U.S. Treasury Securities

The Federal Reserve System, often called the Fed, FRB or Federal Reserve, was created by Congress through the Federal Reserve Act of 1913 to serve as the central bank of the United States. It is not technically one bank but, rather, a system of 12 regional Federal Reserve banks. The Fed’s purpose is to provide the nation with a safe, flexible, and ultimately more stable monetary and financial system.

Duties of the Federal Reserve

Over the years, the Fed’s role in banking and the economy has expanded. The duties of the Fed are (according to the Federal Reserve website):

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

▪  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

▪  Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

▪  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”

Overseeing the Federal Reserve System is the seven-member Federal Reserve Board of Governors; each member is nominated by the President, confirmed by the Senate, and serves a 14-year term. From this Board of Governors, the President nominates a Chairman and Vice Chairman 4-year term (who must also be confirmed by the Senate) to serve 4-year terms.

Monetary Policy Tools

The Federal Reserve has three primary monetary policy tools:

(1) Open Market Operations

(2) Discount Rate

(3) Reserve Requirements

Open Market Operations

The Fed can buy and sell U.S. Treasury securities through its Open Markets Desk at the Federal Reserve Bank of New York, increasing or tightening the money supply by increasing or reducing the overall reserve balances of banks deposited at the Federal Reserve.

The Federal Funds (“Fed Funds”) rate is a rate negotiated between banks to borrow or lend Federal Reserve balances. Banks with excess reserves may lend to other banks with insufficient reserves. The demand and supply of reserves affect the Fed Funds rate. The Federal Reserve has the ability to increase or decrease the total supply of reserves in the system through its Open Market Operations by buying or selling U.S. Treasury securities with a list of designated banks and dealers it trades with, called the Primary Dealers.

When the Fed buys U.S. Treasury securities, it credits the selling bank’s reserve account. This increases (or eases) the overall supply of reserves in the system, thus lowering the Fed Funds rate and increasing the money supply. Conversely, when the Fed sells U.S. treasuries, it debits the buying bank’s reserve account, which decreases the overall supply of reserves, thus raising the Fed Funds rate and reducing the money supply.

Open Market Operations are the Fed’s main primary and preferred tool for effecting monetary policy.

Discount Rate

The Federal Open Market Committee (FOMC) meets eight times per year to set monetary policy. The FOMC consists of twelve 
members; the seven members of the Fed’s Board of Governors, the President of the Federal Reserve Bank of New York and Presidents from four of the remaining eleven Reserve Banks (who serve one year terms on a rotating basis). The other seven Reserve Bank Presidents attend FOMC meetings and participate in discussions but do not vote. The Chairman of the Federal Reserve is also the Chairman of the FOMC.

At its meetings, the FOMC sets the Discount Rate and the target Fed Funds rate. The Discount Rate is the rate at which member banks can borrow reserves
 directly from the Fed, or the “Discount Window”. Typically, this rate is slightly higher than the Fed Funds rate because the Fed prefers to have banks borrow reserves from other banks. Historically, borrowing from the Discount Window was perceived as a sign of weakness. But in recent years, particularly as a result of the latest financial crisis, it has become more acceptable for banks to borrow directly from the Fed.

Unlike the Discount Rate, 
the FOMC cannot set the Fed Funds rate. This rate is negotiated between banks and dealers in the open market. Instead the FOMC establishes a target Fed Funds rate (which can be influenced through Open Market Operations).

Reserve Requirements

The Reserve Requirements for Depository Institutions, also called Regulation D, is a 
Federal Reserve regulation requiring all banks and other financial institutions that accept deposits to keep a percentage of these deposits in reserves.

As of 2006, the minimum required reserve ratio for most banks (depending on deposit size) is 10% of transaction deposits, which typically applies to checking, savings and other on-demand accounts. This regulation can be met with either Vault Cash and/or a deposit at the Fed.

Vault cash is the actual cash that the bank keeps available to meet the cash demands of its customers. The difference between the Minimum Reserve Requirement and Vault Cash must be deposited at the Fed. If a bank does not have enough reserves at the Fed, it must borrow them from other banks in the Fed Funds market. Conversely, excess reserves may be loaned to other banks.

The Federal Reserve has the ability to change the Reserve Ratio, (the percentage of banks’ deposits that must be held in reserve). But this power is rarely 
used as it causes significant financial disruption to banks with low reserve balances.

Federal Reserve Links

Federal Reserve: http://www.federalreserve.gov/

Federal Reserve Bank of New York: http://www.nyfed.org/

Primary Dealers: www.newyorkfed.org/markets/pridealers_current.html