15.1The Federal Reserve Banking System and Central Banks

of 2020. The federal funds rate, which is the interest rate for banks that the Federal Reserve targets with its monetary policy, was slightly above 5% in 2007. By 2009, it had fallen to 0.16%. It then fell again from over 2% to 0.05% in March 2020. During the Great Recession, the Federal Reserve’s situation was further complicated because fiscal policy, the other major tool for managing the economy, was constrained by fears that the federal budget deficit and the public debt were already too high. What were the Federal Reserve’s options? How could the Federal Reserve use monetary policy to stimulate the economy? And while fiscal policy was more aggressive in 2020, the economic situation has in some cases been more severe and additional financial support was necessary. The solution to the problem of the lower bound in both recessions, as we will see in this chapter, was to change the rules of the game. Money, loans, and banks are all interconnected. Money is deposited in bank accounts, which is then loaned to businesses, individuals, and other banks. When the interlocking system of money, loans, and banks works well, economic transactions smoothly occur in goods and labor markets and savers are connected with borrowers. If the money and banking system does not operate smoothly, the economy can either fall into recession or suffer prolonged inflation. The government of every country has public policies that support the system of money, loans, and banking. However, these policies do not always work perfectly. This chapter discusses how monetary policy works and what may prevent it from working perfectly.

15.1 The Federal Reserve Banking System and Central Banks

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain the structure and organization of the U.S. Federal Reserve
• Discuss how central banks impact monetary policy, promote financial stability, and provide banking services

In making decisions about the money supply, a central bank decides whether to raise or lower interest rates and, in this way, to influence macroeconomic policy, whose goal is low unemployment and low inflation. The central bank is also responsible for regulating all or part of the nation’s banking system to protect bank depositors and insure the health of the bank’s balance sheet. We call the organization responsible for conducting monetary policy and ensuring that a nation’s financial system operates smoothly the central bank. Most nations have central banks or currency boards. Some prominent central banks around the world include the European Central Bank, the Bank of Japan, and the Bank of England. In the United States, we call the central bank the Federal Reserve—often abbreviated as just “the Fed.” This section explains the U.S. Federal Reserve's organization and identifies the major central bank's responsibilities.

Structure/Organization of the Federal Reserve

Unlike most central banks, the Federal Reserve is semi-decentralized, mixing government appointees with representation from private-sector banks. At the national level, it is run by a Board of Governors, consisting of seven members appointed by the President of the United States and confirmed by the Senate. Appointments are for 14-year terms and they are arranged so that one term expires January 31 of every even-numbered year. The purpose of the long and staggered terms is to insulate the Board of Governors as much as possible from political pressure so that governors can make policy decisions based only on their economic merits. Additionally, except when filling an unfinished term, each member only serves one term, further insulating decision-making from politics. The Fed's policy decisions do not require congressional approval, and the President cannot ask for a Federal Reserve Governor to resign as the President can with cabinet positions. One member of the Board of Governors is designated as the Chair. For example, from 1987 until early 2006, the Chair was Alan Greenspan. From 2006 until 2014, Ben Bernanke held the post. From 2014 to 2018, Janet Yellen was the Chair. The current Chair is Jerome Powell. See the following Clear It Up feature to find out more about the former and current Chair. CLEAR IT UP Who has the most immediate economic power in the world? FIGURE 15.2Chair of the Federal Reserve Board Jerome H. Powell (Credit: “_NZ79221” by Board of Governors of the Federal Reserve System/Flickr, Public Domain) What individual can make a financial market crash or soar just by making a public statement? It is not Bill Gates or Warren Buffett. It is not even the President of the United States. The answer is the Chair of the Federal Reserve Board of Governors. In 2018, President Donald Trump appointed Jerome H. Powell to a 4-year term as chair of the Federal Reserve, replacing Janet Yellen, who served as the first female chair of the Federal Reserve from 2014–2018 and who now serves as the Treasury Secretary in the Biden administration. In November 2021, Powell was nominated for a second term by President Biden; this appointment was confirmed in early-2022. Powell played a pivotal role during the COVID-19 recession and its aftermath; in March 2020, under his leadership the Fed acted quickly to reduce the effective federal funds rate and expand its lending and bond-buying actions, similar to what Ben Bernanke did during the Great Recession. A centrist at heart, Powell has been criticized for fueling asset prices, even though in his many speeches and testimony before Congress he has consistently emphasized low unemployment rates and has been more tolerant of inflation than others on the Federal Reserve Board. Powell is not an academic economist by training or career—he has a J.D. from Georgetown Law and worked for many years at investment banks and on corporate boards—but this lack of "ivory tower" influences has helped guide a practical approach to economic problems, for which he is best known. The Fed Chair is first among equals on the Board of Governors. While they have only one vote, the Chair controls the agenda, and is the Fed's public voice, so they have more power and influence than one might expect. LINK IT UP Visit this website (https://openstax.org/l/Governors) to see who the current members of the Federal Reserve Board of Governors are. You can follow the links provided for each board member to learn more about their backgrounds, experiences, and when their terms on the board will end. The Federal Reserve is more than the Board of Governors. The Fed also includes 12 regional Federal Reserve banks, each of which is responsible for supporting the commercial banks and economy generally in its district. Figure 15.3 shows the Federal Reserve districts and the cities where their regional headquarters are located. The commercial banks in each district elect a Board of Directors for each regional Federal Reserve bank, and that board chooses a president for each regional Federal Reserve district. Thus, the Federal Reserve System includes both federally and private-sector appointed leaders.

FIGURE 15.3The Twelve Federal Reserve Districts There are twelve regional Federal Reserve banks, each with its district.

What Does a Central Bank Do?

The Federal Reserve, like most central banks, is designed to perform three important functions: 1. To conduct monetary policy 2. To promote stability of the financial system 3. To provide banking services to commercial banks and other depository institutions, and to provide banking services to the federal government. The first two functions are sufficiently important that we will discuss them in their own modules. The third function we will discuss here. The Federal Reserve provides many of the same services to banks as banks provide to their customers. For example, all commercial banks have an account at the Fed where they deposit reserves. Similarly, banks can obtain loans from the Fed through the “discount window” facility, which we will discuss in more detail later. The Fed is also responsible for check processing. When you write a check, for example, to buy groceries, the grocery store deposits the check in its bank account. Then, the grocery store's bank returns the physical check (or an image of that actual check) to your bank, after which it transfers funds from your bank account to the grocery store's account. The Fed is responsible for each of these actions. On a more mundane level, the Federal Reserve ensures that enough currency and coins are circulating through the financial system to meet public demands. For example, each year the Fed increases the amount of currency available in banks around the Christmas shopping season and reduces it again in January. Finally, the Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws. For example, banks are forbidden from discriminating on the basis of age, race, sex, or marital status. Banks are also required to disclose publicly information about the loans they make for buying houses and how they distribute the loans geographically, as well as by sex and race of the loan applicants.

15.2 Bank Regulation

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Discuss the relationship between bank regulation and monetary policy
• Explain bank supervision
• Explain how deposit insurance and lender of last resort are two strategies to protect against bank runs

A safe and stable national financial system is a critical concern of the Federal Reserve. The goal is not only to protect individuals’ savings, but to protect the integrity of the financial system itself. This esoteric task is usually behind the scenes, but came into view during the 2008–2009 financial crisis, when for a brief period of time, critical parts of the financial system failed and firms became unable to obtain financing for ordinary parts of their business. Imagine if suddenly you were unable to access the money in your bank accounts because your checks were not accepted for payment and your debit cards were declined. This gives an idea of a failure of the payments/financial system. Bank regulation is intended to maintain banks' solvency by avoiding excessive risk. Regulation falls into a number of categories, including reserve requirements, capital requirements, and restrictions on the types of investments banks may make. In Money and Banking, we learned that banks are required to hold a minimum percentage of their deposits on hand as reserves. “On hand” is a bit of a misnomer because, while a portion of bank reserves are held as cash in the bank, the majority are held in the bank’s account at the Federal Reserve, and their purpose is to cover desired withdrawals by depositors. Another part of bank regulation is restrictions on the types of investments banks are allowed to make. Banks are permitted to make loans to businesses, individuals, and other banks. They can purchase U.S. Treasury securities but, to protect depositors, they are not permitted to invest in the stock market or other assets that are perceived as too risky. Bank capital is the difference between a bank’s assets and its liabilities. In other words, it is a bank’s net worth. A bank must have positive net worth; otherwise it is insolvent or bankrupt, meaning it would not have enough assets to pay back its liabilities. Regulation requires that banks maintain a minimum net worth, usually expressed as a percent of their assets, to protect their depositors and other creditors. LINK IT UP Visit this website (https://openstax.org/l/bankregulation) to read the brief article, “Stop Confusing Monetary Policy and Bank Regulation.”

Bank Supervision

Several government agencies monitor banks' balance sheets to make sure they have positive net worth and are not taking too high a level of risk. Within the U.S. Department of the Treasury, the Office of the Comptroller of the Currency has a national staff of bank examiners who conduct on-site reviews of the 1,500 or so of the largest national banks. The bank examiners also review any foreign banks that have branches in the United States. The Office of the Comptroller of the Currency also monitors and regulates about 800 savings and loan institutions. The National Credit Union Administration (NCUA) supervises credit unions, which are nonprofit banks that their members run and own. There are about 5,000 credit unions in the U.S. economy today, although the typical credit union is small compared to most banks. The Federal Reserve also has some responsibility for supervising financial institutions. For example, we call conglomerate firms that own banks and other businesses “bank holding companies.” While other regulators like the Office of the Comptroller of the Currency supervises the banks, the Federal Reserve supervises the holding companies.