The Federal Reserve is the central bank of our government. But it’s role in our economy is much more wide reaching. The influence of the Federal Reserve creates the lending landscape we see today and shapes the backbone of our banking industry and open market economy.
The buck stops at the Federal Reserve
The Federal Reserve sets the nation’s monetary policies, monitors and regulates other U.S. banks, and works to maintain a stable economy. You can thank the Fed for reliable banks, stable currency, and low interest rates.
The Fed was created by the Federal Reserve Act of 1913. Its purpose was to unify and stabilize the currency of the United States and to maintain a healthy economy. Prior to its inception, bank failures were commonplace and economic instability was a major problem. When one bank failed, it could cause a chain reaction leading to economic depressions and major unemployment.
How does the Fed work?
The Federal Reserve is comprised of two parts. The central Board of Governors manages the country’s monetary policies, while the 12 Regional Reserve Banks supervise and regulate financial institutions and carries out the policies set by the Board of Governors. The decentralized structure gives the regions the flexibility to respond to scenarios on a localized level.
The two primary objectives of the Federal Reserve are to control inflation and to minimize unemployment. The conscientious management of these two factors encourages a healthy and stable economy.
How does the Fed manage the economy?
The Fed uses three main mechanisms to influence the Federal Funds Rate, which is the rate that banks use to borrow from one another. The Federal Funds Rate has the most direct impact on commercial lending prime rates, and therefore, on the economy. Let’s look at the three tools:
- Open Market Operations (OMC): By buying and selling securities, the Federal Open Market Committee (FOMC) controls the nation’s monetary policy. When the Fed wants to lower interest rates, it can buy more securities from the banks, thus injecting more money into the banks and increasing the availability of loans. With higher supply, interest rates decrease, and vice versa.
- Reserve Requirement: When banks close at the end of the day they are required to have a certain amount in reserve to cover their potential liabilities (withdrawals). Reserves can be held as cash in the vault, or as deposits at Reserve Banks. The Fed’s Board of Governors determines how much these institutions are required to hold in reserve. When a bank closes for the night, if it does not meet the reserve requirements it can either borrow money from other banks or directly from the Federal Reserve Bank. By changing the reserve requirement, the Fed can influence how much money banks need to borrow overnight.
- Discount Rate: To cover their reserve requirements, banks can either borrow from one another or directly from the Fed. When banks borrow directly from the Federal Reserve, they are charged the Discount Rate, which is determined by the Fed’s Board of Governors.
Supervises financial institutions
Consumers must trust their bank to appropriately manage their deposits. A healthy economy relies on consumers’ faith in the financial institutions. In addition to its economic management, the Federal Reserve is responsible for making sure that our nation’s banks are safe and respectable places to manage your money. Through supervision and regulation, the Fed ensures that consumers have confidence in our financial institutions.