What is the U.S. Federal Reserve and what is its role?

A central bank is an institution that manages a country’s money supply and monetary policy with the aim of ensuring that financial conditions remain stable and conducive to growth. Central banks have existed in one form or another for over 300 years and are an essential component of the financial system of almost every country globally. We take a closer look at the central bank of the United States—one of the most influential institutions in the world.

What is the U.S. Federal Reserve?

In the United States, we refer to the U.S. Federal Reserve (Fed) as the central bank, but it’s a Federal Reserve System consisting of:

  • 12 regional Federal Reserve banks
  • The Board of Governors—seven members nominated by the president of the United States and confirmed by the U.S. Senate
  • The Federal Open Market Committee (FOMC), which includes the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of 4 of the 11 regional Federal Reserve banks, each serving one-year terms on a rotating basis.
Regional Federal Reserve banks have responsibility for specific geographic regions
A map of the United States showing the regions that each Federal Reserve bank is responsible for, as well as the location of the Board of Governors in Washington.

Source: U.S. Federal Reserve, John Hancock Investment Management, April 2022.

The 12 regional Federal Reserve banks are the operating arms of the Fed and help implement monetary policy. They’re responsible for monitoring member banks in their jurisdiction and represent the communities within their regions when important economic decisions are made, such as setting interest rates.

What is the Fed responsible for?

The Fed’s responsibilities range from formulating relevant regulation to managing money supply and inflation. Ultimately, its core objective and responsibility is to achieve a stable economic environment that serves the interests of the public.

Some of the Fed’s primary responsibilities include:

  • Price stability and maximum employment

Unlike other central banks such as the Bank of England and the European Central Bank, which focus primarily on price stability (i.e., ensuring that inflation doesn’t get out of hand), the Fed has a so-called dual mandate, meaning it has the twin goal of achieving maximum sustainable employment as well as price stability.

  • Supervision and regulation

The Fed monitors the activities of member banks and other financial institutions to ensure financial soundness and compliance with financial regulation. This ensures overall stability of the financial system and means that financial institutions can provide individuals, businesses, and communities with the resources they need.

  • Distributing money and facilitating payments

Distributing money—currency and coin—throughout the economy is another Fed responsibility. This includes check collection and processing, which mostly takes place electronically. These aspects, in addition to other transactions, form part of the country’s payment system. The Fed plays a key role in ensuring that the payment system is reliable and, therefore, able to contribute to a stable financial system.

What is monetary policy?

Monetary policy is set by the FOMC and is essentially the Fed’s tool kit for achieving many of its objectives. 

Infographic showing the responsibilities of the FOMC as open market operations, setting reserve requirements and the discount rate, nontraditional monetary policy, and FOMC communications.
  • Open market operations—the buying and selling of government securities on the open market to affect the federal funds rate.
  • Reserve requirements—stipulating the amount of cash deposits that banks must keep in reserve and not lend out. This is usually expressed as a percentage of total deposits.
  • Discount rate—setting the federal funds rate, which is the interest rate that Federal Reserve banks charge to other financial institutions for short-term loans (usually overnight to help each other meet reserve requirements).
  • Nontraditional monetary policy—a set of policies used by central banks when traditional monetary policy may not be effective. These can include large-scale asset purchases that increase money supply, thereby encouraging lending and investment.

FOMC communications are also considered key tools that provide important forward guidance to financial markets and the public on intended monetary policy actions. Among other things, communications take the form of meeting minutes, videos, speeches, and the Fed’s dot plot, showing its projections for the federal funds rate. These are typically released after each of the eight FOMC meetings held every year, which highlight factors that reinforce the Fed’s chosen monetary path or issues that may necessitate policy adjustments in the future. These communications prove extremely important to investors and can help inform business decisions.

What is meant by expansionary or contractionary monetary policy?

The Fed’s key objective of ensuring economic stability—primarily through low and stable inflation—requires it to continually monitor, and respond to, changing economic cycles. In an expansionary phase, the Fed aims to encourage individuals and businesses to spend more, leading to overall economic growth. In achieving this, it may choose to deploy specific tools. For example, lowering bank reserve requirements can have the effect of making credit more easily available. Similarly, cuts to the federal funds rate lead to banks lowering the interest rates they charge businesses and individuals, who can then spend more and contribute to economic growth.

In a contractionary phase, the Fed aims to slow an economy that’s displaying signs of overheating. In this instance, it may use different tools such as selling government securities on the open market or raising the federal funds rate. The former has the effect of reducing overall money supply, while the latter makes borrowing for individuals and businesses more expensive. Both actions lead to less spending in the economy.

Is the Fed independent?

The Fed isn’t part of the U.S. federal government. Experience globally has shown that central banks are most effective when they can make decisions without political influence. In the United States, Congress sets monetary policy goals for the Fed—maximum employment, stable inflation, and moderate long-term interest rates—but the Fed independently makes decisions based on best-available evidence and analysis, and in the best interests of the public, as required by the Federal Reserve Act.

A key financial institution globally

The Fed is one of the most important financial institutions in the world. Many central banks globally keep a close watch on the Fed’s actions on a range of issues from interest rates to asset purchases, and financial regulation. Moreover, as the Fed manages the supply of the U.S. dollar—the most widely used currency globally—any decisions it makes may have wide-ranging consequences not only for domestic individuals and businesses, but also for international trading partners and other countries. This makes the Fed a pivotal part of the global financial system. 

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