The Functions of the Federal Reserve

During the past couple of weeks, the financial turmoil has forced many people to focus on the Federal Reserve. While there are a number of good resources for teachers about the Fed, virtually all of them consolidated here, I thought it might be helpful to review some information about the Fed in a way that could help put its recent activity into context.

We are frequently reminded that the Federal Reserve is the "nation's central bank." And we will spend some time on that nearer the end of this post. But there are other functions of the Fed that are frequently overlooked, yet provide a background for what has happened as events have unfolded.

First, the Federal Reserve is a bank - or more precisely, a number of banks - and one of its functions is to act as such. But the Fed has an unusual clientele. Perhaps its most important customer is the U.S. government. The Fed is the government's bank. That means that all moneys sent to the U.S. government in the form of taxes, etc. end up deposited at the Fed. Likewise, Federal payments are drawn on the government's account at the Fed. The reason for this is that prior to the creation of the Federal Reserve, U.S. funds were deposited in private banks. This had the potential for favoritism and political patronage. As a consequence, placing federal monies in the Federal Reserve Banks eliminated that source of conflict.

The Fed also is a bank for banks. This also goes back to the formation of the Federal Reserve. One of the Fed's primary jobs in early years was to help limit bank runs. This was accomplished by charging the Fed with being the "lender of last resort." Essentially, banks could go to the Fed for money (cash specifically) if yhey did not have enough on hand to meet demand. The money would be borrowed against collateral (loans and government securities) and interest charged for the loan - the rate was called the discount rate. (Discount because the interest was paid off the front end of the loan - the loan was discounted by the amount of the interest.) It is this "lender of last resort" function that has played in some of the Fed's actions of the past couple of weeks. But you should be asking "how?" Many of the institutions involved weren't banks - therefore they weren't Fed customers. This brings us to the second function.

Another charge of the Federal Reserve is to maintain an efficient payment system. Usually this is done by providing currency and coin to financial institutions as needed; facilitating the clearing of checks drawn by one bank on another bank; and providing electronic payments and transfers between institutions. But in unusual circumstances, the Fed can provide funds in an effort to prevent the payments system from freezing up. Generally, banks can and do borrow funds from each to facilitate payment. But in times of stress, they may stop lending to one another - and they may stop lending to non-bank financial institutions (brokerages, investment firms, insurance firms). In situations like this, the Fed can step in - lending to banks to enable them to lend to other firms - to prevent the payment mechanism from coming
to a stop. And as we've seen, the Fed and Treasury have moved together to provide funds directly to non-bank financial firms to prevent the same thing. But like the "lender of last resort" idea, the Fed is taking securities as collateral - in some cases stock or stock warrants, in other cases loans.

The final role of the Federal Reserve is to act as the nation's central bank. This means it is responsible for making sure the nation's money supply grows at a rate that is conducive to price stability and maximum sustainable growth. Again, in times of crisis, the Fed may have to choose which of the dual mandates set forth by Congress take precedence. When the financial system is threatening to come to a halt - growth takes the front seat. Consequently, making more funds available (increasing the money supply) may generate concerns about inflation and the value of the dollar, but once the market stabilizes the funds can be drawn out of the system again. This is what happened during the stock market "crash" of 1987.

I've just provided a very general outline here. I would encourage you to check out the site mentioned earlier in this blog. (Here's the link, again.) And you may want to check the web site of your local Federal Reserve Bank to see if they provide additional information or resources.

I look forward to comments.