by James Copenhaver, Director of Investment Management, Wealth Enhancement Group

Spring is here – a great time to put your “financial house” on your spring cleaning to-do list. As you may have heard, the Federal Reserve System is doing its own spring cleaning this year as it begins paring its multi-trillion dollar balance sheet. Many of us know “the Fed” at a high level and are aware that it has taken extraordinary actions during the recent financial crisis, but bring it up at a cocktail party and you are likely to get a lot of shoulder shrugs. This month we will go over some general facts about this important organization. Next month, we will take a look at the unprecedented actions the Federal Reserve has taken and how it is winding down much of the financial intervention measures used during the crisis.

The Federal Reserve System was created by Congress in 1913 to address recurrent banking panics in the United States. Although most citizens agreed the banking system needed to be addressed, the idea of a central bank was controversial because it would have to equally balance the needs of all areas of the United States without having preference to the East Coast money hub. It was designed to facilitate the exchange of payments and act as the “bankers’ bank” across all regions of the U.S. Since its inception, the responsibilities of the Federal Reserve have increased to generally promote a sound banking system and healthy economy.

The Federal Reserve System has three main components: the Board of Governors, Federal Reserve Banks, and the Federal Open Market Committee. The Board of Governors is the national component based in Washington D.C. The Board consists of seven governors serving fourteen-year terms, with each governor appointed by the President of the United States and confirmed by Congress. The position of Chairman, currently held by Ben Bernanke, is an appointed four-year term. The Board works to guide monetary policy, to analyze economic conditions, to supervise the financial services industry and payments system, and to oversee the Reserve Banks.

The twelve regional Federal Reserve Banks and twenty-five branches are the actual operating arms of the Federal Reserve System. These banks supervise commercial banks in their regions and also serve them by storing currency, processing payments, and conducting regionally important research. The Reserve Banks also act as the bank for the Federal Government, collecting and distributing payments, facilitating sales of Treasuries, and assisting with cash management and investment activities.

The Federal Open Market Committee (FOMC) is responsible for directing monetary policy and managing the nation’s money supply. The group’s twelve voting members consist of the seven governors of the Board, the president of Federal Reserve Bank of New York, and four other Reserve Bank presidents, who serve on a rotating basis. The mandate of the FOMC is to keep inflation low and the economy growing at a sustainable rate. This is done through a process of managing the money supply, predominantly by buying and selling government securities through open market operations.

If the Federal Reserve buys securities, it is issuing money to the seller, who then distributes the money through the financial system. If the Federal Reserve sells securities, it removes the security from its reserves and the money collected is removed from the system. In theory, supply and demand work to set the interest rates. The more money available, the less valuable it is and the less people will pay for it in terms of interest rates.

Next month we will take a look at the question: what would the Fed do if there was a theoretically adequate money supply but banks and investors were still reluctant to lend to one another?