What is the Fed?
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This article originally appeared in MarketToday on 4/15/10

What does the Federal Reserve System do? We throw around names for institutions and many may not know what they do, why they were created in the first place, and how they work. Occasionally, we have a new customer to our premium services that is overwhelmed by all of the jargon in the world of investing.

We try to limit this, but it does creep into our lexicon when we deal in the markets every day. I dare guess, many of us that speak of some entities with authority, may not have knowledge deeper than passing familiarity.

The Federal Reserve System was created by an act of congress in 1913. It was done in the wee hours of the morning, with Republican’s kept in the dark. Does it sound familiar?

The Democrats held a majority in the Senate, and under President Woodrow Wilson (D), were willing to run over the opposition.  Witness the report on The Incredibal Timeline that created the Federal Reserve in 1913, 96 years ago.

“The Federal Reserve Act was scheduled during the unlikely hours of 1.30 am to 4.30 am…on Monday 22 December 1913, at which 20 to 40 substantial differences in the House and Senate versions were supposedly described, deliberated upon, debated, reconciled and voted upon in a near-miraculous four-and-a-half to nine minutes per item…

At 4.30 am, a prepared report of this Committee was handed to the printers. Senator Bristow of Kansas, the Republican leader, stated on the Congressional Record that the Conference Committee had met without notifying them (Republicans), and that Republicans were not present and were given no opportunity either to read or sign the Conference Committee report. The Conference report is normally read on the Senate floor. The Republicans did not even see the report. Some senators stated on the floor of the Senate that they had no knowledge of the contents of the Bill.

At 6.02 PM on 23 December, when many members had already left the Capital for the Christmas holiday, the very same day that the Bill was hurried through the House and Senate, President Woodrow Wilson signed the Federal Reserve Act of 1913 into law.”

Before the Federal Reserve System, and the resulting fractional banking system, banks maintained reserves in cash to pay depositors that wanted to withdraw funds.  When a “bank run” occurred, the victim bank could quickly run out of cash.  Nationally Chartered banks held treasury bonds, and deposited funds in ‘reserve’ banks.  When treasury bonds declined in value, the bank’s assets were reduced, this is what we call today “mark to market.”

The Federal Reserve stated duties are:

1.) Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.

2.) Supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers.

3.) Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.

4.) Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system.

One can argue they have done a woeful job on numbers two and three.

We think of the first duty listed as the most nefarious. This is where the Fed causes the most problems. The tug of war between maintaining high employment, stable prices (inflation) and moderate long term interest rates is subject to political calculations. Balancing these different duties is what leads to real estate bubbles. Inflation in the eighties, to pay for the Vietnam War, was a result of the Fed trying to serve its master.  Inflation let the government pay off debts with cheaper money.

The Federal Reserve follows Keynesian economics, increasing money supply to prime the pump. The problem is they always talk about taking away the punch bowl once the party is going, but never do. Again, witness the real estate bubble we are presently paying for. If you would like to go back further, read about the roaring ‘20’s. The Federal Reserve inflated the money supply to pay for WWI, keeping interest rates low. This fueled the stock market to new highs on speculation. When loans were pulled back on the margins, the slide began.

How is the Federal Reserve Organized?  There are seven Federal Reserve governors appointed by the President and confirmed by the Senate.  These seven positions include the Chairman (Bernanke) and a Vice-Chairman.  There are twelve independent Federal Reserve Bank districts that operate 25 branches.   Each chooses their district president.

The Federal Open Market Committee (FOMC) overseas monetary policy.  The FOMC consists of the seven governors, and five of the district presidents.  The New York Fed President is always one of the five, with the other four positions rotated among the other eleven Districts.

The New York Federal Reserve is always one of the districts represented on the FOMC because they are solely responsible for all “open market operations.” Open market operations are the process of managing the money supply. Money supply is managed with buying and selling in government securities, or until recently mortgage backed securities (MBS).  Buying securities increases money supply, selling securities decreases money supply.

The Board of Governors appoints three members to each of the twelve local district boards.  The other board members are nominated by member banks.

Federal governors serve a 14 year term.  Positions are rotated, so presidents cannot “stack” the board.  Senator Chris Dodd withheld two appointments by former President Bush.  This has allowed Obama to appoint those two, plus the vice-chair has resigned and must be replaced.  These three plus re-appointing Bernanke has allowed Obama to appoint four board members in his first year.

I hope this has helped you understand the Federal Reserve System.

Sources for this article: federalreserve.gov, Wikipedia.org, seekingalpha.com, hubpages.com, lewrockwell.com

Speaking of the creation of the Federal Reserve:
"This Act establishes the most gigantic trust on earth... The worst legislative crime of the ages is perpetrated by this banking and currency Bill."-Rep. Charles A. Lindbergh, Sr.

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions. It may contain errors and you should not make investment decisions based solely on what you believe you have read here. Do your own research, it is your money. If you lose it, it is your responsibility, not ours or your grandmothers! The editor may or may not have a position in any securities discussed. The editor may have held a position in a security earlier, or in the future.

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