What is the Federal Reserve?

We live in a world beset on all sides with mysteries and riddles – The Life and Opinions of Tristram Shandy, Gentleman

Most libertarians are against the Federal Reserve (and for good reason). But if you ask most people how it works, a glossy look of obliviousness comes across their faces when asked to explain what it is or how it functions. Both the history and operations of the Federal Reserve remain a mystery to most, and this is no accident. My intent is not to go over the history of the Fed, but rather, what it is, how it functions, what its stated goals are, and what it does to achieve these goals.


Why was it created?

The Federal Reserve Act of 1913 created the Federal Reserve System. The main argument for a central bank was to stabilize the currency and provide liquidity to the market during slumps. It was argued that a central bank was needed to manage the monetary policy of the country in response to financial panics that occur. Its official long title is as follows:

“An act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes” (1).


How is set up?

The Act set up what is known as the Federal Reserve System (FRS or “The Fed”), which began operations in 1914. It created 12 Reserve Banks, which are privately owned banks that directly work with the Federal government to determine monetary policy. Twelve regions were established throughout the U.S., with one district bank allotted per region.

In addition to the 12 Federal Reserve district banks, there are 25 Federal Reserve branch banks (2). Therefore, there are 37 Federal Reserve banks nationwide.

“The Federal Reserve System is supervised by the Board of Governors. Located in Washington, D.C., the Board is a federal government agency consisting of seven members appointed by the President of the United States and confirmed by the U.S. Senate. The Board has about 1,850 employees” (3).

The 7 members of the Board are appointed by the president of the U.S. and approved by the Senate to serve 14-year terms. The president and the Senate also respectively appoint and confirm 2 members from the Board to be Chairman and Vice-Chairman, with each serving a 4-year term.

Each of the twelve district banks has 9 directors, 3 of which are appointed by the Board. The remaining 6 directors are elected by member commercial banks residing in their respective districts. The 9 directors of each bank then appoint a president for their respective banks. Each district bank hires the remaining employees. While the Federal Reserve Board is considered a government agency, their 1,850 employees are not government employees, nor are the 12 district banks, which are privately owned and operated, hiring its own employees (with the exception of its 9 appointed and elected directors).

The Board’s primary responsibility is to formulate monetary policy. Monetary policy simply means controlling the money supply. There are a few ways the Fed can do this, the most common example being printing money to buy government bonds. The FRB also determines reserve ratios of banks, discount rate policy, regulatory responsibilities, and lending regulations. How the Fed accomplishes these tasks will be discussed in a separate article.

The Board meets several times a week. Some meetings are open to the public, while other meetings that involve the consideration of confidential information are closed off to the public. It is also routine for the Board to confer with Administration and Congressional leaders, with other government agencies (such as the Treasury), with other central banks around the world, and with academic figures.

In addition to the Board, there is also a 12-member Federal Open Market Committee (FOMC). The 7 Board members comprise 7 of the 12 voting members of the FOMC. This means that the Board always comprises a majority of the FOMC. The duty of the FOMC is to make “key decisions affecting the cost and availability of money and credit in the economy” (4).

The remaining 5 FOMC members are the presidents from the 12 district banks, and serve 1-year terms. The New York President always serves on the FOMC; the other 11 presidents rotate 1-year terms on the FOMC (5). By tradition, the Chairman of the Board is also the Chairman of the FOMC. The Vice-Chairman of the FOMC is usually the President of the New York branch. The FOMC must meet at least 4 times a year; however, they usually meet more frequently, generally every 5-8 weeks.

The Fed is given the authority to print “Federal Reserve Notes”, otherwise known as the dollar. The 1913 act made these notes “lawful money”, receivable with the U.S. Treasury and all Federal Reserve member banks. In 1933, they were declared legal tender (6).

Before the Fed, dollars represented receipts to real wealth, in our case, gold. The dollar to gold ratio was a fixed proportion, where $1 was equal to 23.22 grains (or 1.5046 grams) of gold (7). $20.67 was equal to 1 troy ounce of gold (8). This was known as the Gold Standard, where the parity of a dollar always represented a fixed amount of a gold. Federal Reserve Notes helped to remove any sort of fixed parity of wealth represented by a note. The monetary history and debasement of currency is left for another time.

Today, Federal Reserves notes are monetized government debt. They are not backed by any claim to real wealth. These notes are then fiat money, and only accepted as money because of legal tender laws. These notes are only valuable and can function as claims to real wealth because legal tender laws make it illegal not to use them for public debts. How money is created from debt will be explained in a separate article.


What are the Fed’s stated goals today?

From the aforementioned prospectus, the design of the FRS allows it to exercise its stated functions. It has the established member banks to furnish an elastic currency, rediscount commercial paper, and supervise the member banks.

In spite its prospectus, these elements are only a means of accomplishing an end. The real question is when and when not to use these means. When should the Fed stop making currency elastic? When should it rediscount commercial paper? The answers to these questions are determined by the Fed’s 2 stated primary goals: unemployment and price stability.

Before we continue we must set down the following distinction:

Inflation is strictly defined as an increase in the supply of money. The effect of inflation is expressed in the economy with price inflation, where prices are higher than they otherwise would have been in the absence of inflation.

If unemployment is deemed too high for the Fed, it will loosen the money supply and ease credit in order to stimulate the economy. More money in the economy causes a temporary boom in production, businesses can borrow at cheaper than market rates, compelling them to expand (often beyond their means), which includes hiring more workers. The effects these policies will be discussed in a separate article.

On the other hand, inflation dilutes the purchasing power of those who hold the dollar. There is only so much real wealth in the U.S. to go around, and dollars are the only claims to this real wealth (via due to legal tender laws). Think of the following illustration:

inflation1  If money is printed, the ratio of dollars (claims to real assets) to real assets increases, though real assets haven’t increased. The effect of this increase appears as an increase in prices, or price inflation. The ratio is by no means strictly proportional and there may be several deflationary reasons (9) why price inflation doesn’t occur in spite of inflation.


What can the Fed do to achieve its goals?

Now that we know the Fed’s 2 primary goals, how are they achieved? We already discussed how: monetary policy, which means manipulating the supply of money. The problem with the Fed achieving its goals is that its only weapon is monetary manipulation. Manipulating the money supply causes price inflation/deflation (among other things). The looser the monetary policy, the lower unemployment tends to go, but the greater the price inflation. It can only give up its price stability objective in order to achieve its employment objective, and vice versa.

It is a mutually exclusive, zero-sum game of tradeoffs. The Fed cannot accomplish its 2 primary goals; it can only attempt to accomplish them. Many consider Fed policy as a balancing act, but the teeter-totter can only fall one way on the fulcrum – either choosing price stability or choosing employment. To believe otherwise is to take gold and diamonds as copper and glass.

We now know why the Fed was created, how it functions, what its stated goals are, and how it attempts to accomplish those goals. There are several points that will be expanded upon in following articles, sed haec, hactenus. It is there that the how of monetary policy is explained and how this affects the economy.

 

References:

  1. http://www.federalreserve.gov/aboutthefed/officialtitle.htm
  2. http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=Federal%20Reserve%20deposits
  3. http://newyorkfed.org/aboutthefed/fedpoint/fed46.html
  4. http://www.federalreserve.gov/pubs/frseries/frseri.htm
  5. http://www.mindcontagion.org/fed/fedfacts.html
  6. http://www.federalreserve.gov/faqs/currency_15197.htm
  7. http://en.wikipedia.org/wiki/Gold_Standard_Act
  8. http://en.wikipedia.org/wiki/Gold_standard#Gold_exchange_standard
  9. http://austrianeconomics.liberty.me/2014/11/04/hey-austrians-where-is-the-inflation/