THE BLOG

What Exactly Is 'The Fed' Reserving?

03/13/2014 11:04 am ET | Updated May 13, 2014

We live in a world that is dominated by policymakers. Thanks to an anemic recovery and a world where uncertainty defies quantification, central bankers are the shamans of today.

Few are more influential than the Federal Reserve, particularly in the aftermath of 2007-09. The Fed sets monetary policy for the U.S. and arguably -- given the U.S.' financial clout -- is the de-facto central bank for much of the world. Every word and decision is carefully scrutinized by the financial markets, much as ancient soothsayers may have read tea leaves or entrails. And their varying interpretations lead to dramatic swings of emotion that have a very real impact on Main Street.

The Fed is both the savior and the bogeyman of tomorrow. Yet amidst all the rhetoric and dogma, there are many questions about how The Fed operates.

Here are five things to think about regarding the Federal Reserve:

1. Is The Fed a public or private organization?

The Federal Reserve is a strange beast that is neither public nor private. This is a state of affairs rooted in its original purpose. At the end of the 19th century, a series of U.S. bank panics led to recurrent financial crises. It culminated in the Panic of 1907, which led an exasperated French banker to describe the U.S. as "a great financial nuisance". The result was the creation of the Federal Reserve in 1913 to provide a stable financial infrastructure that could balance the needs of the public and private banks in times of stress.

Today, the Fed is a unique polyglot comprising both public and private aspects. At the bottom sit its member banks. The member banks are all private banks -- over 3,000 at last count. At the top sits the Board of Governors of the Federal Reserve System, which is a public entity and whose seven members are appointed by the president.

It gets complicated in between. Bridging the divide between public and private spheres sit twelve regional Federal Reserve Banks. These are owned by the private member banks but their policies are set by the Board of Governors. Each has a board of directors, appointed by both the Board of Governors and the member banks. Even the division of monies spans both worlds. The regional Feds pay a 6 percent dividend to the member banks, with any additional earnings above that going to the Treasury.

The FOMC (Federal Open Market Committee), which sets the monetary policy of the U.S., is a similar hybrid. It contains all seven members of the Board of Governors and the presidents of the twelve regional Feds, though only five of the latter may vote at any given time.

2. Does The Fed control the economy?

This would be nice if it were true. The Federal Reserve has a pervasive influence on the U.S. economy. In recent years, its role and prominence have grown, as people turn to the Fed to nurture the U.S. economy back to sustained growth. But belief is distinct from fact.

The Federal Reserve actually only controls a very small though key part of the economic environment -- short-term interest rates. It sets the interest rates that commercial banks are charged when they borrow overnight from their regional Fed bank. It also influences the rate at which banks lend reserves to each other by buying and selling U.S. securities to adjust the amount of money available.

Over the years, tools have been added to the above. The Fed sets the level of reserves that banks have to keep at their regional Feds, which controls at a crude level their ability to leverage up and make loans. More lately, it also can extend credit to banks, buy assets and inject money into the system -- all of which were used to powerful effect in the recent crisis.

But everything else sits outside the Fed's direct control. Modern banking is typified by fractional reserving, a notion where the money deposited is loaned out repeatedly and only a small amount held back in reserve. The bank is borrowing from you (what did you think that low interest rate was for?). Through this provision of credit, the economy receives a huge influx of capital to help it grow.

For all its best intentions, the Fed only controls the smallest modicum of what can be construed as money. The wider world of money and credit -- checking accounts, mortgages, business lending, derivatives and so on -- these all are driven by forces of supply and demand that the Fed has no power over. It cannot tell people how much to save or borrow. It cannot order banks who to lend to and who not to. It does not regulate financial activities. It has no ability to set the other great part of economic policy -- fiscal policy -- which is controlled by Congress.

The Fed can only hope to influence people and markets through the mallet-like base tools at its disposal. Raise interest rates today and it becomes more expensive to borrow. Cut them or inject money and it becomes cheaper. Everything else is based on the Fed's credibility and the emotional trust of the people it hopes to influence.

3. Does The Fed Cost Tax Payers Money?

Contrary to rhetoric, the Fed does not cost the U.S. taxpayer anything. The private member banks contribute share capital that funds the whole enterprise. The salaries of all the employees and management as well as the ongoing operations are paid by its own income.

Indeed, the Fed actually is a valuable source of subsidy and revenue to the U.S. government. All the interest income from the Treasuries it owns is rebated back to the Treasury as are any profits from its other holdings (all after the 6 percent dividend). In recent years, as the Fed's balance sheet has grown dramatically in size, so have the returns to government. The Fed rebated $47 billion in 2009 and $88 billion in 2012. The real question, some may argue, perhaps is whether the Fed is actually the best hedge fund in history.

4. Is The Fed an Independent Organization?

The Fed is often viewed as an independent central bank. It controls interest rates as well as the supply of money, and does not need Congressional permission to make changes. The upkeep is not paid for by the government.

However, this is not the same as independence in practice. The Board of Governors is appointed by the President and needs to be approved by the Senate. Consequently, throughout recent U.S. history, there is a remarkable convergence of policy between the executive and monetary authorities. Past chairmen such as Arthur Burns, Paul Volcker, Alan Greenspan and Ben Bernanke have all needed support from the incumbent Presidents to push through their monetary policies. They have also often been supportive in many cases to the needs of government, alternately supporting growth and fighting economic fires.

Most recently, it is only through the Fed's help in purchasing large amounts of government Treasuries and distressed assets that the government has been able to run large deficits and provide additional stimulus to the economy.

5. Is The Fed a financial cabal or a gigantic conspiracy?

The first murmurings of what was to become the Fed began in 1910. In the aftermath of the 1907 panic, it was clear that the financialization of the U.S. had also embedded a deep source of future instability into society. Money and debt were now structural parts of the economy. In 1910, representatives from the U.S. government, led by the Senate Republican leader Nelson Aldrich, met with leading banks in secret for ten days to concoct a plan to create a central body to stabilize the system.

The location was Jekyll Island, Georgia. In hindsight, they could have picked somewhere with a better name, especially given the conspiracy theories that followed. From the Great Depression through to the latest rounds of quantitative easing, many have seen a shadowy hand directing the Fed's actions to the detriment of society.

The truth, however, is that the Jekyll Island meeting was known to Congress, if not the public. The original Aldrich Plan met with stiff resistance and was rejected repeatedly, precisely because it was seen as an attempt to put the U.S.' future into the hands of a despised elite of private bankers. Aldrich's own connections -- his daughter was married to John D. Rockefeller Jr. -- were further evidence of conspiracy to his detractors.

When a revised plan for a central bank was finally passed in 1913, it contained a key change -- the imposition of a Board of Governors on top that was appointed solely by the government. In retrospect, it's hard to imagine a conspiracy of bankers thinking at the outset that placing themselves under government scrutiny was the way to control the system. Certainly, evidence from current events indicates that more scrutiny is for bankers the financial equivalent of Santa's lump of coal.

The conspiracy theorists are evidence more of our ability to find patterns where none exist. Perhaps, they should revisit Hanlon's Razor: Never attribute to malice that which can be adequately explained by human error.