Central Banking and the Federal Reserve: Structure, FOMC, and Tools
Structure of the System
The Fed, created in 1913, has three parts. The Board of Governors (seven members, 14-year staggered terms, appointed by the President and confirmed by the Senate) supervises bank holding companies and sets reserve requirements and the discount rate (subject to Reserve Bank approval). The twelve Reserve Banks, owned by member banks but operationally public, clear checks, distribute currency, supervise banks, and lend through the discount window. The New York Fed conducts open market operations and runs the foreign exchange desk.
The FOMC
The Federal Open Market Committee has 12 voting members: the seven governors, the New York Fed president, and four of the remaining eleven Reserve Bank presidents, who rotate annually (Chicago and Cleveland share one seat). The Chair leads the Committee. It meets eight times a year and sets a target range for the federal funds rate.
Tools
- Open market operations - the primary, continuous tool. Buying securities adds reserves and pushes the funds rate down.
- Discount window - lending at the primary credit rate; a ceiling in normal times.
- Reserve requirements - rarely adjusted; the ratio on transaction deposits was set to zero in 2020.
- Post-2008 additions - interest on reserve balances (a floor under the funds rate), overnight reverse repos, and large-scale asset purchases (quantitative easing).
Independence and mandate
The Fed has instrument independence: it chooses tools without political approval, while Congress sets goals - the dual mandate of maximum employment and price stability, with a 2% longer-run inflation target formalized in 2012. The Fed is self-financed from securities earnings, not a congressional appropriation.
Worked example
The Fed wants a lower funds rate, so it buys $2 billion of Treasuries from dealers. Dealer bank reserves rise by $2 billion, the supply of federal funds shifts right, and the effective rate falls toward the target range. The Fed's balance sheet expands; deposits and the money supply can eventually rise by a multiple of the reserve injection.
Traps
Confusing the Board with the FOMC; assuming all twelve Reserve Bank presidents vote; treating the discount rate as the policy rate; forgetting that the funds rate is a market rate the Fed targets, not a rate it sets by decree.