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How the FOMC Really Works?

How the Federal Reserve Works

By Jason Dyken MD MBA

Tip: Checks. Due to the onslaught of electronic check collection, the Federal Reserve now processes paper checks at just one location nationwide, down from 45 locations in 2003.

Source: Board of Governors of the Federal Reserve System, 2016

QUESTION

Have you ever taken a close look at paper money? Each U.S. bill has the words “Federal Reserve Note” imprinted across the top.

But many individuals may not know why the bill is issued by the Federal Reserve and what role the Federal Reserve plays in the economy.

How the FOMC Really works?

Here’s an inside look

The Federal Reserve, often referred to as the Fed, is the country’s central bank. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Prior to its creation, the U.S. economy was plagued by frequent episodes of panic, bank failures, and limited credit.

The Fed has four main roles in the U.S. economy.

Economy Watch

In addition to its other duties, the Fed has been given three mandates with the economy: maintain maximum employment, maintain stable price levels, and maintain moderate long-term interest rates.

Fast Fact: Unwieldy Patchwork. In the early 1800s, the U.S. had no central bank and no common currency. The monetary system ran through a patchwork of state-chartered banks with no federal regulation. By 1860, there were nearly 8,000 of these banks, each issuing its own banknotes.

Source: Federal Reserve Bank of San Francisco, 2018

It’s important to remember that “the Fed” cannot directly control employment, inflation, or long-term interest rates. Rather, it uses a number of tools at its disposal to influence the availability and cost of money and credit. This, in turn, influences the willingness of consumers and businesses to spend money on goods and services.

For example, if the Fed maneuvers short-term interest rates lower, borrowing money becomes less expensive and people may be motivated to spend. Consumer spending may stimulate economic growth, which may cause companies to produce more product and potentially increase employment. When short-term rates are low, the Fed closely monitors economic activity to watch for signs of rising prices.

On the other hand, if the Fed pushes short-term rates higher, borrowing money becomes more expensive and people may be less motivated to spend. This may, in turn, slow economic growth and cause companies to decrease employment. When short-term rates are high, the Fed must watch for signs of a decline in overall price levels.

Supervise and Regulate

The Fed establishes and enforces the regulations banks, savings and loans, and credit unions must follow. It works with other federal and state agencies to ensure these financial institutions are financially sound and consumers are receiving fair and equitable treatment. When an organization is found to have problems, the Fed uses its authority to have the organization correct the problems.

Financial System

The Fed maintains the stability of the financial system by providing payment services. In times of financial strain, the Fed is authorized to step in as a lender of last resort, providing liquidity to an individual bank or the entire banking system.

For example, the Fed may step in and offer to buy the government bonds owned by a particular bank. By so doing, the Fed provides the bank with money that it can use for its own purposes.

Banker for Banks, U.S. Government

The Fed provides financial services to banks and other depository institutions and to the U.S. government. For banks, savings and loans, and credit unions, it maintains accounts and provides various payment services, including collecting checks, electronically transferring funds, distributing new money, and receiving and destroying old, worn-out money. For the federal government, the Fed pays Treasury checks; processes electronic payments; and issues, transfers, and redeems U.S. government securities.

Each day, the Fed is behind the scenes supporting the economy and providing services to the U.S. financial system. And while the Fed’s duties are many and varied, its focus is to maintain confidence in banking institutions.

***

A De-Centralized Central Bank System

The Federal Reserve System consists of 12 independent banks that operate under the supervision of a federally appointed Board of Governors in Washington, D.C. Each of these banks works within a specific district, as shown.

Source: Federal Reserve Board of Governors, 2018

  • U.S. Bureau of Engraving and Printing, 2018
  • Federal Reserve Bank of San Francisco, 2018
  • Board of Governors of the Federal Reserve System, 2016

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2 Responses

  1. How Does the Federal Reserve Affect the Economy?

    If you follow financial news, you’ve probably heard many references to “the Fed” along the lines of “the Fed held interest rates,” or “market watchers are wondering what the Fed will do next.” So what exactly is the Fed and what does it do?

    What is the Federal Reserve?

    The Federal Reserve — or “the Fed” as it’s commonly called — is the central bank of the United States. The Fed was created in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system.

    Today, the Federal Reserve’s responsibilities fall into four general areas:

    •Conducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices
    •Supervising and regulating banks and other important financial institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers
    •Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
    •Providing certain financial services to the U.S. government, U.S. financial institutions, and foreign official institutions, and playing a major role in operating and overseeing the nation’s payments systems

    How is the Fed organized?

    The Federal Reserve is composed of three key entities — the Board of Governors (Federal Reserve Board), 12 Federal Reserve Banks, and the Federal Open Market Committee.

    The Board of Governors consists of seven people who are nominated by the president and approved by the Senate. Each person is appointed for a 14-year term (terms are staggered, with one beginning every two years). The Board of Governors conducts official business in Washington, D.C., and is headed by the chair (currently, Jerome Powell), who is perhaps the most visible face of U.S. economic and monetary policy.

    Next are 12 regional Federal Reserve Banks that are responsible for typical day-to-day bank operations. The banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Each regional bank has its own president and oversees thousands of smaller member banks in its region.

    The Federal Open Market Committee (FOMC) is responsible for setting U.S. monetary policy. The FOMC is made up of the Board of Governors and the 12 regional bank presidents. The FOMC typically meets eight times per year. When people wait with bated breath to see what the Fed will do next, they’re usually referring to the FOMC.

    How does the Fed impact the economy?

    One of the most important responsibilities of the Fed is setting the federal funds target rate, which is the interest rate banks charge each other for overnight loans. The federal funds target rate serves as a benchmark for many short-term interest rates, such as rates used for savings accounts, money market accounts, and short-term bonds. The target rate also serves as a basis for the prime rate. Through the FOMC, the Fed uses the federal funds target rate as a means to influence economic growth.

    To stimulate the economy, the Fed lowers the target rate. If interest rates are low, the presumption is that consumers can borrow more and, consequently, spend more. For instance, lower interest rates on car loans, home mortgages, and credit cards make them more accessible to consumers. Lower interest rates often weaken the value of the dollar compared to other currencies. A weaker dollar means some foreign goods are costlier, so consumers will tend to buy American-made goods. An increased demand for goods and services often increases employment and wages. This is essentially the course the FOMC took following the 2008 financial crisis in an attempt to spur the economy.

    On the other hand, if consumer prices are rising too quickly (inflation), the Fed raises the target rate, making money more costly to borrow. Since loans are harder to get and more expensive, consumers and businesses are less likely to borrow, which slows economic growth and reels in inflation.

    People often look to the Fed for clues on which way interest rates are headed and for the Fed’s economic analysis and forecasting. Members of the Federal Reserve regularly conduct economic research, give speeches, and testify about inflation and unemployment, which can provide insight about where the economy might be headed. All of this information can be useful for consumers when making borrowing and investing decisions.

    Mike Green, RIA

    Like

  2. What is a Liquidity Trap?

    A liquidity trap is a situation in which interest rates are low and savings rates are high, rendering FOMC monetary policy ineffective.

    In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise (which would push bond prices down). Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

    https://www.thebalance.com/liquidity-trap-examples-with-5-signs-and-5-cures-3306141

    Adam

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