How the Fed Works: The Nation's Central Bankers, Supposedly Insulated from Politics, Try to Keep Monetary Policy on an Even Keel-And the Economic Ship of State Moving Forward. Kevin Hassett, a Former Fed Economist Himself, Tells All

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1 What is the Federal Reserve?

For 94 years, the Fed has been the central bank of the United States. its primary duties are conducting the nation's monetary policy, supervising and regulating banks, and providing financial services and liquidity (that is, ready cash) to depository institutions and the federal government.

Providing liquidity sometimes means being a lender of last resort. A lender of last resort can save a bank during a run by providing cash to the embattled financial institution. Throughout the early history of the United States, there was no official lender of last resort. Following a severe bank panic in 1907, the worst of four panics over a 34-year period, Congress appointed a commission to study the issue. The result was the Federal Reserve Act of 1913, which established the Federal Reserve System.

The Fed is widely dispersed around the country. It has three major parts: the Washington-based Board of Governors, 12 regional Federal Reserve banks, and the Federal Open Market Committee (FOMC).

It is the FOMC, whose members include all of the governors, the president of the New York Fed, and four regional bank presidents in rotation, that has the high visibility job of directing the operations that determine interest rates.

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2 Who owns the Fed?

The Fed as a whole is a government organization that is not really owned by anyone, but each regional Federal Reserve bank is technically owned by the private commercial banks in its district.

Each of the regional Fed banks has its own board of governors and issues stock to commercial banks, which are required to purchase shares equal in value to 6 percent of their capital. The regional Fed bank actually holds only half of that money, the rest being "subject to call" by the governors in case of an extreme liquidity crisis. Owning stock, however, does not grant authority, much less control. Member commercial banks do receive a 6 percent dividend on their paid-in stock, but they cannot sell the stock or use it as collateral for loans. In addition, the Fed's Board of Governors in Washington-not the boards of the regional Reserve banks-is responsible for regulatory functions.

3 Where does the Fed get its money?

The main source of income is seigniorage revenue. Whenever the Fed increases the amount of money in circulation, it purchases new currency from the U.5. Treasury for cents on the dollar. For example, if a member bank needs an extra million dollars, it calls the Fed to order currency, and the Fed asks the Treasury to print the amount. The Fed gives the money to the bank, and debits the bank's reserve account. The Fed then invests the reserves in government securities as collateral, and profits from the interest accrue to its own account. In 2006, after accounting for expenses, the Fed returned $29 billion in profits to the U.S. Treasury (Figure 1).

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4 Do Congress and the President influence the Fed?

The founders of the Federal Reserve understood that sound monetary policy requires central bankers to make unpopular decisions. As a result, the 1913 law gave the Fed a much higher degree of independence than other government agencies. The Fed has its own source of funds, so Congress cannot guide monetary policy through withholding or bestowing appropriations. Governors are appointed for 14-year terms, tenure that is second in length only to the lifetime appointments of federal judges.

But the independence has boundaries. Each member of the seven-person Board of Governors is appointed by the President and confirmed by the Senate. The Federal Reserve must report annually to the Speaker of the House and twice annually to the banking committees of Congress. Of course, Congress can pass new laws affecting the Fed at any time. And Fed bankers read the newspapers. They aren't completely insulated from politics. …