What is the “Federal Reserve”?

The Federal Reserve System, the “Federal Reserve”, or often just ‘the Fed,’ is actually the central bank of the USA. It was established in 1913 by then President, Woodrow Wilson, signing the Federal Reserve Act into law. The purpose for the creation of the Fed was to provide the nation with an economic system offering greater stability and flexibility. The three key objectives of the Act are establishing and maintaining maximum employment, stable prices, and moderate long-term interest rates.

Who Controls the Fed?

The Fed derives its authority from the Congress of the United States. It is governed by the Federal Reserve Board which comprises seven members. These members are nominated by the President of the United States, and are then confirmed by the US Senate. Each member may serve a full-term of 14 years.

What are the Functions of the Federal Reserve?

The primary functions of the Fed fall into several areas. One of its key responsibilities is the regulation of banking and financial institutions. This duty includes ensuring the compliance of banks with laws and regulations, including consumer protection laws.

Another major responsibility of the Fed is creating and implementing the nation's monetary policy. The influencing of money and credit conditions in the economy is conducted in keeping with the objectives of maximum employment and stable prices. The basis of conducting this monetary policy involves controlling the availability and cost of money and credit in order to encourage a healthy economy.

Adjusting the interest rates is one of the functions of the Fed, and this is done through the buying or selling of government backed securities. Buying a large amount of these securities creates a surge of cash-flow into the banking system, a process known as quantitative easing, and thereby allows the interest rates to lower. Conversely, selling substantial quantities of the securities effects a raising of interest rates as the cash-flow in the banking system is reduced.

A special policy, officially named the maturity extension program, but commonly referred to as Operation Twist, was implemented by the Fed in late 2011. The basis of this operation was buying long-term Treasury bonds while concurrently selling the shorter-dated bonds it already held to facilitate the lowering of long-term interest rates.

The third major area of responsibility of the Fed is to maintain stability in the financial system and to manage potential systematic risk in financial markets. Systematic risk can result from war and political turmoil, as well as from recession and interest rates. This type of risk affects the entire market, and therefore cannot be managed by diversification. The management of systematic risk may include strategies such as taking control of a major market player such as a hedge fund that has ventured into dangerous territory. The Fed may also use methods such as the cost and increasing the amount of credit available to commercial banks in order to enable the flow of capital in credit markets.

The fourth major role of the Fed is as the bankers’ bank as well as the bank of the government. The Federal Reserve Banks provide services to banks and credit unions in the same manner that these financial institutions offer services to consumers. These services include the collection of checks and the transfer of funds electronically. The services that the Fed provides to the government incorporate the selling and redeeming of government securities.

How the Fed Affects the Stock Market

As almost any trader will attest, the actions of the Fed have a huge impact on the movement of the stock market. This is also true when a certain move by the Fed is anticipated, and then does not eventuate.

A regular event that has great influence on the market is the meeting of the Federal Open Market Committee which occurs eight times a year. At these meetings, the rate of interest for the major Federal Reserve funds is set, and other interest rates follow the direction of this rate.

In Conclusion

Understanding the structure and purpose of the Federal Reserve, and how it affects the economy, interest rates and, as a result, the stock market; is an important part of a trader’s knowledge.