The Federal Reserve System is the central banking system of the United States. Created in 1913 by the Federal Reserve Act, it is a federal banking system composed of a presidential appointed Board of Governors. It includes 12 regional Federal Reserve Banks located in major cities throughout the nation acting as fiscal agents for the U.S. Treasury, each with its own nine-member board of directors. There are also numerous private U.S. member banks, which subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks. The intent of Congress in shaping the Federal Reserve Act was to keep politics out of monetary policy. The System is independent of other branches and agencies of government. It is self-financed and therefore is not subject to the congressional budgetary process (Federalreserve.gov, 2007). Mission 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 banking 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, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation’s payments systems Ownership The Federal Reserve System is not owned by anyone and is not a private, profit-making institution.
Instead, it is an independent entity within the government, having both public purposes and private aspects. As the nation’s central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as “independent within the government.” The twelve regional Federal Reserve Banks, which were established by Congress as the operating arms of the nation’s central banking system, are organized much like private corporations–possibly leading to some confusion about “ownership.” For example, the Reserve Banks issue shares of stock to member banks.
However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year. Funding The Federal Reserve’s income is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other sources of income are the interest on foreign currency investments held by the System; fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations; and interest on loans to depository institutions (the rate on which is the so-called discount rate). After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.
Accountability The Federal Reserve’s ultimate accountability is to Congress, which at any time can amend the Federal Reserve Act. Legislation requires that the Federal Reserve report annually on its activities to the Speaker of the House of Representatives, and twice annually on its plans for monetary policy to the banking committees of Congress. Fed officials also testify before Congress when requested. To ensure financial accountability, the financial statements of the Federal Reserve Banks and the Board of Governors are audited annually by an independent outside auditor. In addition, the Government Accountability Office, as well as the Board’s Office of Inspector General, can audit Federal Reserve activities. Appointments to the Board The members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14-year terms of office. Members may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term. The President designates, and the Senate confirms, two members of the Board to be Chairman and Vice Chairman, for four-year terms.
Representation Only one member of the Board may be selected from any one of the twelve Federal Reserve Districts. In making appointments, the President is directed by law to select a “fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country” (Federalreserve.gov, 2007). These aspects of selection are intended to ensure representation of regional interests and the interests of various sectors of the public. Contacts within Government As they carry out their duties, members of the Board routinely confer with officials of other government agencies, representatives of banking industry groups, officials of the central banks of other countries and members of Congress. For example, they meet frequently with Treasury officials and the Council of Economic Advisers to help evaluate the economic climate and to discuss objectives for the nation’s economy. Governors also discuss the international monetary system with central bankers of other countries and are in close contact with the heads of the U.S. agencies that make foreign loans and conduct foreign financial transactions.
The members of the Board of Governors of the Federal Reserve System are nominated by the President and confirmed by the Senate. A full term is fourteen years, and a member who serves a full term may not be reappointed. The chairman and vice chairman term of office is four years, and are named by the President and confirmed by the Senate. Ben Bernanke succeeded Alan Greenspan as Chairman of the Federal Reserve on February 1, 2006. Bernanke was born December 13, 1953, in Augusta, Georgia, but grew up in Dillon, S.C. Bernanke graduated valedictorian of his high school class and went on to receive his undergraduate degree in economics from Harvard. After graduating from Harvard in 1975, he went on to complete his PhD in economics from the Massachusetts Institute of Technology in 1979.
He taught at the Stanford Graduate School of Business from 1979 until 1985, was a visiting professor at New York University and went on to become a tenured professor at Princeton University in the Department of Economics. He chaired that department from 1996 until September 2002. He resigned his position at Princeton July 1, 2005. Mr. Bernanke was a member of the Board of Governors of the Federal Reserve System from 2002 to 2005. On February 1, 2006, he was appointed as a member of the Board for a fourteen-year term and to a four-year term as Chairman. Donald Kohn was born in Philadelphia, Pennsylvania on November 7, 1942. He received a B.A. in economics in 1964 from the College of Wooster and a Ph.D. in economics in 1971 from the University of Michigan. He served on the Federal Reserve’s staff as Adviser to the Board for Monetary Policy from 2001-2002, Secretary of the Federal Open Market Committee from 1987-2002, Director of the Division of Monetary Affairs (1987-2001), and Deputy Staff Director for Monetary and Financial Policy (1983-87).
He also held several positions in the Board’s Division of Research and Statistics–Associate Director (1981-83), Chief of Capital Markets (1978-81), and Economist (1975-78). The rest of the board members include Kevin Warsh, Randall Kroszner and Frederic Mishkin. The primary responsibility of the Board members is the formulation of monetary policy. The Board members constitute a majority of the 12-member Federal Open Market Committee (FOMC), the group that makes the key decisions affecting the cost and availability of money and credit in the economy. The other members of the FOMC are Reserve Bank presidents, one of whom is the president of the Federal Reserve Bank of New York. The other Bank presidents serve one-year terms on a rotating basis. The FOMC determines its own organization, and by tradition it elects the Chairman of the Board of Governors as its Chairman and the President of the New York Bank as its Vice Chairman. The Board sets reserve requirements and shares the responsibility with the Reserve Banks for discount rate policy. These two functions plus open market operations constitute the Monetary Policy tools of the Federal Reserve System .
In addition to monetary policy responsibilities, the Federal Reserve Board has regulatory and supervisory responsibilities over banks that are members of the System, bank holding companies, international banking facilities in the United States, foreign activities of member banks, and the U.S. activities of foreign-owned banks. The Board also sets margin requirements, which limit the use of credit for purchasing or carrying securities. Also, the Board plays a key role in assuring the smooth functioning and continued development of the nation’s vast payments system. Another area of Board responsibility is the development and administration of regulations that implement major federal laws governing consumer credit such as the Truth in Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act and the Truth in Savings Act. Definition The term monetary policy refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit as a means of helping to promote national economic goals. Monetary policy is made by the Federal Open Market Committee (FOMC), which consists of the Board of Governors of the Federal Reserve System and the Reserve Bank presidents (Federalreserve.gov, 2006). Implementation The Federal Reserve implements monetary policy using three major tools: Open market operations – The buying and selling of U.S. Treasury and federal agency securities in the open market Discount window lending – Lending to depository institutions directly from their Federal Reserve Bank’s lending facility (the discount window), at rates set by the Reserve Banks and approved by the Board of Governors Reserve requirements – Requirements regarding the amount of funds that depository institutions must hold in reserve against deposits made by their customers.
Using these tools, the Federal Reserve influences the demand for and supply of balances that depository institutions hold on deposit at Federal Reserve Banks (the key component of reserves) and thus the federal funds rate; the interest rate charged by one depository institution on an overnight sale of balances at the Federal Reserve to another depository institution. Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and, ultimately, a range of economic variables, including employment, output, and the prices of goods and services. Types There are several types of monetary policies that involve the modifying of currency in circulation. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals. The different types of policy are also called monetary regimes and focus on specific goals: Inflation Targeting – The target is to keep inflation within a desired range. Price Level Targeting – Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years.
Monetary Aggregates – An approach based on a constant growth in the money supply. This approach is also called monetarism. Fixed Exchange Rate – This policy is based on maintaining a fixed exchange rate with a foreign currency. Gold Standard – A system in which the price of the national currency as measured in units of gold bars. Mixed Policy – In practice a mixed policy approach is most like ‘inflation targeting’, however some consideration is also given to other goals such as economic growth, unemployment and asset bubbles. This type of policy was used by the Federal Reserve in 1998 (Wikipedia, 2008). Economists have contributed much to making the design of monetary policy more scientific. From the articulation of general principles for good policy to the construction of small models that can be used to simulate the impacts of alternative policies, recent research by academic and central bank economists has contributed to our knowledge about monetary policy (Walsh, 2001). Definition Inflation is the loss in purchasing power of a currency unit such as the dollar, usually expressed as a general rise in the prices of goods and services; in other words, a sustained rise in overall price levels. As an economy grows, businesses and consumers spend more money on goods and services.
In the growth stage of an economic cycle, demand typically outstrips the supply of goods, and producers can raise their prices. In the U.S., the inflation syndrome is often described as “too many dollars chasing too few goods;” in other words, as spending outpaces the production of goods and services, the supply of dollars in an economy exceeds the amount needed for financial transactions. The result is the purchasing power of a dollar declines (Bond Basics, 2006). How Is Inflation Measured? There are several regularly reported measures of inflation that investors can use to track inflation. In the U.S., the two most widely monitored indicators are the Producer Price Index (PPI) and the Consumer Price Index (CPI). The PPI, previously called the wholesale price index, measures prices paid to producers, usually by retailers. The PPI picks up price trends relatively early in the inflation cycle.
The more widely followed CPI reflects retail prices of goods and services, including housing costs, transportation, and healthcare. Many private and government contracts, such as social security payments or labor contracts, are explicitly linked to changes in the CPI. When economists try to measure the rate of inflation, they generally focus on “core inflation.” Unlike the “headline,” or reported inflation, core inflation excludes food and energy prices, which are subject to sharp, short-term price swings. Types Types of Inflation: Demand Pull – Occurs when there is too much spending in the economy. Sometimes described as ‘too many dollars chasing too few goods’. When the amounts of money buyers want to spend increases more rapidly than the supply of goods and services, then prices will be pulled upward. Cost Push – Occurs when increasing costs of production are passed on to consumers in the form of higher prices. This can be caused by increased wages, higher import prices for raw materials, increased taxes or interest rates. What Causes Inflation? Economists do not always agree on what spurs inflation at any given time. However, certain forces clearly contribute to inflation. Rising commodity prices are perhaps the most visible inflationary force because when commodities rise in price, the costs of basic goods and services generally increase.
Higher oil prices, in particular, can have the most noticeable impact on an economy. Higher oil prices mean first, that gasoline prices will rise. This, in turn, means that the prices of all goods and services that are transported to their markets by truck, rail or ship will also rise. At the same time, jet fuel prices go up, raising the prices of airline tickets and air transport; heating oil prices also rise, hurting both consumers and businesses. By causing price increases throughout an economy, rising oil prices take money out of the pockets of consumers and businesses. Economists therefore view oil price hikes as a “tax,” in effect, that can depress an already weak economy.. In addition to oil price hikes, exchange rate movements can be an early indicator of inflation. As a country’s currency depreciates, it becomes more expensive to purchase imported goods, which puts upward pressure on prices overall. For example, when the dollar weakened to a record low against the euro in the first half of 2003, the cost of European imports in the U.S. rose, suggesting that inflation could increase in the U.S.
Over the long term, currencies of countries with higher inflation rates tend to depreciate relative to those with lower rates. Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation rates. Another cause of inflation is natural disasters. We can use hurricane Katrina as a great example. Insurance companies have estimated the damage from hurricane Katrina at $25 Billion Dollars. That amount in primarily for actual property damage and does not take into consideration the loss of revenue while things are being rebuilt. What about the loss of jobs from the companies who won’t be rebuilding because they didn’t have insurance? According to the “Financial Times” current estimates of “total economic losses” are closer to $100 Billion (McMahon, 2007). What about the destruction of factories? A factory is different from a house because it produces things. Lastly, because of a natural disaster like Katrina, there is a very good chance that the FED will loosen the money supply to stimulate the economy to compensate for the loss of jobs. So we possibly have two inflationary factors; the destruction of assets and an increase in the money supply. Inflation poses a threat to investors because it chips away at real savings and investment returns. Most investors aim to increase their long-term purchasing power.
Inflation puts this goal at risk because investment returns must first keep up with the rate of inflation in order to increase real purchasing power. For example, an investment that returns 2% before inflation in an environment of 3% inflation will actually produce a negative return (-1%) when adjusted for inflation. Another example would be a five-year bond with a principal value of $100. If the rate of inflation is 3% annually, the value of the principal adjusted for inflation will sink to about $84 over the five-year term of the bond. Inflation can be harmful to fixed-income returns in particular. Many investors buy fixed-income securities because they want a stable income stream, which comes in the form of interest, or coupon, payments. However, because the rate of interest, or coupon, on most fixed-income securities remains the same until maturity, the purchasing power of the interest payments declines as inflation rises. Inflation can adversely affect fixed-income investments in another way. When inflation rises, interest rates also tend to rise either due to market expectations of higher inflation or because the Federal Reserve has raised interest rates in an attempt to fight inflation. When interest rates rise, bond prices fall.
Thus, inflation may lead to a fall in bond prices, potentially reducing total returns on bonds. Because of inflation’s impact, the interest rate on a fixed-income security can be expressed in two ways: Nominal, or stated, interest rate – the rate of interest on a bond without any adjustment for inflation. The nominal interest rate reflects two factors: the rate of interest that would prevail if inflation were zero and the expected rate of inflation, which shows that investors demand to be compensated for the loss of return due to inflation. Most economists believe that nominal interest rates reflect the market’s expectations for inflation: Rising nominal interest rates indicate that inflation is expected to climb, while falling rates indicate that inflation is expected to drop. Real interest rate – the nominal rate minus the rate of inflation. Because it takes inflation into account, the real interest rate is more indicative of the growth in the investor’s purchasing power. If a bond has a nominal interest rate of 5% and inflation is 2%, the real interest rate is 3%. Unlike bonds, some assets rise in price as inflation rises.
Price rises can sometimes offset the negative impact of inflation: Common stocks have often been a good investment relative to inflation over the very long term, because companies can raise prices for their products when their costs increase in an inflationary environment. Higher prices may translate into higher earnings. Commodities generally rise with inflation. Commodity futures, which reflect expected prices in the future, might therefore react positively to an upward change in expected inflation. As we see in our current economy, persistent inflation tends to lower business confidence. This can contribute to higher unemployment and to lower economic growth, because companies are uncertain about future costs and their level of profit. Inflation can also affect an company’s competitive position in relation to other nations; if America’s economy rises faster than other countries, it becomes cheaper to purchase imports. Inflation also affects the nation’s economic output because it distorts the pattern of resource allocation.
During periods of low inflation, money capital is best used productively – investing in capital equipment and producing goods and services for sale at a profit (Bond Basics, 2006). Inflation tends to redistribute income and wealth in the economy. All things being equal, the redistribution favors: Borrowers of funds – because the real value of repayments diminishes over time. Holders of real assets (buildings, land and jewelry) – because they usually keep pace with rising prices. The government – which gains in times of inflation because income tax collections automatically increase under a progressive income tax scale. Inflation’s redistribution of income and wealth tends to be at the expense of: lenders of money, who find they are repaid in money that has reduced purchasing power. Those on fixed nominal incomes where the purchasing power of their incomes will diminish with time unless they are fully indexed. Holders of assets, such as cash, which do not increase in value as well as real assets. Central banks, including the U.S. Federal Reserve (the Fed), attempt to control inflation by regulating the pace of economic activity. Management of the money supply by the Fed, and by other central banks in their home regions, is known as monetary policy.
Raising and lowering interest rates is the most common way of implementing monetary policy. They usually try to affect economic activity by raising and lowering short-term interest rates. Lowering short-term rates encourages banks to borrow from the Fed and from each other, effectively increasing the money supply within the economy. Banks, in turn, make more loans to businesses and consumers, which stimulates spending and overall economic activity. As economic growth picks up, inflation generally increases. Raising short-term rates has the opposite effect: it discourages borrowing, decreases the money supply, dampens economic activity and subdues inflation. The Federal Reserve can also tighten or relax banks’ reserve requirements. Banks must hold a percentage of their deposits with the Fed or as cash on hand. Raising the reserve requirements restricts banks’ lending capacity, thus slowing economic activity, while easing reserve requirements generally stimulates economic activity.
The Federal Reserve is often credited with engineering, through monetary policy, the long period of deflation in the U.S. that helped lead to the stock market gains of the 1990s. Starting in 1979, then-Fed Chairman Paul Volcker allowed short-term interest rates to rise continuously to break an inflationary spiral that had driven the CPI to almost 15%. In the following years, the Federal Reserve responded to economic conditions with great care, causing rates to rise and fall as needed, and brought inflation down to less than 2% by mid-2002 (Bond Basics, 2006). The federal government at times will attempt to fight inflation through fiscal policy. Although not all economists agree on the efficacy of fiscal policy, the government can attempt to fight inflation by raising taxes or reducing spending, thereby putting a damper on economic activity; conversely, it can combat deflation with tax cuts and increased spending designed to stimulate economic activity. If inflation is anticipated, then the effects will be reduced as people may plan for it.