The Federal Reserve System

The Federal Reserve acts as an independent central bank—its decisions do not have to be affirmed by the president or the Congress. While the Congress retains ultimate authority to coin and print money and to set its value, it delegated this authority to the Federal Reserve Board with the Federal Reserve Act of 1913. Fearful that the Federal Reserve was growing too independent, the Congress passed the Humphrey-Hawkins Act of 1978 requiring the Federal Reserve to submit a report on the state of the economy to Congress twice a year. The report is presented by the chairman of the Federal Reserve Board of Governors at hearings before committees in the U.S. Senate and House of Representatives.

The Federal Reserve System was explicitly empowered by the Congress “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.”

The Federal Reserve System is made up of a Board of Governors and twelve regional Federal Reserve Banks located in major cities throughout the country. There are seven members that sit on the Board of Governors. Each member must be nominated by the president of the United States and confirmed by the Senate. Members are appointed to serve fourteen-year nonrenewable terms. The president also nominates members of the board to serve as chair and vice chair for four-year renewable terms. These appointments must also be confirmed by the Senate.

The most important policy making body of the Federal Reserve System is the Federal Open Market Committee (FOMC). It is composed of the seven governors, the president of the Federal Reserve Bank of New York, and four other Reserve Bank presidents that serve on a rotating basis.

The FOMC can affect monetary policy through the use of three tools:

1. Open market operations — the buying and selling of U.S. government securities
2. Altering reserve requirements — the amount of funds that commercial banks must hold in reserve against deposits
3. Adjusting the discount rate — the interest rate charged to commercial banks

These tools can be used to tighten or expand the money supply. For example, if the FOMC wants to control inflation, it can restrict the nation’s money supply by selling government securities and raising the amount of money that banks need to set aside for reserve requirements. Both of these actions would take money out of circulation. In theory, a smaller supply of money would lead to less spending, which would lead to lower prices. The FOMC can also raise interest rates to help control inflation. By making money more expensive to borrow, consumers would be more likely to save money rather than spend it. This could also lead to lower prices.

The FOMC meets eight times during the year to consider economic developments and to vote on policy. In the early 2000s, Federal Reserve officials raised interest rates several times. In 2000, the committee voted to raise short-term interest rates by half of a percentage point to 6.5 percent, the highest level since 1991. This was done in an effort to slow the pace of the U.S. economy and keep inflation at a low, manageable level. In 2002, however, the Federal Reserve slashed interest rates to an all-time low to stimulate a stagnant economy.