The Federal Reserve: CNBC Explains

The Federal Reserve System—or the "Fed" as it's known—arguably plays the most crucial role in the U.S. economy.  

The Federal Reserve headquarters in Washington, DC.

Yet most people have little idea how the Fed works, what it actually does and why its decisions have so much impact. Here are the details.

What is the Federal Reserve?

The Fed is the gatekeeper of the U.S. economy and is part of the federal government.

Based in Washington, D.C., the Fed is the bank of the U.S. government and regulates the nation's financial institutions. It's comprised of a network of 12 Federal Reserve Banks and a number of branches. This is all overseen by the Fed's Board of Governors, which we'll detail a little later.

Besides being the nation's central bank, the Fed studies economic trends and makes policy decisions on how to make the economy "run better."

The Fed is an independent agency—which means it can make decisions on its own, without needing approval from any other branch of government. However, it is subject to questions from Congress over its actions. The Federal Reserve chairman regularly testifies to both the Senate and the House.

But while the Fed has to explain itself, it is theoretically free from political pressure. One caveat on this 'freedom'—Fed board members are nominated by the President and must be approved by the Senate.

What does the Federal Reserve System do?

The Fed's mandate is "to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates," according to the Federal Reserve's web site.

What does that mean? The Fed has to make sure the U.S. has a sound banking system and a healthy economy.

To do that, the Fed makes decisions over monetary policy to help maintain employment, keep prices stable, and keep interest rates at a level that helps the economy. It also supervises and regulates banks to make sure they are safe places for people to keep their money, and to protect consumers’ credit rights.

But there's more.

The Fed plays a major role in clearing checks, processing electronic payments, and distributing coin and paper money to the nation's banks, credit unions, savings and loan associations. For example, when you cash a check or have money electronically transferred, there is a good chance that a Fed Bank will handle the transfer of money from one bank to another.

The Federal Reserve System also conducts research on the U.S. and regional economies and distributes information about the economy to the public through published articles, speeches by board members, seminars and web sites.

This information is released to the public as part of the Fed's mandate to study the economy.

Two important outlets for this information are:

• The Beige Book—named this way because of the report's tan cover. It's a report published eight times per year. Each Federal Reserve bank gathers anecdotal information on current economic conditions in its district. The beige book generally consists of reports from bank and branch directors and interviews with key business contacts, economists, market experts, and other sources.
• Fed Minutes—these are notes from discussions the Federal Open Market Committee has over economic policy. They are released eight times a year, after each meeting. They often detail disagreements between members over what policy to follow.

These two reports are followed very closely—by the stock market and economists in general— to gauge how the economy is doing and what the Federal Reserve board is thinking.

When was the Federal Reserve created and why?

The U.S. Congress created the Federal Reserve System on December 23, 1913, with the signing of the Federal Reserve Act by then-President Woodrow Wilson.

Before then, the U.S. has had two major periods of central banks—which could be considered an over-simplified form of the Federal Reserve—one starting in 1791 and the other in 1816. Each was an attempt to create a disciplined banking policy and help avoid economic collapses.

However, fears of a central bank being too powerful in setting financial policy brought about their ends. Congress failed to renew the first national bank's charter in 1811.

The 1816 central bank period ended in 1836 when then President Andrew Jackson refused to renew its charter—claiming the bank would be run, in his words, by "Eastern Elites."

However, a series of U.S. bank collapses in 1873, 1893 and especially in 1907, pushed many in Congress to call once again for a centralized banking system.

In 1907, there was a massive run on the banks—people demanding their money—and the banks started recalling all of their loans to pay off customers. This was started after large blocks of fraudulent stocks and bonds were sold to corner the market on one firm—the United Copper Company.

The scheme failed and banks who were part of the effort went bankrupt—and that spread to other banks across the country.

The bank panic of 1907 resulted in a congressional investigation that concluded: "a central bank was necessary so that these kinds of panics would never happen again."

However, it wasn't until 1913 before a law was actually passed—when Congress was able to work out a compromise on the Fed's mandate.

What is monetary policy?

We've mentioned that the Fed makes decisions over monetary policy. So what is that? It's the regulation of interest rates and the availability of money in order to provide economic growth and prevent downturns. This is the nuts and bolts of what the Fed does.

If the economy needs to grow faster and create more jobs, the Fed can supply more credit to banks for lending.

It can also lower interest rates that banks use to borrow money from the Fed, making it cheaper for banks to lend. This is referred to as the Discount Rate—the interest rate that an eligible depository institution is charged to borrow short-term funds directly from a Federal Reserve Bank.

The Fed can also lower banks' reserves—meaning banks would need to carry less money on their books—and can lend more to businesses and consumers as well as to other banks. This tactic increases the money supply in the economy.

Another way the Fed increases the money supply is by buying government securities, like treasury bonds, from the public. This is a form of what's called quantitative easing . Buying government securities makes more money available with the aim of increasing consumer spending and boosting the economy.

Now, if the Fed believes the economy is growing too fast and needs to slow down and avoid inflation—the increased costs of goods and services—it's going to do the opposite of what we've just mentioned.

To put some brakes on the economy, the Fed will increase interest rates for borrowing, make banks hold on to more of their money and therefore decrease lending. It will also stop buying securities, a strategy that in turn cuts down on the amount of money that's in the economy.

What is the FOMC?

This is the group within the Fed that makes the decisions we just mentioned. FOMC stands for the Federal Open Market Committee .

The FOMC meets eight times per year to set key interest rates and to decide whether to increase or decrease the money supply—which the Fed does by buying and selling government securities.

The FOMC consists of 12 members—the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four of the other 11 Reserve Bank presidents.

The four Reserve Bank presidents serve one-year terms on a rotating basis. Non-voting Reserve Bank presidents attend the meetings of the Committee, participate in discussions, and contribute information about economic conditions in their District.

Where does the Fed get its money?

The Federal Reserve makes money—lots of it. The Fed has nearly $3 trillion in assets, as of July 2011. The majority of revenue comes from open market operations—specifically the interest on the Fed's portfolio of Treasury securities as well as the money that comes from the buying/selling of the securities and their derivatives.

Other Fed revenue come from sales of financial services like check and electronic payment processing and discount loans to banks. There's also interest on foreign deposits within the Federal Banking system.

However, the Fed doesn't really keep the money. The government receives all of the system's annual profits—after certain expenses. In 2010, the Federal Reserve made a profit of $82 billion and transferred $79 billion to the U.S. Treasury.