There’s just something about panic and uncertainty that people don’t like. Conversely, certainty and consistency build trust. After all, when you’re confident that everything is and will be steady for the foreseeable future, when you have a pretty good idea of what to expect, you can calmly, rationally, and confidently make decisions. In the world of finance and especially to anyone using the U.S. Dollar, one of the main watchmen and guarantors of that trust and certainty is the Federal Reserve. Though it’s not uncommon to have heard of “the Fed,” especially when it comes to things like interest rates, actually understanding the what, why, and how of the Federal Reserve is slightly more difficult.
Starting with the terminology, the first half of the term, Federal, comes from the French fédéral which is derived from the Latin foedus (genitive foederis), meaning ‘covenant, treaty, or league’, and was first used to denote a form of government where numerous states combine to form a singular political unit (yet retain a certain degree of autonomy) in James Hodges’ 1703 work The Rights and Interests of the Two British Monarchies. Treatise I., which defines the term as: “A Confederate or Federal Union is that, whereby Distinct, Free, and Independent Kingdoms, Dominions or States, do unite their separate Interests into one common Interest, for the mutual benefit of both, so far as relates to certain Conditions and Articles agreed upon betwixt them, retaining in the meantime their several Independencies, National Distinctions, and the different Laws, Customs, and Government of each.” Reserve, coming from the Middle French reserver, which is derived from the Latin reservare, meaning ‘to keep back, retain, withhold’, was first used in the sense of a stock or unused quantity of something by Sir Thomas Browne in his 1646 work denouncing errors and superstitions of the age, Pseudodoxia Epidemica (literally Vulgar Errors), stating that: “A Reserve of Childishness we have not shaken off from School.” Combining these two terms and viewing them through a financial lens, the Federal Reserve is a central government agency in a system of separate powers that is tasked with maintaining monetary stability by acting as a reserve (among other things).
First mentioned in writing by The Wall Street Journal on the 4 June, 1913: “It has been suggested that the Treasury Department establish a division to be called the ‘Federal Reserve Division’, which should conduct reserve agencies in each reserve city to exercise the functions of the proposed reserve banks.”, and created on December 23, 1913 via the Federal Reserve Act of 1913 after a number of financial panics, notably the Panic of 1907, the Federal Reserve was established as an independent central bank to provide stability by preventing panics and economic disruption caused by business and bank failures. Overall, the operations of the Federal Reserve can be broken down into four areas:
- Enacting national monetary policy via monetary and credit conditions in the US to ensure maximum employment, price stability (inflation), and moderate long-term interest rates.
- Regulate banking institutions to ensure systemic safety and protect consumer rights.
- Maintain overall stability of the financial system and contain systemic risk.
- Provide financial services to depository institutions, the U.S. government and foreign institutions.
Understandably, fulfilling these varied roles is quite a substantial order. And to accomplish these tasks, the Federal Reserve employs a number of tools. For example, in order to change the amount of reserves a private bank must keep, the Fed can change the interest rate that banks charge each other for overnight loans of federal funds, set the rate for overnight loans that member banks borrow directly from the Fed, or simply change the fractional reserve requirement, meaning the amount of currency reserves that a commercial bank must maintain. Aside from these standard tools, specific new tools, such as those implemented during the Great Recession (Term Auction Facility, Term Securities Lending Facility, and Primary Dealer Credit Facility, etc.) have also been used when necessary and, in need persists, rolled into the Fed’s permanent arsenal of tools. Finally, of course, is one of the more controversial tools – a “nuclear option,” if you prefer – quantitative policy, which involves the Federal Reserve taking an active role in the market and buying corporate bonds and mortgage-backed securities held by banks or other financial institutions, thus freeing up capital in order to restore normal business functions.
As the common saying goes, “If the Federal Reserve had access to nuclear weapons, they’d be the most powerful entity on Earth.” For an independent federal agency with only twelve regional banks and a board of governors consisting of only seven members, this may seem like an overstatement, but, when considering the immense power, the Federal Reserve wields, there’s more than a grain of truth to that statement.