The Federal Reserve System To promote the development of a sound economy and a reliable banking system, Congress passed, and President Woodrow Wilson signed, the Federal Reserve Act on December 23, 1913. The act was a response to the recurring bank failures and financial panics that had plagued the nation. After much disagreement, but eventual compromise, all parties to the discussions--the government, banks, other financial institutions, and a few business and labor leaders--agreed that a central U.S. bank was essential for the economic health of the country. Starting with the goal of stabilizing the nation's monetary and financial system, the Federal Reserves System (Commonly called the Fed) has undertaken a number of responsibilities that are described later in this article. Structure of the System Designed by Congress and subject to congressional authority, the Fed is a politically independent and financially self-sufficient federal agency. It consists of the following components: 1. A central bank, sometimes called the government's bank, located in Washington, D. C. 2. Twelve regional Reserve Banks, located in the following cities: Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco, and St. Louis. Each Reserve Bank relies on advisory groups for information and suggestions. Some of the more important ones concern operations, small business and agriculture, and thrift institutions (savings banks, savings and loan associations, and credit unions). Reserve Bank officials also meet periodically to discuss mutual problems. These groups include the Conference of Presidents, the Conference of First Vice Presidents, the Conference of Chairmen, and the Financial Services Policy Committee. 3. Twenty-five branch banks, located within defined areas of the Reserve Banks. For example, branch banks within the San Francisco Reserve Bank area are located in Los Angeles, Portland (Oregon), Salt Lake City, and Seattle. 4. Member banks, located throughout the country. Some are national banks (all of which are commercial banks) chartered by the federal government and, by law, are members of the Fed. Others are state commercial banks that have chosen to be members. Of the more than 9000 commercial banks in the country, more than 3700 are members of the Fed. Other depository institutions, including nonmember commercial banks and thrift institutions, are subject to many of the Fed's rules and regulations. A member bank is required to purchase stock from its Reserve Bank in an amount equal to 3 percent of its combined capital and surplus. However, this investment does not represent control of or a financial interest in the Reserve Bank. In return for its investment, however, a member bank receives a 6 percent annual dividend and the right to vote in elections of directors of its Reserve Bank. Governance of the System These are three basic components in the governance structure of the Fed: 1. The Fed's primary policy-making group is the seven-member Board of Governors. Appointed by the president and confirmed by the Senate, members serve for one fourteen-year term only. A member who is appointed to fill an unexpired term may be appointed for an additional full term. From among the seven members, the Board's chairman and vice chairman are also appointed and confirmed by the president and the Senate for four-year terms. 2. There are three advisory groups that aid the Board of Governors: 1. Federal Advisory Council, consisting of one member from each Reserve Bank. Its major concerns involve banking and economic issues. 2. Consumer Advisory Council, consisting of thirty specialists in consumer and financial matters. 3. Thrift Institutions Advisory Council, consisting of people representing thrift institutions. This Council is concerned with issues affecting those institutions. * The Federal Open Market Committee (FOMC) consists of the seven-member Board of Governors, the New York Federal Reserve Bank president, and an additional four Reserve Bank presidents who serve on a one-year rotating basis. By tradition, the Committee elects the Board of Governors chairman as its chairman and the New York Reserve Bank president as its vice chairman. Although all twelve Reserve Bank presidents attend the FOMC's eight-times-a-year formal meetings, only the Board, the New York Reserve Bank president, and the four rotating presidents are voting members. Activities and Responsibilities of the Federal Reserve System In conjunction with the FOMC and the twelve Reserve Banks, the Board of Governors' main concern is the development of monetary policy, which it carries out through three means: 1. The establishment of reserve-level rates; that is, amounts that member banks must set aside to be reserved against deposits. These amounts depend on the nation's economic activity status, with emphasis placed on price levels and the volume of business and consumer expenditures. By the lowering of the required reserve-level rate, banks can increase the proportion of funds they are able to lend to customers. By raising the required reserve-level rate, the opposite effect takes place. Thus, the Fed can influence such factors as economic activities, the money supply, interest rates, credit availability, and prices. However, a change in a reserve-level rate usually causes banks to change their strategic plans. In addition, a reserve-level rate increase is costly to banks. Consequently, changes in reserve-level rates are uncommon. 2. The approval of discount rates (interest rates at which member banks may borrow short-term funds from their Reserve Bank). When inflation threatens, a discount-rate increase tends to dampen economic activity because then banks charge higher interest rates to borrowers. On the other hand, a discount-rate decrease is designed to stimulate business activity. The term "discount window" is often used when describing a Reserve Bank facility that extends credit to a member bank. 3. Another rate, the federal funds rate, is an important factor affecting day-to-day bank operations. This is the rate charged by one depository institution to another for the overnight loan of funds. This happens when one bank is short of funds while another has a surplus. The rate is not fixed; it may change from day to day and from bank to bank. 4. Open-market operations (the purchase and sale of U.S. government securities in the open market). These activities are conducted by the FOMC, of which the Board of Governors comprises the majority. The Fed buys and sells U.S. government securities such as Treasury bills from banks and others several times a week. As a result, the amounts banks have available to lend to borrowers are affected. For example, when the Fed buys securities, banks have more funds, so interest rates tend to drop. The opposite occurs when the Fed sells its securities. By and large, open-market operations comprise the most powerful tool the Fed has to influence monetary policy. Other activities and responsibilities of the Federal Reserve System include the following: 1. Supervision of the twelve Reserve Banks and their branches. With regard to the latter, the Board of Governors, through the Reserve Banks, uses both on- and off-site examinations to maintain awareness of each member bank's activities. These activities include the quality of loans, capital levels, and the availability of cash. 2. Cooperative efforts of the U.S. Treasury and the Fed. For example, the Fed acts as the Treasury's fiscal agent by putting pa per money and coins into circulation, handling Treasury securities, and maintaining a checking account for the Treasury's receipts and payments. 3. Oversight of banking organizations, such as bank holding companies (companies that own or control one or more banks). 4. Provision of an efficient payments system; for example, check collections and electronic transactions. With billions of checks in circulation each year, the Fed plays a major role in assuring their efficient processing. By arrangements among the Reserve Banks, member banks and nonmember banks, checks are credited or debited (added to or subtracted from) to depositors' accounts speedily and accurately. Electronic methods are being used increasingly to transfer funds (and securities, too). One such method, involving very large sums, is called "Fedwire." An other is the Automated Clearinghouse (ACH), which is used by the government, businesses, and individuals for the receipt or payment of recurring items, such as Social Security. 5. Enforcement of consumer credit protection laws. These laws include the Community Reinvestment Act, which pro motes community credit needs; the Equal Credit Opportunity Act, which prohibits discrimination in credit transactions on the basis of marital status, race, sex, and so forth; the Fair Credit Reporting Act, which allows consumers access to their credit records for the purpose of correcting errors; and the Truth in Lending Act, which enables consumers to determine the true amount they are paying for credit. 6. Establishment of banking rules and regulations. 7. Determination of margin requirements (the amount of credit granted investors for the purchase of securities, such as shares of stock). The borrowed funds are usually secured from a bank or a brokerage firm (a company that sells stocks and/or bonds). Margin requirements that are too liberal can damage the stock market and the economy. 8. Approval or disapproval of applications for bank mergers (two or more banks joining together to form one new bank). The Fed also acts if the new bank is to become a state member bank of the Federal Reserve System. 9. Approval and supervision of the Edge Act (named for Senator Walter Edge of New Jersey) and "agreement corporations." Both cases involve corporations that are chartered to engage in international banking. Edge Act corporations are chartered by the Fed, while "agreement corporations" secure their charters from the states. The latter are so named because they must agree to conform to activities permitted to Edge Act corporations. The Fed is also responsible for approving and regulating foreign branches of member banks and for developing policies regarding foreign lending by member banks. 10. Issuance and redemption of U.S. savings bonds. Regardless of how the bonds are purchased--for example, through an employer savings plan or a bank--it is the Fed that processes the applications and sends the bonds. Summary Since it holds substantial U.S. government securities, the Federal Reserve System earns sufficient interest to operate without government appropriations. Consequently, it is both a financially self-sufficient and politically independent agency that exerts great influence on the nation's economy. It bolsters domestic consumer confidence and is a major player in global economic activities. On 23 December 1913, the Owen-Glass Act founded the Federal Reserve System--the central bank of the United States. "The Fed," as most call it, is unique in that it is not one bank but, rather, twelve regional banks coordinated by a central board in Washington, D.C. A central bank is a bank for banks. It does for banks what banks do for individuals and business firms. It holds their deposits--or legal reserves--for safekeeping; it makes loans; and it creates its own credit in the form of created deposits, or additional legal reserves, or bank notes, called Federal Reserve notes. It lends to banks only if they appear strong enough to repay the loan. It also has the responsibility of promoting economic stability, insofar as that is possible, by controlling credit. Founded in 1781, the nation's first bank, the Bank of North America, was possibly the first central bank. Certainly, the first Bank of the United States (1791-1811), serving as fiscal agent and regulator of the currency as well as doing a commercial banking business, was a central bank in its day. So too was the second Bank of the United States (1816-1836). It performed that function badly between 1817 and 1820, but improved between 1825 and 1826. The Independent Treasury System, which existed between 1840 and 1841 and between 1846 and 1921, was in no sense a central bank. A great fault of the National Banking System (1863-1913) was its lack of a central bank. The idea, and even the name, was politically taboo, which helps explain the form and name taken by the Federal Reserve System. The faults of the National Banking System, especially perversely elastic bank notes--the paradox of dispersed legal reserves that were unhappily drawn as if by a magnet to finance stock speculation in New York--and the lack of a central bank to deal with the panics of 1873, 1884, 1893, and 1907, pointed out the need for reform. After the 1907 panic, a foreign central banker called the United States "a great financial nuisance." J. P. Morgan was the hero of the panic, saving the nation as if he were a one-man central bank. However, in doing this, he showed that he had more financial power than it seemed safe for one man to possess in a democracy. The 1912 Pujo Money Trust investigation further underlined his control over all kinds of banks. (Congressman Arsene Pujo, who became chairman of the House Banking and Currency Committee in 1911, obtained authorization from Congress to investigate the money trust, an investigation highlighted by the sensational interrogation of Morgan.) Meanwhile, the Aldrich-Vreeland Currency Act of 30 May 1908 provided machinery to handle any near-term crisis and created the National Monetary Commission to investigate foreign banking systems and suggest reforms. In 1911, Republican Sen. Nelson Aldrich proposed a National Reserve Association that consisted of a central bank, fifteen branches, and a top board controlled by the nation's leading bankers, which critics said J. P. Morgan, in turn, dominated. The proposal never passed, and the Democrats won the 1912 election. They accepted the groundwork done by Aldrich and others, but President Woodrow Wilson insisted that the nation's president choose the top board of this quasi-public institution. Democratic Rep. Carter Glass pushed the bill through Congress. All national banks had to immediately suscribe 3 percent of their capital and surplus for stock in the Federal Reserve System so that it had the capital to begin operations. State banks could also become "members," that is, share in the ownership and privileges of the system. The new plan superimposed the Federal Reserve System on the National Banking System, with the new law correcting the major and minor shortcomings of the old one. In addition to providing a central bank, it supplied an elastic note issue of Federal Reserve notes based on commercial paper whose supply rose and fell with the needs of business; it required member banks to keep half their legal reserves (after mid-1917 all of them) in their district Federal Reserve banks; and it improved the check-clearing system. On 10 August 1914, the seven-man board took office, and on 16 November the banks opened for business. World War I having just begun, the new system was already much needed, but some of the controversial parts of the law were so vague that only practice could provide an interpretation of them. For that to be achieved, the system needed wise and able leadership. This did not come from the board in Washington, chaired by the secretary of the treasury and often in disagreement about how much to cooperate with the Treasury, but instead from Benjamin Strong, head of the system's biggest bank--that of New York. He was largely responsible for persuading bankers to accept the Federal Reserve System and for enlarging its influence. At first, the Federal Reserve's chief responsibilities were to create enough credit to carry on the nation's part of World War I and to process Liberty Bond sales. The system's lower reserve requirements for deposits in member banks contributed also to a sharp credit expansion by 1920, accompanied by a doubling of the price level. In 1919, out of deference to the Treasury's needs, the Federal Reserve delayed too long in raising discount rates, a step needed to discourage commodity speculation. That was a major mistake. In 1922, the system's leaders became aware of the value of open-market buying operations to promote recovery, and open-market selling operations to choke off speculative booms. Strong worked in the 1920s with Montagu Norman, head of the Bank of England, to help bring other nations back to the gold standard. To assist them, he employed open-market buying operations and lowered discount rates so that Americans would not draw off their precious funds at the crucial moment of resumption. Nonetheless, plentiful U.S. funds and other reasons promoted stock market speculation in the United States. Strong's admirers felt he might have controlled the situation had he lived, but in February 1928 he fell sick and, on 16 October, died. As in 1919, the Federal Reserve did too little too late to stop the speculative boom that culminated in the October 1929 crash. In the years 1930-1932, more than 5,000 banks failed; in 1933, 4,000 more failed. Whether the Federal Reserve should have made credit easier than it did is still debatable. Businessmen were not in a borrowing mood, and banks gave loans close scrutiny. The bank disaster, with a $1 billion loss to depositors between 1931 and 1933, brought on congressional investigations and revelations, as well as demands for reforms and measures to promote recovery. Congress subsequently overhauled the Federal Reserve System. By the act of 27 February 1932, Congress temporarily permitted the Federal Reserve to use federal government obligations as well as gold and commercial paper to back Federal Reserve notes and deposits. A dearth of commercial paper during the depression, along with bank failures that stimulated hoarding, created a currency shortage. A new backing for the bank notes was essential. However justified at the moment, the law soon became permanent and made inflation in the future easier. Four other measures around this time were very important. These were the Banking Act of 16 June 1933; parts of the Securities Act of 27 May 1933 and of the Securities Exchange Act of 19 June 1934; and the Banking Act of 23 August 1935. Taken together, the acts had four basic goals: (1) to restore confidence in the banks, (2) to strengthen the banks, (3) to remove temptations to speculate, and (4) to increase the powers of the Federal Reserve System, notably of the board. To restore confidence, the 1933 and 1935 banking acts set up the Federal Deposit Insurance Corporation, which first sharply reduced, and, after 1945, virtually eliminated, bank failures. To strengthen banks, the acts softened restrictions on branch banking and real estate loans, and admitted mutual savings banks and some others. It was felt that the Federal Reserve could do more to control banks if they were brought into the system. To remove temptations to speculate, the banks were forbidden to pay interest on demand deposits, forbidden to use Federal Reserve credit for speculative purposes, and obliged to dispose of their investment affiliates. To increase the system's powers, the board was reorganized, without the secretary of treasury, and given more control over member banks; the Federal Reserve bank boards were assigned a more subordinate role; and the board gained more control over open-market operations and got important new credit-regulating powers. These last included the authority to raise or lower margin requirements and also to raise member bank legal reserve requirements to as much as double the previous figures. The board, in 1936-1937, doubled reserve requirements because reduced borrowing during the depression, huge gold inflows caused by the dollar devaluation in January 1934, and the growing threat of war in Europe, were causing member banks to have large excess reserves. Banks with excess reserves are not dependent on the Federal Reserve and so cannot be controlled by it. This action probably helped to bring on the 1937 recession. During the Great Depression, World War II, and even afterward, the Federal Reserve, with Marriner Eccles as board chairman (1936-1948), kept interest rates low and encouraged member banks to buy government obligations. The new Keynesian economic philosophy (the theory by John Maynard Keynes, perhaps the most important figure in the history of economics, that active government intervention is the best way to assure economic growth and stability) stressed the importance of low interest rates to promote investment, employment, and recovery, with the result that--for about a decade--it became almost the duty of the Federal Reserve to keep the nation on what was sometimes called a "low interest rate standard." In World War II, as in World War I, the Federal Reserve assisted with bond drives and saw to it that the federal government and member banks had ample funds for the war effort. Demand deposits tripled between 1940 and 1945, and the price level doubled during the 1940s; there was somewhat less inflation with somewhat more provocation than during World War I. The Federal Reserve's regulation limiting consumer credit, price controls, and the depression before the war, were mainly responsible. Regulation W (selective controls on consumer credit) was in effect from 1 September 1941 to 1 November 1947, and twice briefly again before 1952. The board also kept margin requirements high, but it was unable to use its open market or discount tools to limit credit expansion. On the contrary, it had to maintain a "pattern of rates" on federal government obligations, ranging from three-eighths of 1 percent for Treasury bills to 2.5 percent for long-term bonds. That often amounted to open-market buying operations, which promoted inflation. Admittedly, it also encouraged war-bond buying by keeping bond prices at par or better. Securities support purchases (1941-1945), executed for the system by the New York Federal Reserve Bank, raised the system's holdings of Treasury obligations from about $2 billion to about $24 billion. The rationale for the Federal Reserve continuing these purchases after the war was the Treasury's wish to hold down interest charges on the $250 billion public debt and the fear of a postwar depression, based on Keynesian economics and memory of the 1921 depression. The Federal Reserve was not fully relieved of the duty to support federal government security prices until it concluded its "accord" with the Treasury, reported on 4 March 1951. Thereafter, interest rates moved more freely, and the Federal Reserve could again use open-market selling operations and have more freedom to raise discount rates. At times, bond prices fell sharply and there were complaints of "tight money." Board chairman William McChesney Martin, who succeeded Thomas McCabe (1948-1951) on 2 April 1951, pursued a middle-of-the-road policy during the 1950s, letting interest rates find their natural level whenever possible but using credit controls to curb speculative booms in 1953, 1956-1957, and 1959-1960 and to reduce recession and unemployment in 1954, 1958, and late 1960. After the Full Employment Act of 1946, the Federal Reserve, along with many other federal agencies, was expected to play its part in promoting full employment. For many years, the thirty member banks in New York and Chicago complained of the unfairness of legal reserve requirements that were higher for them than for other banks, and bankers generally felt they should be permitted to consider cash held in the banks as part of their legal reserves. A law of 28 July 1959 reduced member banks to two classifications: 295 reserve city banks in fifty-one cities, and about 6,000 "country" banks, starting not later than 28 July 1962. According to this law, member banks might consider their vault cash as legal reserves. Thereafter, the requirement for legal reserves against demand deposits ranged between 10 and 22 percent for member city banks and between 7 and 14 percent for member country banks. During the period 1961-1972, stimulating economic growth, enacting social welfare reforms, and waging war in Vietnam were among the major activities of the federal government that: (1) raised annual expenditures from $97 billion in fiscal 1960 to $268 billion in fiscal 1974; (2) saw a budget deficit in all but three years of that period; (3) raised the public debt by almost 70 percent; and (4) increased the money supply (currency and demand deposits) from $144 billion on 31 December 1960 to $281 billion on 30 October 1974. As early as 1958, the nation's international balance of payments situation was draining off its gold reserves (reflected in the Federal Reserve's gold certificate holdings). These fell from $23 billion on 31 December 1957 to $15.5 billion on 31 December 1964. With only $1.4 billion free (without penalties to the Federal Reserve) for payments to foreign creditors, Congress, on 18 February 1965, repealed the 25 percent gold certificate requirement against deposits in Federal Reserve banks on the theory that this action would increase confidence in the dollar by making $3.5 billion in additional gold available to foreign central banks or for credit expansion at home. Unfortunately, the situation worsened. On 18 March 1968, Congress removed a similar 25 percent reserve requirement against Federal Reserve notes, thereby freeing up all of the nation's gold. Nevertheless, the gold drain became so alarming that, on 15 August 1971, President Richard M. Nixon announced that the United States would no longer redeem its dollars in gold. All these developments affected, and were affected by, Federal Reserve policies. During much of the 1960s, government economists thought they had the fiscal and monetary tools to "fine tune" the economy (that is, to dampen booms and to soften depressions), but the recession of 1966 damaged that belief. During the late 1960s, the monetarist school of economists, led by Milton Friedman of the University of Chicago, which sought to increase the money supply at a modest but steady rate, had considerable influence. In general, Reserve board chairman Martin advocated a moderate rate of credit expansion, and, in late May 1965, commented on the "disquieting similarities between our present prosperity and the fabulous'20s." Regardless, Congress and President Lyndon B. Johnson continued their heavy spending policies, but the president reappointed Martin as chairman in March 1967 because his departure might have alarmed European central bankers and precipitated a monetary crisis. With Martin's retirement early in 1970 and Arthur F. Burns's appointment as board chairman, credit became somewhat easier again. Throughout this era, restraining inflation--a vital concern of the Federal Reserve--was increasingly difficult. What did the money supply consist of? If demand deposits are money, why not readily convertible time deposits? Furthermore, if time deposits are money, as monetarists contended, then why not savings and loan association "deposits," or U.S. government E and H bonds? What of the quite unregulated Eurodollar supply? As a result of such uncontrolled increases in the money supply, consumer prices rose 66 percent in the period 1960-1974, most of it occurring after 1965. As of 27 November 1974, members of the Federal Reserve System included 5,767 of the 14,384 banks in the United States, and they held 77 percent of all bank deposits in the nation. Nevertheless, the Federal Reserve has changed markedly in structure, scope, and procedures since the 1970s. In the middle of that decade, it confronted what came to be known as "the attrition problem," a drop off in the number of banks participating in the Federal Reserve System. The decrease resulted from the prevalence of unusually high interest rates that, because of the central bank's so-called reserve requirement, made membership in the system unattractive to banks. In the United States, the federal government issues bank charters to national banks while the states issue them to state banks. A federal statute required all national banks to join the Federal Reserve; membership was optional for state banks. The Fed provided many privileges to its members but required them to hold reserves in non-interest-earning accounts at one of the twelve district Federal Reserve banks or as vault cash. While many states assessed reserve requirements for nonmember banks, the amounts were usually lower than the federal reserves, and the funds could be held in an interest-earning form. As interest rates rose to historical highs in the mid-1970s, the cost of membership in the Fed began to outweigh the benefits for many banks, because their profits were reduced by the reserve requirement. State banks began to withdraw from the Federal Reserve, and some national banks took up state charters in order to be able to drop their memberships. Federal Reserve officials feared they were losing control of the national banking system as a result of the attrition in membership. The Depository Institutions Deregulation and Monetary Control Act of 1980 addressed the attrition problem by requiring reserves for all banks and thrift institutions offering accounts on which checks could be drawn. The act phased out most ceilings on deposit interest and allowed institutions subject to Federal Reserve requirements, whether members or not, to have access to the so-called discount window, that is, to borrow from the Federal Reserve, and to use other services such as check processing and electronic funds transfer on a fee-for-service basis. In the same decade, a period of dramatic growth began in international banking, with foreign banks setting up branches and subsidiaries within the United States. Some U.S. banks claimed to be at a competitive disadvantage because foreign banks escaped the regulations and restrictions placed on domestic banks, such as those affecting branching of banks and nonbanking activities. In addition, foreign banks were free of the reserve requirement. The International Banking Act of 1978 gave regulatory and supervisory authority over foreign banks to the Federal Reserve. Together with the Depository Institutions Act of 1980, it helped level the playing field for domestic banks. Unlike most other countries where the central bank is closely controlled by the government, the Federal Reserve System enjoys a fair amount of independence in pursuing its principal function, the control of the nation's money supply. Since passage of the Full Employment and Balanced Growth (Humphrey-Hawkins) Act of 1978, Congress has required the Federal Reserve to report to it twice each year, in February and July, on "objectives and plans...with respect to the ranges of growth or diminution of the monetary and credit aggregates." The Federal Reserve System must "include an explanation of the reason for any revisions to or deviations from such objectives and plans." These reports enable Congress to monitor monetary policy and performance and to improve coordination of monetary and government fiscal policies. The independence of the Federal Reserve System and its accountability continued to be controversial issues into the 1990s. Federal Reserve System, United States Created by the passage of the Federal Reserve Act in 1913, the Federal Reserve System serves as the central bank of the United States. Commonly known as the Fed, it conducts monetary policy for the nation by exerting direct influence on the money supply, interest rates, and the purchase of government securities. It is the means by which federally issued currency and coinage reaches financial institutions, which receive these through the 12 Federal Reserve district banks located in various major cities throughout the United States. The Fed also sets the interest rate at which it loans money to member financial institutions, thus establishing a baseline for the rates of interest at which money is borrowed and lent throughout the United States. Conducting Monetary Policy The initial mandate granted to the Federal Reserve System by Congress was to provide and ensure stability, safety, and flexibility in the national monetary and financial system. Since 1913, the responsibilities and powers accorded to the Fed have grown considerably. Today the Federal Reserve shapes, directs, and conducts U.S. monetary policy. Its overall concern is the well being of the national economy, which it seeks to achieve through a number of measurable goals, including price stability and full employment. These goals it achieves, in turn, through three principal means at its disposal: the control of the money supply by the issuance of currency to member financial institutions, the setting of interest rates at which it loans funds to those institutions, and the open market purchase of government securities. Controlling the money supply. Under the Legal Tender Act of 1862, the United States began issuing currency notes, known as U.S. notes, through the Treasury Department, and continued to do so until January 21, 1971. At the time it passed the act, Congress set a limit of $300 million on the value of U.S. notes that could be in circulation at any one time. Significant by the standards of the Civil War era, this sum represents a tiny portion of the funds in circulation today, which are known as Federal Reserve notes. Whereas U.S. notes represented obligations of the federal government alone, Federal Reserve notes, authorized under the 1913 act that created the Fed itself, represent an obligation both of the federal government and the Federal Reserve system. The original Legal Tender Act was accordingly amended to include Federal Reserve notes as legal tender, meaning that they legally satisfy debts equal to the face value of the note tendered. It is technically illegal to refuse legal tender (which today is synonymous with Federal Reserve notes) for services already rendered, though it is not illegal to refuse it for services not yet rendered. Therefore, a business that accepts only checks or credit must post a notice indicating this, so that the customer is aware of the fact prior to tendering payment. Setting interest rates. In addition to controlling the money supply through the issuance of legal tender, the Federal Reserve directly affects monetary policy by a second and perhaps even more significant means: the setting of interest rates. This is accomplished by determining the discount rate, or the rate it charges member institutions for loans. These institutions, in turn, charge other depository institutions a certain rate for overnight loans of funds that are immediately available at the Federal Reserve Bank. The rate at which Fed member banks charge money to depository institutions, known as the federal funds rate, will always be slightly higher than the discount rate, but varies from institution to institution, and from day to day. In order to turn a profit, banks that borrow money at the federal funds rate, in turn, charge borrowers--both businesses and individuals--slightly higher rates. By this chain of relationships, the Fed exerts an all but direct influence on consumer credit costs ranging from the annual percentage rate on a credit card to the rate charged on a 30-year housing loan. Open market operations. In addition to setting interest rates and controlling the money supply, the Fed conducts monetary policy through a third instrument, open market operations, or the buying and selling on the open market of securities issued by the U.S. Treasury and federal agencies. These securities include bonds of various types, as well as other government certificates. In each case, the value of the bond or certificate ultimately rests in the fiscal strength of the federal government. Historically, the Federal Reserve has tied its objectives for open market operations either to a certain quantity of reserves, or a certain price. Prior to the administration of Federal Reserve Chairman Alan Greenspan, who was appointed by President Ronald Reagan in 1987, the Fed tended to focus on seeking a desired quantity of securities as reserves. Since that time, however, the Fed has sought to attain desirable levels in the price of securities, which are the federal funds rate. From 1995, it began announcing target levels for the federal funds rate, which rose in the healthy economic climate of 1999 and 2000, but fell in the recessionary economies of 2001 and 2002. Maintaining Financial Stability The open market operations of the Federal Reserve System are a clear means by which the Fed helps to maintain both financial and ultimately, political stability in the nation. Although it continually pursues its objective of ensuring stability through the three significant means at its disposal, the actions of the Federal Reserve become particularly evident during periods of financial upheaval. The stock market crash of October, 1987, the Asian financial crisis and its aftermath in late 1998, and the terrorist attacks of September, 2001 each presented an occasion in which the U.S. financial system faced challenges, and when consumer faith in the national economy wavered. In each such situation, as well as in less significant crises, the Federal Reserve has gone into action, ensuring monetary liquidity through large balances of available cash; keeping interest rates manageable by extending discount loans to depository institutions; and setting the example of faith in U.S. institutions by purchasing government securities on the open market. Even in times when the affairs of the nation are running more smoothly, the Fed continues to influence monetary policy. Americans are less likely to take note of the Federal Reserve in those situations, yet it is the Fed itself that deserves much of the credit for the stability in such times. The most visible means by which the Fed affects the economy is through the discount rate, which serves, in effect, like a gas pedal for economic growth. When rates are low, economic activity increases, and the economy grows. If the economy grows too fast, the Fed may raise interest rates as a means of ensuring price stability and protecting against inflation. Structure of the Federal Reserve The chairman of the Federal Reserve leads a seven-member Board of Governors, all of whom are appointed by U.S. presidents. The president also appoints the chairman and vice-chairman from among the board members, appointments that must be confirmed by the U.S. Senate. Alongside the board is another entity that arguably exerts as much power, the Federal Open Market Committee (FOMC), which oversees open market operations. The FOMC sets the objective for open market operations, meaning that it sets the federal funds rate. If the Fed purchases securities, thus adding to reserves, then depository institutions will tend to take on new loans and investments, which has the effect of lowering interest rates. Of the seats on the FOMC, seven are filled by the members of the Board of Governors, and an eighth by the president of the New York Federal Reserve Bank. The other four are divided among the 11 other Federal Reserve banks, which fall into four groups (Boston, Philadelphia, and Richmond; Chicago and Cleveland; Atlanta, St. Louis, and Dallas; Minneapolis, Kansas City, and San Francisco), with presidents from each city in a group serving rotating one-year terms. Banks. Although there are only 12 Federal Reserve banks, each has branches in other cities. For example, the Federal Reserve Bank of San Francisco has branches in Los Angeles, Portland, Seattle, and Salt Lake City. The 12 district banks release currency, and every banknote issued in the United States bears the seal of one of the district banks to the left of the portrait on the observe side. Federal Reserve banks sell stock to member institutions, which include national and state-chartered banks, as well as trust companies. All national banks, which are chartered by the Office of the Comptroller of the Currency in the Treasury Department, automatically belong to the Fed, while state banks and trust companies have to meet requirements set by the Board of Governors. All members are required to purchase from their regional Federal Reserve banks stock equal to six percent of their capital, of which half is paid in, while the other half can be called in by the Board of Governors. Relationship with the federal government. The Federal Reserve System is a part of the government in the sense that it was created by Congress, and is subject to congressional oversight. Furthermore, its leadership is appointed by presidents, although board members' 14-year terms extend far beyond the term of the chief executive who appointed them. Unlike most bureaus of the federal government, however, the Fed is independent of any cabinet-level department. Its decisions do not require the approval of the president, Congress, or any other member or body of the executive or legislative branches. Nor does it depend on funding appropriated by Congress. Almost alone among government institutions, the Fed actually pays for itself through the interest it receives on its holdings of federal securities, and through the fees it charges depository institutions for such services as processing and clearing checks. As a non-profit institution, it turns its net earnings over to the Treasury each year. These earnings are far from inconsiderable: in 2001, the Federal Reserve paid $27.14 billion to the federal government.
