Resource: Federal Reserve Paper Grading Guide
Write a 1,050- to 1,400-word paper about The Federal Reserve’s structure and functions.
Describe the Federal Reserve’s structure and primary functions.
Explain the effect the Federal Reserve’s policies have on financial markets, institutions and interest rates.
Access the Federal Reserve Economic data web page. https://fred.stlouisfed.org/ In the At a Glance frame near the bottom of the page you will find eight data series. List all eight series of data and explain what the data portrays and its importance.
Format your paper consistent with APA guidelines.4 Functions of the Fed
CHAPTER OBJECTIVES
The specific objectives of this chapter are to:
· ▪ describe the organizational structure of the Fed,
· ▪ describe how the Fed influences monetary policy,
· ▪ explain how the Fed revised its lending role in response to the credit crisis, and
· ▪ explain how monetary policy is used in other countries.
The Federal Reserve System (the Fed) is involved (along with other agencies) in regulating commercial banks. It is responsible for conducting periodic evaluations of state-chartered banks and savings institutions with more than $50 billion in assets. Its role as regulator is discussed in Chapter 18 .
4-1 OVERVIEW
As the central bank of the United States, the Fed has the responsibility for conducting national monetary policy in an attempt to achieve full employment and price stability (low or zero inflation) in the United States. With its monetary policy, the Fed can influence the state of the U.S. economy in the following ways. First, since the Fed’s monetary policy affects interest rates, it has a strong influence on the cost of borrowing by households and thus affects the amount of monthly payments on mortgages, car loans, and other loans. In this way, monetary policy determines what households can afford and therefore how much consumers spend.
Second, monetary policy also affects the cost of borrowing by businesses and thereby influences how much money businesses are willing to borrow to support or expand their operations. By its effect on the amount of spending by households and businesses, monetary policy influences the aggregate demand for products and services in the United States and therefore influences the national income level and employment level. Since the aggregate demand can affect the price level of products and services, the Fed indirectly influences the price level and hence the rate of inflation in the United States.
Because the Fed’s monetary policy affects interest rates, it has a direct effect on the prices of debt securities. It can also indirectly affect the prices of equity securities by affecting economic conditions, which influence the future cash flows generated by publicly traded businesses. Overall, the Fed’s monetary policy can have a major impact on households, businesses, and investors. A more detailed explanation of how the Fed’s monetary policy affects interest rates is provided in Chapter 5 .
WEB
www.clevelandfed.org
Features economic and banking topics.
4-2 ORGANIZATIONAL STRUCTURE OF THE FED
During the late 1800s and early 1900s, the United States experienced several banking panics that culminated in a major crisis in 1907. This motivated Congress to establish a central bank. In 1913, the Federal Reserve Act was implemented, which established reserve requirements for the commercial banks that chose to become members. It also specified 12 districts across the United States as well as a city in each district where a Federal Reserve district bank was to be established. Initially, each district bank had the ability to affect the money supply (as will be explained later in this chapter). Each district bank focused on its particular district without much concern for other districts. Over time, the system became more centralized, and money supply decisions were assigned to a particular group of individuals rather than across 12 district banks.
The Fed earns most of its income from the interest on its holdings of U.S. government securities (to be discussed shortly). It also earns some income from providing services to financial institutions. Most of its income is transferred to the Treasury.
The Fed as it exists today has five major components:
· ▪ Federal Reserve district banks
· ▪ Member banks
· ▪ Board of Governors
· ▪ Federal Open Market Committee (FOMC)
· ▪ Advisory committees
4-2a Federal Reserve District Banks
The 12 Federal Reserve districts are identified in Exhibit 4.1 , along with the city where each district bank is located. The New York district bank is considered the most important because many large banks are located in this district. Commercial banks that become members of the Fed are required to purchase stock in their Federal Reserve district bank . This stock, which is not traded in a secondary market, pays a maximum dividend of 6 percent annually.
Each Fed district bank has nine directors. There are three Class A directors, who are employees or officers of a bank in that district and are elected by member banks to represent member banks. There are three Class B directors, who are not affiliated with any bank and are elected by member banks to represent the public. There are also three Class C directors, who are not affiliated with any bank and are appointed by the Board of Governors (to be discussed shortly). The president of each Fed district bank is appointed by the three Class B and three Class C directors representing that district.
Fed district banks facilitate operations within the banking system by clearing checks, replacing old currency, and providing loans (through the so-called discount window) to depository institutions in need of funds. They also collect economic data and conduct research projects on commercial banking and economic trends.
4-2b Member Banks
Commercial banks can elect to become member banks if they meet specific requirements of the Board of Governors. All national banks (chartered by the Comptroller of the Currency) are required to be members of the Fed, but other banks (chartered by their respective states) are not. Currently, about 35 percent of all banks are members; these banks account for about 70 percent of all bank deposits.
4-2c Board of Governors
The Board of Governors (sometimes called the Federal Reserve Board) is made up of seven individual members with offices in Washington, D.C. Each member is appointed by the President of the United States and serves a nonrenewable 14-year term. This long term is thought to reduce political pressure on the governors and thus encourage the development of policies that will benefit the U.S. economy over the long run. The terms are staggered so that one term expires in every even-numbered year.
WEB
www.federalreserve.gov
Background on the Board of Governors, board meetings, board members, and the structure of the Fed.
Exhibit 4.1 Locations of Federal Reserve District Banks
One of the seven board members is selected by the president to be the Federal Reserve chairman for a four-year term, which may be renewed. The chairman has no more voting power than any other member but may have more influence. Paul Volcker (chairman from 1979 to 1987), Alan Greenspan (chairman from 1987 to 2006), and Ben Bernanke (whose term began in 2006) were regarded as being highly persuasive.
As a result of the Financial Reform Act of 2010, one of the seven board members is designated by the president to be the Vice Chairman for Supervision; this member is responsible for developing policy recommendations that concern regulating the Board of Governors. The Vice Chairman reports to Congress semiannually. The board participates in setting credit controls, such as margin requirements (percentage of a purchase of securities that must be paid with no borrowed funds). With regard to monetary policy, the board has the power to revise reserve requirements imposed on depository institutions. The board can also control the money supply by participating in the decisions of the Federal Open Market Committee, discussed next.
WEB
www.federalreserve.gov/monetarypolicy/fomc.htm
Find information about the Federal Open Market Committee (FOMC).
4-2d Federal Open Market Committee
The Federal Open Market Committee (FOMC) is made up of the seven members of the Board of Governors plus the presidents of five Fed district banks (the New York district bank plus 4 of the other 11 Fed district banks as determined on a rotating basis). Presidents of the seven remaining Fed district banks typically participate in the FOMC meetings but are not allowed to vote on policy decisions. The chairman of the Board of Governors serves as chairman of the FOMC.
The main goals of the FOMC are to achieve stable economic growth and price stability (low inflation). Achievement of these goals would stabilize financial markets and interest rates. The FOMC attempts to achieve its goals by controlling the money supply, as described shortly.
4-2e Advisory Committees
The Federal Advisory Council consists of one member from each Federal Reserve district who represents the banking industry. Each district’s member is elected each year by the board of directors of the respective district bank. The council meets with the Board of Governors in Washington, D.C., at least four times a year and makes recommendations about economic and banking issues.
The Consumer Advisory Council is made up of 30 members who represent the financial institutions industry and its consumers. This committee normally meets with the Board of Governors four times a year to discuss consumer issues.
The Thrift Institutions Advisory Council is made up of 12 members who represent savings banks, savings and loan associations, and credit unions. Its purpose is to offer views on issues specifically related to these institutions. It meets with the Board of Governors three times a year.
4-2f Integration of Federal Reserve Components
Exhibit 4.2 shows the relationships among the various components of the Federal Reserve System. The advisory committees advise the board, while the board oversees operations of the district banks. The board and representatives of the district banks make up the FOMC.
4-2g Consumer Financial Protection Bureau
As a result of the Financial Reform Act of 2010, the Consumer Financial Protection Bureau was established. It is housed within the Federal Reserve but is independent of the other Fed committees. The bureau’s director is appointed by the president with consent of the Senate. The bureau is responsible for regulating financial products and services, including online banking, certificates of deposit, and mortgages. In theory, the bureau can act quickly to protect consumers from deceptive practices rather than waiting for Congress to pass new laws. Financial services administered by auto dealers are exempt from the bureau’s oversight. An Office of Financial Literacy will also be created to educate individuals about financial products and services.
WEB
www.federalreserve.gov/monetarypolicy/fomccalendars.htm
Provides minutes of FOMC meetings. Notice from the minutes how much attention is given to any economic indicators that can be used to anticipate future economic growth or inflation.
4-3 HOW THE FED CONTROLS MONEY SUPPLY
The Fed controls the money supply in order to affect interest rates and thereby affect economic conditions. Financial market participants closely monitor the Fed’s actions so that they can anticipate how the money supply will be affected. They then use this information to forecast economic conditions and securities prices. The relationship between the money supply and economic conditions is discussed in detail in the following chapter. First, it is important to understand how the Fed controls the money supply.
Exhibit 4.2 Integration of Federal Reserve Components
4-3a Open Market Operations
The FOMC meets eight times a year. At each meeting, targets for the money supply growth level and the interest rate level are determined, and actions are taken to implement the monetary policy dictated by the FOMC. If the Fed wants to consider changing its targets for money growth or interest rates before its next scheduled meeting it may hold a conference call meeting.
Pre-Meeting Economic Reports About two weeks before the FOMC meeting, FOMC members are sent the Beige Book , which is a consolidated report of regional economic conditions in each of the 12 districts. Each Federal Reserve district bank is responsible for reporting its regional conditions, and all of these reports are consolidated to compose the Beige Book.
About one week before the FOMC meeting, participants receive analyses of the economy and economic forecasts. Thus there is much information for participants to study before the meeting.
Economic Presentations The FOMC meeting is conducted in the boardroom of the Federal Reserve Building in Washington, D.C. The seven members of the Board of Governors, the 12 presidents of the Fed district banks, and staff members (typically economists) of the Board of Governors are in attendance. The meeting begins with presentations by the staff members about current economic conditions and recent economic trends. Presentations include data and trends for wages, consumer prices, unemployment, gross domestic product, business inventories, foreign exchange rates, interest rates, and financial market conditions.
The staff members also assess production levels, business investment, residential construction, international trade, and international economic growth. This assessment is conducted in order to predict economic growth and inflation in the United States, assuming that the Fed does not adjust its monetary policy. For example, a decline in business inventories may lead to an expectation of stronger economic growth, since firms will need to boost production in order to replenish inventories. Conversely, an increase in inventories may indicate that firms will reduce their production and possibly their workforces as well. An increase in business investment indicates that businesses are expanding their production capacity and are likely to increase production in the future. An increase in economic growth in foreign countries is important because a portion of the rising incomes in those countries will be spent on U.S. products or services. The Fed uses this information to determine whether U.S. economic growth is adequate.
Much attention is also given to any factors that can affect inflation. For example, oil prices are closely monitored because they affect the cost of producing and transporting many products. A decline in business inventories when production is near full capacity may indicate an excessive demand for products that will pull prices up. This condition indicates the potential for higher inflation because firms may raise the prices of their products when they are producing near full capacity and experience shortages. Firms that attempt to expand their capacity under these conditions will have to raise wages to obtain additional qualified employees. The firms will incur higher costs from raising wages and therefore raise the prices of their products. The Fed becomes concerned when several indicators suggest that higher inflation is likely.
The staff members typically base their forecasts for economic conditions on the assumption that the prevailing monetary growth level will continue in the future. When it is highly likely that the monetary growth level will be changed, they provide forecasts for economic conditions under different monetary growth scenarios. Their goal is to provide facts and economic forecasts, not to make judgments about the appropriate monetary policy. The members normally receive some economic information a few days before the meeting so that they are prepared when the staff members make their presentations.
FOMC Decisions Once the presentations are completed, each FOMC member has a chance to offer recommendations as to whether the federal funds rate target should be changed. The target may be specified as a specific point estimate, such as 2.5 percent, or as a range, such as from 2.5 to 2.75 percent.
In general, evidence that the economy is weakening may result in recommendations that the Fed implement a monetary policy to reduce the federal funds rate and stimulate the economy. For example, Exhibit 4.3 shows how the federal funds rate was reduced near the end of 2007 and in 2008 as the economy weakened. In December 2008, the Fed set the targeted federal funds rate in the form of a range between 0 and 0.25 percent. The goal was to stimulate the economy by reducing interest rates in order to encourage more borrowing and spending by households and businesses. The Fed maintained the federal funds rate within this range over the 2009–2013 period.
When there is evidence of a very strong economy and high inflation, the Fed tends to implement a monetary policy that will increase the federal funds rate and reduce economic growth. This policy would be intended to reduce any inflationary pressure that is attributed to excess demand for products and services. The participants are commonly given three options for monetary policy, which are intended to cover a range of the most reasonable policies and should include at least one policy that is satisfactory to each member.
Exhibit 4.3 Federal Funds Rate over Time
The FOMC meeting allows for participation by voting and nonvoting members. The chairman of the Fed may also offer a recommendation and usually has some influence over the other members. After all members have provided their recommendations, the voting members of the FOMC vote on whether the interest rate target levels should be revised. Most FOMC decisions on monetary policy are unanimous, although it is not unusual for some decisions to have one or two dissenting votes.
FOMC Statement Following the FOMC meeting, the committee provides a statement that summarizes its conclusion. The FOMC has in recent years begun to recognize the importance of this statement, which is used (along with other information) by many participants in the financial markets to generate forecasts of the economy. Since 2007, voting members vote not only on the proper policy but also on the corresponding communication (statement) of that policy to the public. The statement is clearly written with meaningful details. This is an improvement over previous years, when the statement contained vague phrases that made it difficult for the public to understand the FOMC’s plans. The statement provided by the committee following each meeting is widely publicized in the news media and also can be accessed on Federal Reserve websites.
Minutes of FOMC Meeting Within three weeks of a FOMC meeting, the minutes for that meeting are provided to the public and are also accessible on Federal Reserve websites. The minutes commonly illustrate the different points of view held by various participants at the FOMC meeting.
4-3b Role of the Fed’s Trading Desk
If the FOMC determines that a change in its monetary policy is appropriate, its decision is forwarded to the Trading Desk (or the Open Market Desk ) at the New York Federal Reserve District Bank through a statement called the policy directive . The FOMC specifies a desired target for the federal funds rate, the rate charged by banks on short-term loans to each other. Even though this rate is determined by the banks that participate in the federal funds market, it is subject to the supply and demand for funds in the banking system. Thus, the Fed influences the federal funds rate by revising the amount of funds in the banking system.
Since all short-term interest rates are affected by the supply of and demand for funds, they tend to move together. Thus the Fed’s actions affect all short-term interest rates that are market determined and may even affect long-term interest rates as well.
After receiving a policy directive from the FOMC, the manager of the Trading Desk instructs traders who work at that desk on the amount of Treasury securities to buy or sell in the secondary market based on the directive. The buying and selling of government securities (through the Trading Desk) is referred to as open market operations. Even though the Trading Desk at the Federal Reserve Bank of New York receives a policy directive from the FOMC only eight times a year, it continuously conducts open market operations to control the money supply in response to ongoing changes in bank deposit levels. The FOMC is not limited to issuing new policy directives only on its scheduled meeting dates. It can hold additional meetings at any time to consider changing the federal funds rate.
WEB
www.treasurydirect.gov
Treasury note and bond auction results.
Fed Purchase of Securities When traders at the Trading Desk at the New York Fed are instructed to lower the federal funds rate, they purchase Treasury securities in the secondary market. First, they call government securities dealers to obtain their list of securities for sale, including the denomination and maturity of each security, and the dealer’s ask quote (the price at which the dealer is willing to sell the security). From this list, the traders attempt to purchase those Treasury securities that are most attractive (lowest prices for whatever maturities are desired) until they have purchased the amount requested by the manager of the Trading Desk. The accounting department of the New York Fed then notifies the government bond department to receive and pay for those securities.
When the Fed purchases securities through government securities dealers, the bank account balances of the dealers increase and so the total deposits in the banking system increase. This increase in the supply of funds places downward pressure on the federal funds rate. The Fed increases the total amount of funds at the dealers’ banks until the federal funds rate declines to the new targeted level. Such activity, which is initiated by the FOMC’s policy directive, represents a loosening of money supply growth.
