By Kelly Campbell, Founder and CEO of Campbell Wealth Management
The Federal Reserve System, or The Fed, for short, is the central banking system of the U.S. There are 12 large regional banks in the system. Created in 1913, the Fed is tasked with three primary objectives:
1) Moderate long term interest rates
2) Stabilize prices (inflation)
The Fed also plays the role of the United States’ central bank. A central bank serves as the bankers’ bank and the government’s bank.
Originally the Fed was created to address banking panics. In 1907 a stock market collapse led to a run on banks. Banks are only required to hold a fraction of their deposits in reserve, the rest is loaned out. In 1907, depositors were concerned that the money that they had deposited in their banks would no longer be there, so they withdrew funds en masse. This led to the collapse of many banks.
The Fed now acts as a “lender of last resort”, and stands ready to lend the necessary funds to banks if/when a run occurs. That way, depositors get their money back, and the banks are able to collect the proceeds from the loans that they have made over time. On occasion, a private bank may not have enough funds in reserve due to timing of its loans, or unexpected larger amounts of withdrawals. The private bank can then borrow from the Fed to make up for the temporary shortfall. The interest rate that the Fed makes these short term loans to institutions is called the Discount Rate.
Banks in the US keep a portion of their reserves at the Fed, which enables the Fed to be the go-between between private banks lending to one another. The Fed regulates the interest rate that these institutions can lend to each other. This rate is called the Fed Funds Rate.
Another role of a central bank is to regulate the money supply. The Fed issues paper and coin currency, while the US Treasury actually prints the currency. The Fed also plays an important role in the U.S. payments system, by providing banking services to the Federal government as well as private banks. These services include payment processing, electronically transferring funds, and processing US government securities.
By controlling the money supply the Fed Funds Rate and the Discount Rate, the Fed has the ability to influence inflation and overall interest rates, which indirectly affects many economic activities such as capital spending and employment. These are the primary tools utilized to achieve its stated objectives.
The Fed is unique in that it is not really a government institution. The Fed receives no funding from your tax dollars. The seven-member Board of Governors is appointed by the President, but must be confirmed by the Senate. Governors serve 14 year terms.
Founder and CEO, Campbell Wealth Management