Federal Reserve System

The U.S. Federal Reserve System is the private central banking system which acts as the government’s monetary agent; the Fed supervises member banks, regulates capital markets, and sets the reserve ratio. Congress originally intended for the central bank to remain insulated from the federal government and political influence, but over time, the Fed and the Treasury have begun to merge as they collaborate more closely on government spending and monetary policy.

The Fed does not physically print money, but rather issues credit digitally to member commercial banks. Because the Fed does not technically have the authority to spend, it can only increase the money supply by lending money and thus creating new reserves for commercial banks.

The Fed may finance a Congressional project by purchasing government Treasury securities, creating new reserve accounts, and then remitting interest payments back to the U.S. Treasury. As a result, the government can borrow with essentially no cost of capital.

Structure of the Federal Reserve System

The Federal Reserve banks are not part of the federal government. They are private corporations that provide liquidity to the rest of the banking system by creating new reserve accounts. The U.S. Federal Reserve system includes 12 reserve banks. Those 12 reserve banks operate in New York, Boston, Cleveland, Philadelphia, Atlanta, Chicago, St. Louis, Richmond, Dallas, San Francisco, Minneapolis, and Kansas City.

Congress oversees the U.S. Federal Reserve System, including the Board of Governors, the Federal Open Market Committee (FOMC), and the Federal Reserve Banks. The Fed consists of several advisory councils, including the Federal Advisory Council (FAC), Community Depository Institutions Advisory Council (CDIAC), Model Validation Council, and Community Advisory Council (CAC).

The Creation of the Federal Reserve

The Fed was created in response to the Panic of 1907, in which the New York Stock Exchange (NYSE) plummeted more than 50% over a three week period. At the time, the independent treasury system in the U.S. could not inject sufficient liquidity into the market to counteract the massive sell-offs that were occurring, and there was no reserve banking system to shore up the large commercial banks and trust companies that were invested in the NYSE.

As the value of their investments rapidly declined, investors sought to withdrawal cash from deposit accounts. However, commercial banks were so overleveraged that they could not service the cash needs of depositors across the country. JP Morgan and other prominent contemporary financiers intervened and provided liquidity, saving the banking system.

The Aldrich-Vreeland Act

Prior to 1913, there were several failed attempts at creating a central bank. Realizing that the banking system was under-equipped to handle financial crises and reacted slowly to emergency scenarios, Congress passed the Aldrich-Vreeland Act, which established the National Monetary Commission to reform banking laws. The Commission agreed to propose a Federal Reserve central banking system, which the U.S. President, Woodrow Wilson, signed into law in 1913.

The financiers who propped up the banking system during the Panic of 1907 stressed the importance of keeping the Federal Reserve separated from lobbyist manipulation on Wall Street and political influence in Washington D.C.. Thus, it was agreed that the 12 Federal Reserve banks would be geographically separated from one another.

The Fed’s Dual Mandate

The Fed has a dual mandate: its first mission is to minimize unemployment with moderate interest rates over the mid to long term. The second mandate is to stabilize the price of goods. Its authoritative powers include creating reserve accounts for commercial banks, buying and holding U.S. Treasury securities, and setting the federal funds rate.

The Fed was originally intended to remain separate from the Treasury because, when combined, the two institutions can exert tremendous influence over the value of the dollar and the amount of capital flowing between assets and currency.