- The Washington Times - Thursday, June 18, 2009

What is the Federal Reserve System? Answer: The Federal Reserve System, or the Fed, was created in 1913 by the Federal Reserve Act after the Panic of 1907. It is a quasi-public, quasi-private institution that operates as the central banking system of the United States under the oversight of Congress.

The Fed conducts monetary policy, mostly by manipulating short-term interest rates, in pursuit of the three goals outlined in the Federal Reserve Act: “maximum employment, stable prices and moderate long-term interest rates.” The Fed also supervises and regulates bank holding companies and its member banks (all nationally chartered banks are required to be members, and state banks may become members). And the Fed is the lead regulator on consumer-finance issues.

Q: How is the Fed structured?

A: The largely independent Fed is made up of its Washington-based Board of Governors and 12 regional Federal Reserve Banks. “The Board of Governors of the Federal Reserve System is a federal government agency,” the Fed’s Web site states.

The seven governors are appointed to staggered 14-year terms by the president and must be confirmed by the Senate. The president appoints, and the Senate confirms, two of the governors as chairman and vice chairman who serve simultaneous four-year terms. In early 2006, Ben S. Bernanke succeeded Alan Greenspan, who had served as Fed chairman since August 1987. Mr. Bernanke’s term expires Feb. 1.

The 12 regional Federal Reserve Banks serve as the operating arms of the central bank. These regional banks, which include private and public aspects in their makeup, are organized like private corporations. Member banks are required to subscribe to stock in their regional bank. That stock, which receives a 6 percent annual dividend, cannot be sold, transferred or offered as collateral. Nor does it carry the same control and financial interest that common shareholders have in for-profit corporations.

Q: How is the Fed financed?

A: The Fed, which receives no money from Congress, finances itself, mostly through the interest income it earns from U.S. Treasury securities it holds. For 2007, the Federal Reserve Banks generated $42.6 billion in operating income (mostly interest receipts), incurred $4.3 billion in expenses (including $872 million in assessments by the Board of Governors to pay for its operations), reported net income of $38.7 billion, paid $992 million in dividends and returned $34.6 billion to the U.S. Treasury, which Congress spent on other programs.

Q: How does the Fed control short-term interest rates?

A: The Federal Open Market Committee (FOMC), which has 12 voting members and is chaired by Mr. Bernanke, is the Fed’s interest-rate policy committee. The FOMC formally meets eight times a year and at other times when necessary. The voting members include the seven governors, the president of the New York Federal Reserve Bank (who serves as vice chairman) and the presidents of four other regional banks (who serve one-year terms on a rotating basis).

The FOMC sets the federal funds rate, which is the interest rate that banks charge each other for mostly overnight loans of any excess reserves they hold above the levels they are required to keep on deposit at the Fed’s regional banks. Many other short-term interest rates, including the prime rate and Treasury yields, are tied to the fed funds rate.

When the FOMC wants to change the federal funds rate, it conducts “open market operations” by buying or selling Treasury debt securities. If it wants to raise the price of those securities, which would lower the interest rate, it can buy the securities at that price.

Q: What is the federal funds rate today?

A: Between August 2007, when the financial crisis erupted, and December 2008, the Fed lowered the federal funds rate from 5.25 percent to its current target level between 0 percent and 0.25 percent.

Q: Because the Fed cannot lower the fed funds rate below zero, what else has it done to mitigate the ongoing financial crisis?

A: The Fed has followed what many economists call “the kitchen sink strategy.”

The Fed has adopted extraordinary and often-unprecedented policies to inject liquidity into the financial markets. In effect, it has acted as “lender of last resort.”

The Fed has frequently invoked the “unusual and exigent circumstances” clause in the Federal Reserve Act, which allows it to extend credit to entities that are not depository institutions. Such lending had not been done since the 1930s.

The Fed has made it much easier and less costly to borrow from its discount window. It regularly auctions short-term funds and accepts a wide variety of collateral. The FOMC has authorized tens of billions of dollars’ worth of temporary currency-swap arrangements with more than a dozen other central banks to help them meet the growing demand for dollar funding.

The Fed has created a lending facility for primary dealers, who buy and sell Treasury securities in open market operations, and, over time, has lowered collateral requirements. The Fed has authorized the use of hundreds of billions of dollars to backstop the commercial-paper and money-fund markets. And it has committed up to $1 trillion to support the issuance of asset-backed securities collateralized by student loans, auto loans, Small Business Administration-guaranteed loans and commercial and residential mortgage-backed securities.

To help reduce the cost and increase the availability of residential mortgage credit, the Fed created programs to purchase (1) up to $100 billion in bonds issued by government-sponsored enterprises such as Fannie Mae and Freddie Mac; (2) up to $500 billion in GSE-issued mortgage-backed securities; (3) up to $300 billion in long-term Treasury debt securities to lower 30-year fixed-rate mortgages.

The Fed has also directly involved itself in financial crises afflicting specific companies, including Bear Stearns, American International Group, Citigroup and Bank of America.

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