8/20/13

THE CENTRAL BANK AND YOUR INVESTMENTS: ORGANIZATION OF THE FEDERAL RESERVE SYSTEM

Just prior to the founding of the Federal Reserve, the nation was plagued with financial crises. At times these crises led to panic where people raced to their banks to withdraw their deposits. A particularly severe panic in 1907 resulted in bank runs that wreaked havoc on the fragile banking system and ultimately led Congress in 1913 to write the Federal Reserve Act. Initially created to address these banking panics, the Federal Reserve is now charged with a number of broader responsibilities, including fostering a sound banking system and a healthy economy.

Establishing the nation's first central bank was no simple task. Although the need for a central bank was generally undisputed, for decades early supporters debated the delicate balance between national and regional interests. On a national front, the central bank had to be structured to facilitate the exchange of payments among regions to strengthen the U.S. standing in the world economy. On a regional front, it had to be responsive to local liquidity needs, which would vary across regions of the U.S. Another critical balancing act was that between the private interest of banks and the centralized responsibility of government.

What emerged with the Federal Reserve system was a central bank under public control with countless checks and balances. Congress oversees the entire Federal Reserve system, and the Fed must work within the objectives established by Congress. Yet, Congress gave the Federal Reserve the autonomy to carry out its responsibility insulated from political pressure.

Each of the Fed's three parts: The Board of Governors, The Regional Reserve Banks, and the Federal Open-Market Committee, operate cooperatively, yet independent of the Federal government to carry out the Fed's core responsibilities. What makes the Federal Reserve independent? Three structural features: the appointment procedures for governors, the appointment procedures for Federal Reserve Bank presidents, and the funding of the Federal Reserve.

There are seven governors on the Federal Reserve Board and they are appointed by the President of the United States and confirmed by the Senate. Independence is derived from a couple of factors. First, the appointments are staggered to reduce the chance that a single U.S. president could load the board with appointees. Second, their terms of office are 14 years, much longer than elected officials' terms.

The appointment procedure for Federal Reserve Bank presidents is also an element that provides independence to the Federal Reserve. Each Reserve Bank president is appointed to a five-year term by the Bank's board of directors, subject to final approval by the Board of Governors. This procedure adds to independence because the directors of each Reserve Bank are not chosen by politicians, but are selected to provide a cross-section of interests within the region, including those of depository institutions, known financial businesses, labor, and the public.

Last, but not least, what provides independence of our central bank is the funding. The Fed is structured to be self sufficient in the sense that it meets its operating expenses primarily from the interest earnings on its portfolio of securities. Therefore, it is independent of congressional decisions about appropriation. Even though the Fed is independent of congressional appropriations and administrative control, it is ultimately accountable to Congress and comes under government audit and review. The chairman, other governors, and Reserve bank presidents, report regularly to the Congress on monetary policy, regulatory policy, and a variety of other issues and meet with senior administration officials to discuss the Federal Reserves' and the Federal Government's economic programs.

At the core of the Federal Reserve system is the Board of Governors or Federal Reserve Board. The Board of Governors is located in Washington, D.C. and is a federal government agency - that is the Fed's centralized component.

The Board consists of seven members, called governors. These governors guide the Federal Reserve policy action. The seven governors, along with a host of economists and support staff, help write the policies that help make our banks financially sound and help formulate the policies that make our nation economically strong.

A considerable amount of information concerning the activities of the Board of Governors, of economists and specialized surveys that are performed by the Federal Reserve system are available on the Internet by accessing the web site of the Federal Reserve system. Investors are urged to carefully read the many reports and studies released by the Fed and available free of charge through the Internet. Governors actively lead committees to study prevailing economic issues from affordable housing and consumer banking laws to interstate banking and electronic commerce. The Board also exercises broad supervisory controls over member banks insuring that commercial banks operate responsibly and comply with federal regulations.

Probably their most important responsibility, however, is participating on the Federal Open Market Committee (FOMC), the committee that directs the nation's monetary policy. Heading the Board are a chairman and vice-chairman, who are appointed by the United States president to serve four-year terms.

The chairman reports twice a year to Congress on the Fed's monetary policy objectives, testifies before Congress on numerous other issues, and meets periodically with the Secretary of the Treasury.

The FOMC is the Fed's chief monetary policymaking body. The role of the FOMC is to manage the nation's money supply. The FOMC meets typically eight times a year in Washington, D.C.

At each meeting the Committee discusses the outlook of the U.S. economy and the best way to promote the economy's sustainable growth. The Committee then discusses how the Fed will use its various policy tools to put the policy in place. What the policy tools are will be discussed in the next section. Finally, it is used as a directive which drives one of three outcomes: easing, tightening, or maintaining the growth of the nation's money supply - whichever is conducive to fostering a healthy economy at the time.

The FOMC has nineteen members, twelve of whom are voting members - the seven members of the Board of Governors, the President of the Federal Reserve Bank of New York, and four other Reserve Bank president who serve one term on a rotating basis. At every meeting, however, all twelve Reserve Bank presidents participate in FOMC policy discussions, whether or not they are voting members. The minutes of the Federal Open Market Committee are also available on the Internet. These minutes are very valuable reading for those investors who want to learn how to analyze economic and financial data, how the Fed interprets these data, and how they use these data to impact the interest rates and the economic environment. This is definitely recommended reading for investors to establish a sound and informed investment strategy. Even if these minutes are available with some delay, they still provide valuable clues on monetary policy, and in which direction the Federal Reserve is leaning.

The third part of the Federal Reserve System is constituted by the twelve Federal Reserve Banks. The operations of the Federal Reserve System are conducted through a nationwide network of twelve Federal Reserve banks with branches around the country. Each branch of a Federal Reserve bank has its own board of directors of five or seven members. A majority of three or four, as the case may be, is appointed by the head office directors and the others by the Board of Governors.

The directors of each Federal Reserve bank oversee the operations of their banks under the overall supervision of the Board of Governors. They establish, subject to approval by the Board, the interest rates the banks charge on short-term collateral loans to member banks and on any loans that may be extended to non-member institutions. National banks are required by law to be members of the system. Commercial banks chartered by any of the fifty states may elect to become members if they meet the requirements established by the Board of Governors. The member banks own all of the stock of the Reserve Banks. Non-member institutions, that is institutions that elected not to be part of the Federal Reserve system, also include savings banks, savings and loan associations, and credit unions. The directors appoint and recommend the salaries of the bank president and first vice president, subject to final approval by the Board.

Earnings of the Federal Reserve banks are derived primarily from interest received on their holdings of securities acquired through open market operations and on their loans to member banks. More than eighty percent of Reserve Banks' earnings have been paid into the Treasury since the Federal Reserve System was established. Should a Reserve Bank be liquidated, its surplus, after all obligations have been met, would become the property of the U.S. Government.

(From Chapter 6 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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2 comments:

Alicia Sanders said...

Even though it seems like there is nothing to panic about at this very moment and banks have been working more or less stable past year, I still feel very unsecure when it comes to deposit cash. We all know what has happened 6 years ago and we surely know that situation is still very vulnerable in the entire world. Well you never know if Eurozone will continue its existence, for example. It sometimes feel more secure to borrow money from online lending service rather than turning to a bank facility! So yes, investments are unsafe at this stage of the US recovery

Wydawnictwo Witanet said...

That's right

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