee
The Beige Book
"Federal Reserve Policy, Inflation, & Inflation Targeting" A Report by the U.S. Congressional Joint Economic Committee