How the Fed is run, and what it does

By , Staff writer of The Christian Science Monitor

Ben Bernanke has been nominated to hold what is arguably the world's most influential seat of financial power. Yet the job of Federal Reserve chairman is also little understood. Here is a primer on the nation's central bank:

Why does the Federal Reserve exist?

In the early 1900s, the United States was a fast-growing industrial power with a history of periodic banking crises - and a populist wariness of creating a powerful central bank. The Federal Reserve Act of 1913 created a partially decentralized system that evolved, by the 1940s, mechanisms to maintain price stability and prevent financial panics that could cause bank failures and depression. Some of the Fed's jobs are mundane - such as processing millions of private checks and electronic payments as they flow through the US banking system. But its larger mission is to maintain confidence in the wider system of private banking.

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Who runs the Fed?

A seven-member Board of Governors, led by a chairman and vice chairman, steers the Fed nationally. The Board members are appointed by the president and confirmed by the Senate, and they serve 14-year terms that are staggered to maintain a degree of continuity. Twelve regional Federal Reserve Banks, meanwhile, operate under the Board's general oversight. Each regional bank is headed by a president chosen by that bank's board of directors, subject to approval by the Fed's national board.

What does the chairman do?

While he gets the same single vote as other officials at key meetings, the chairman takes the lead role in guiding Fed policy. He is also the most public face of the Fed to the outside world, testifying to Congress semiannually and often moving markets with words of calm or blunt warnings about economic conditions.

How does monetary policy work?

Setting US monetary policy - influencing the cost and availability of money or credit - is the activity that generally puts the Fed in the news. The goal is to provide a stable climate for business growth - and to head off uncontrolled inflation or deflation. The Fed has three levers that influence the monetary climate. First, it tells deposit-taking institutions what share of funds must be held in reserve against deposit liabilities. Second, it sets the "discount rate," the interest rate charged on loans from the Fed to private banks. Third, and most prominent, the Fed can buy and sell US Treasury securities to influence the availability of credit. If the Fed wants credit to be more available, it buys securities and pays by crediting the reserves of private banks involved in the transaction. Banks thus have more money to lend. As the money supply expands, interest rates should fall. When the Fed sells securities, banks end up with less money to lend. Interest rates should rise.

The Fed's objective in these transactions is often to make the "federal funds rate," the interest that banks charge one another for overnight loans, hit a Fed-ordained target.

How are interest rates set?

The target for the federal funds rate is decided by majority vote at regular meetings of the Federal Open Market Committee, which generally meets eight times a year. The panel, headed by the Fed chairman, includes the Fed governors, the head of the Federal Reserve Bank of New York, and the presidents of four other regional Fed banks (serving in rotation). Their goal in raising interest rates is usually to prevent a cycle of easy credit that could propel consumer and business spending into an inflationary spiral. Their goal in lowering interest rates is typically to make sure the economy has an adequate supply of money to grow at its "real" (noninflationary) potential. Too tight a policy can choke the economy into a recession.

The Fed doesn't directly set the rates that banks charge on home mortgages, credit cards, and the like. But the private marketplace for credit is influenced by the Fed - not only by its actions, but also by its statements about the economy, which hint at future policy steps.

How does the Fed relate to other public and private financial institutions?

For all the Fed's power, other bodies such as private investment banks and the central banks of other nations wield their own large clout. Still, in addition the activities outlined above, the Fed has other roles. It works with other agencies to supervise private banks. And it cooperates with branches of the US Treasury to help put new currency into circulation, or to destroy old currency and coin.

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