Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Demystifying the Federal Reserve

Financial professionals routinely keep one eye on the Federal Reserve, but most Americans’ awareness only becomes acute during times of economic stress. The latest round of interest rate hikes intended to tamp spiraling inflation will have a direct impact on borrowers, savers, investors, and workers as the economy slows. Yet many do not fully understand the structure and function of the institution which has sometimes been shrouded in seemingly impenetrable complexity and mystery. In fact, the Federal Reserve System is an essential pillar of a sound economy and is actually quite transparent in its structure and functioning.

The Fed is the American version of a central bank, the institution within a nation responsible for supervision of monetary policy including controlling the money supply, regulating banks, providing financial services to the Federal Government, and lending emergency support during financial crises. The world’s oldest central bank, the Bank of England, was founded in 1694 primarily to help fund the war with France. Today most countries recognize some central banking organization as essential to maintaining financial stability.

The US whiffed in its first two attempts at creating its own version. The First Bank of the United States (1791-1811) was deemed superfluous once the Revolutionary War debt was extinguished, while the Second Bank of the United States (1816-1836) died from mismanagement and populist agrarian resistance. The current incarnation was established in 1913 under the Federal Reserve Act in response to a series of bank panics and failures that repeatedly crippled the economy.

While the Fed was created by Congress and is subject to Congressional regulation, it is not technically a part of the Government and receives no budgetary appropriations. It funds itself through interest income on the securities it holds, in addition to fees for services provided to commercial banks like check clearing and ACH funds transfers. At the end of each fiscal year, any surplus income above expenses is transferred to the US Treasury.

Unlike most countries’ concept of a single entity like the Bank of England, the American version was devised to comprise both public and private characteristics including a central governing board as well as 12 decentralized regional banks.

The governing body in Washington is the Federal Reserve Board of Governors consisting of 7 members appointed by the President and confirmed by the US Senate to oversee overall operation of the system and set out broad policy goals. Governors serve staggered 14-year terms. In addition, a Chair and Vice Chair are selected by the President and confirmed by the Senate to serve 4-year terms, to which they can be reappointed. The current Chairman, Jerome Powell, was nominated in 2018 by President Trump and reappointed by President Biden for a second term. The Chairman leads most policy discussions and serves as the point person for public communications from the Fed. The Board of Governors is considered an independent agency and maintains autonomy for its policy decisions, and essential feature of an effective central banking system.

Away from Washington and closer to local economic dynamics are the 12 regional Reserve Banks, each operating withing its own district. The Reserve Banks operate semi-autonomously but report to the Board of Governors and provide a host of banking and regulatory services to US financial institutions and serve as bankers to the US Treasury. They also conduct and distribute research and data on economic and business conditions within their districts. East Tennessee resides in the Atlanta district while West Tennessee is in the St. Louis region.

Each Reserve Bank has its own Board of Directors charged to serve in the public interest, and each Board elects a President to act as its chief executive. Central Bank Presidents’ public statements are closely followed for clues as to future policy shifts.

The 12 Reserve Banks are “owned” by commercial banks in their regions who are members of the Federal Reserve System, which includes all national banks and many state-chartered banks. But member banks’ ownership is not like stock in the traditional sense. Banks are required to subscribe to Reserve Bank shares and receive dividends but may not sell their shares. Over time, each regional Reserve Bank has specialized in a particular function; for example, all check clearing today is conducted by the Atlanta Fed.

The third leg of the Fed triad is known as the Federal Open Market Committee or FOMC. where decisions on monetary policy are taken and implemented, including raising or lowering interest rates and buying or selling bonds for the Fed’s portfolio to affect the money supply. The FOMC consists of the 7 Governors as well as the President of the Federal Reserve Bank of New York plus 4 other bank Presidents who rotate in 1-year terms. The Chair of the Board of Governors also chairs the FOMC and typically communicates the Committee’s decisions to the public and the markets. The latest announcement by the FOMC is evidence that the Fed has become significantly more concerned about inflation than its policy stance from just a few months ago suggested.

Prior to the crisis of 2008, Fed Chairmen tended to remain tight-lipped to avoid creating ripples in financial markets. Chairman Ben Bernanke reversed that policy and ushered in substantially greater transparency including public press conferences and release of minutes from FOMC meetings. This policy has continued under Chairs Yellen and Powell and made the operation of the system far more accessible to all.

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