Understanding the Federal Reserve

During periods of national economic turmoil and uncertainty, public interest – and awareness – in the United States Federal Reserve (the Fed) grows in conjunction with the sense of financial uncertainty. Americans seem to fundamentally understand the Fed, the nation’s central bank, is the only entity with the size, authority and experience needed to make national monetary decisions, though distracting misconceptions and time-honored myths still abound. While the Fed tends to garner more media attention during times of economic woe, as occurred during the recession of the early 1980s and is presently the case during this Great Recession, many Americans still do not know the intricacies of the benevolent behemoth we as a country have entrusted to keep our economy stable by maintaining sufficient cash in circulation, job stability and price stability.

Charles Plosser, president of the Federal Reserve Bank of Philadelphia, made just this point during a speech titled Demystifying the Federal Reserve at Lafayette College in September of 2009. The Fed as it now stands is the culmination of centuries of banking innovation, trial and error, false starts and economic need. Since the Fed plays such an integral role in the overall economic and financial health of the nation, it is prudent those affilitated with real estate possess a thorough understanding of how it is structured and how it performs its corrective functions.

Banking before there was a Fed

The concept of a centralized banking system has always been controversial. Even the Founding Fathers were in disagreement as to its usefulness, most notably Thomas Jefferson and James Madison who adamantly opposed it.

Some early citizens of formative America, mostly Northern merchants, recognized the necessity of a centralized banking system to unify the American monetary system after the Revolutionary War. A source of their motivation was the debacle surrounding the continental, the form of currency issued by Congress after the start of the Revolutionary War, which was counterfeited by the British to intentionally destabilize the American economy.

Alexander Hamilton, the first United States Secretary of the Treasury, is frequently credited as being the intellectual father of the United States central banking system. Under his guidance, the First Bank of the United States, located in Philadelphia, was given a 20-year charter by Congress between 1791 and 1811. However, the First Bank of the United States, modeled largely after the Bank of England, only vaguely resembled the Fed as it currently exists today. Its scope of authority and monetary influence was comparatively limited and primitive, providing only 20% of the nation’s money supply. Additionally, many citizens, particularly Southern members of Congress, were distrustful of the centralized bank, fearing it favored the economic interest of the Northern colonies over those of the South.

At the end of 1811, the charter was not renewed and no US centralized banks were in existence for five consecutive years. However, the War of 1812 between the United States and Great Britain caused massive inflation, making it difficult for the United States to procure adequate funds to finance the war. Thus, the Second Bank of the United States was charted from 1816 through 1836. However, this too was short lived due to the same public distrust of centralized banking which accused it of political pandering and geographic favoritism.

After the closure of the Second Bank of the United States, many years of decentralized and inefficient banking ensued. 1837-1862 was the Free Banking Era which was reliant exclusively on state-chartered banks. However, most state-chartered banks were highly ephemeral and rarely lasted more than five-years – a bane to overall economic stability.

Under the Banking Act of 1863, a system of national banks was installed between 1863 and 1913. At least initially, it was created with the intent to provide funding for the Union army during the Civil War. Under the national banking system, a national currency based on bank purchases of United States Treasury Securities was established, as was the Office of the Comptroller of Currency to protect against counterfeiting.

However, each incarnation of United States banking system lacked a fundamental necessary trait: the ability to enact forward-looking monetary policies to keep national inflation in check and the authority to act as a financial safety-net as the lender of last resort in times of extreme economic disaster. After the Panic of 1907 in which the New York Stock Exchange precipitously plummeted 50% from its high of the prior year, it was clear an elastic money supply – which only a central bank could provide – was needed to ensure long-term financial longevity and to avoid future apocalyptical upsets.

The Fed emerges: the bankers’ bank

In 1913, nearly 80 years after the expiration of the charter on the Second Bank of the United States, President Woodrow Wilson signed the Federal Reserve Act, also called the Glass-Owen Act, into law. Congress created the Fed to:

  • conduct the nation’s monetary policy, with the ultimate goal of maintaining prudent long-term interest rates, high employment and stable prices;
  • distribute funds to banks to re-lend to investors and borrowers;
  • supervise and regulate banks’ monetary decisions to ensure long-term financial health; and
  • stabilize the national economy in periods of financial distress.

The Fed created in 1913 and the current Fed is substantively the same. As its primary function of distributing funds, the Fed daily pumps and withdraws money from the market. The Fed accomplishes this by making money loans to banks, which then relend the funds to investors and consumers for all types of purposes, such as purchase-assist consumer financing and commercial lending. For this, the Fed has an unlimited and endless funding capacity.

The vehicles through which the Fed distributes money are the twelve Reserve Banks. Reserve Banks provide funds to private banks within their districts, called liquidity, to fulfill the short-term lending needs of private banks. The rate on the money private banks pay to the Fed is called the discount rate.

In economically unstable times, like the present, it is the role of the Fed to prop up the financial market to ensure money is still available for loans to be made to business owners and asset holders. To encourage private banks to borrow, the Fed lowers the short-term discount rate, making money “cheaper” for mortgage, commercial and Wall Street bankers alike, which if borrowed, increases their cash on hand to lend to consumers and business.

All nationally charted banks and some qualifying state banks, called member banks, hold stock in the Fed. Unlike stock in a standard private corporation, Fed stocks cannot be traded or sold. Member banks receive a fixed 6% annual dividend on their stock paid by the Fed.

Structure of the American central bank

The Fed is a uniquely American variation of a centralized banking system. In response to the pre1913 criticism that a centralized bank would cater to a particular political or business interest, the Fed is divided into twelve District Reserve Banks which form the operating arms of the Fed’s central banking system. The districts are strategically located throughout the nation and are under the supervision of the Board of Governors in Washington D.C.

The Federal Reserve Districts, which publish prodigious amounts of information about the states within their districts, are as follows:

Editor’s note – Click on any district above to access papers, charts and real estate related data specific to the district.

By dividing the “centralized” banks into numerous regions – in effect decentralizing it – all political, economic and regional interests are taken into account and fully represented. Each Reserve Bank is governed by a Board of Directors containing nine members.

The Fed acts independently within the government though is not entirely independent of it. This limited independence is a mandatory requisite for allowing the Fed to craft future-minded monetary policy which is unhindered by temporary political influences which emanate from Congress or the Administration. The Fed is able to maintain its semi-independent state by being structured as a hybrid of both public and private voices.

The Reserve Banks are similar to private-sector corporations. Each Reserve Bank has a board of directors consisting of members of the public and individuals in private business who provide grassroots insight into the workings of their districts. In each of the twelve districts, the non-politically appointed board of directors nominates one Reserve Bank district president to represent their district. In California, the 12th Federal Reserve district president is Janet Yellen.

But the Fed is beholden to the public sector as well. The Board of Governors for the Fed located in Washington D.C. contains seven members, all of whom are appointed by the President and confirmed by the Senate. Thus, the Board of Governors is the governmental aspect of the Fed. These governors may serve only one term, though the term is 14 years, substantially longer than most political positions. Board of Governors’ terms are unusually long since the Governors are expected to base their policy decisions on the future well-being of the nation, not the immediate future. Also, changes in the Fed’s policies take many years to reach fruition and are difficult to gauge in the short-term.

Five rotating Reserve Bank presidents (one of whom is always from New York, historically the most influencial district nationally and internationally) and seven members of the Board Governors make up the Federal Open Market Committee (FOMC). The FOMC meets at least four times each year in Washington D.C., though since 1981 it has met more than eight times per year and more often when economic conditions necessitate it. Prior to each meeting, the Manager of the System Open Market Account compiles written reports detailing the current and prospective economic environment each district is encountering, called the beige book, including:

  • the conditions of the financial markets;
  • relevant data on foreign exchange markets;
  • employment and production statistics;
  • consumer income and spending trends;
  • residential and commercial construction;
  • interest rates; and
  • fiscal policy.

As these reports analyze the entire county, not exclusively the dense urban areas or political hotbeds, each diverse voice and interest of the nation is represented. The reports are studied by each FOMC member as well as nonmember Reserve Bank presidents. The FOMC members then discuss their views regarding the appropriate course of future monetary policy and provide recommendations to achieve these goals. Once a consensus is reached regarding open market funding operations and plans for long-term growth, it is codified in a directive. The directive is implemented by the New York Reserve Bank, as it executes transactions for the System Market Open Account through the action on Wall Street.

Open market funding operations is the conduit though which the FOMC, as a component of the Fed, influences the total amount of money and credit available in the nation’s economy. It is the ultimate goal of the Fed to keep the open market with enough cash reserves and credit to promote borrowing by businessmen, consumers and investors. The amount of funds introduced into circulation must constantly be kept in check to ensure long-term price stability and sustainable economic growth (read: jobs). If too much liquidity (cash) drowns the market, called easy money conditions, the Fed increases their short-term lending rate to pull some of the excess money back in from bankers not willing to pay that rate. If the market becomes cash-starved, called tight money conditions, as occurred after the financial crash of 2008, the Fed lowers its short-term interest rate, making cash “cheaper” for private banks to borrow, and in turn lend to investors until all involved regain their financial footing and confidence. The private banks are the conduit through which the Fed provides cash – barter – for the economy to function

Who funds the Fed?

The Fed receives no funding from Congress or the Treasury as it is entirely self-sufficient, a trait similar to a private corporation. The Fed funds its operating expenses and interest paid to its depositors though:

  • the interest earned on the loans it makes to member banks;
  • investments in government securities; and
  • revenue collected for administering services for financial institutions.

The Fed is interested only in covering its own costs of operations. If any residual profits beyond the cost of operations exist, it is refunded back to the United States Treasury, which was close to $35 billion in 2008.

Though the Fed is partially independent from the government, it is still fully accountable. The Board of Governors in the FOMC must keep meticulous records of their monetary actions and report them annually to Congress. The FOMC must also make the minutes of their FOMC meetings available to the public within three weeks from when the meeting was held. Thus, the Fed is designed to be entirely transparent to both the government and the public which funds it.

Other roles of the Fed

In addition to controlling the level of cash available – liquidity – in the markets, the Fed performs regulatory and administrative actions. The Fed assumes a supervisory role over its member banks and formulates regulations which provide the structure of the Fed’s long-term economic plans.

The Fed also ensures the US payments systems, such as clearing and settlement services needed by banks and bank customers, are running effectively and accurately. Billions of dollars are processed in all District Banks on a daily basis, as are millions of checks, called check clearing.

In contrast to the Fed, the US Treasury is the entity which physically prints all US currency which will be placed in circulation.  However, it is the Fed that limits introduction of the printed currency into circulation, generally as the cash is needed by the private banking system. Similarly, the Fed removes currency from circulation if it is damaged, worn out or believed to be counterfeit.

While the Fed lends a bulk of its money to its member banks, it also functions as a lender for the federal government. The Fed is a depository for your payment of federal taxes and also processes the sale and redemption of government securitized debt instruments, called Treasury Bills. Treasury Bills are sold to the public, member banks and other financial institutions.

The Fed never has nor will it issue or buy mortgages, one common misconception of Fed activity.

The Fed is a benevolent benefactor, entrusted with sustaining the US financial market and acting assertively when financial crises strike. The Fed is a monetary defibrillator, resurrecting the troubled economy by pumping large amounts of cheap money into a tight market to encourage all users of money to borrower once again. Once economic health is sufficiently revived, the excess funds of resuscitation are withdrawn, an activity soon to commence and cause temporary ill effects in the real estate market.

And while its inner workings may be beyond the conscious thought of many, the Fed is entirely transparent to those who are curious enough to look. With its fusion of private/public governance and centralization/decentralization, plus its need to balance the interest of Wall Street, Main Street and Washington D.C., the Fed is as uniquely American as baseball, apple pie and jazz.