Principal of Bank Operation

Reflection Paper on Fed Tour

Thanh Le

The Federal Reserve plays the role as the central bank of the United States to conduct

monetary policies, to regulate banking activities, and to facilitate the payment process of

financial transactions. Its goal is to help US economy function smoothly and meet economic

goals of price stability (core inflation at 2%) and growing real GDP. The monetary policy is to

influence money and credit which conditions strong output growth, income increases, ideal

employment rate (5-5.5%).

The term “money” infers to cash in circulation and the amount people/businesses have in

bank account; the term “credit” means the amount banks and lender can lend. Fed makes sure

money and credit do not grow either too slowly or too rapidly. If they grow too slowly, funds for

loans will be inadequate. Consequently businesses find harder (higher interest) to borrow for

investments, business expansions, or major purchases. It can also lead to recession which implies

decrease in production and spending and as well rise in unemployment. On the other hand, when

money and credit grow excessively, inflation can occur and bring in negative effects. For

example, with high inflation, income may grow at slower pace than pace of price increase, and

therefore individual loses purchasing power and results in less purchases. Inflation can also make

business in predicament in making plans due to higher uncertainty of cost and prices.

Subsequently, businesses can also reduce purchases and investment. So either extremity of

money and credit results in negative economic effects.

So to keep balances in economy between production and inflation, Fed has three main

tools: Open Market Operations (OMC), Reserve Requirements, and the Discount Rate. By

definition, Open Market Operations are purchases or sales by Fed of US government securities.

When Fed buys securities, it is called expansionary monetary policy; when Fed pays for these

securities by crediting the amount of purchase to account of seller’s banks. The banks then credit

seller’s account. Therefore, there will be more money and credit in banking system to lend out.

Banks then charge each other less interest on short term loans (lower federal fund rates), and

consequently banks charge less on loans. With interest rates fall, spending in economy will

increase.

The opposite takes place when Fed sells government securities and collects payments

from buyers’ bank at Fed. The bank then debits amounts from buyer’s account. Banks have less

to lend, and interest rate increases, along with decline in purchases. One important note is Fed

does not conduct OMC with ALL individual and financial institutions. In fact, it deals with

around twenty large firms/ brokers that buy or sell government securities (like GoldmanSach). It

ensures large purchases or sales take place efficiently, quickly, and safely over electronic means.

Another important note is OMC is independent of amount of cash in circulation. However, if for

some extraordinary reasons causing public to hold on excessive cash, Fed will conduct purchases

of securities to give banks more money to lend.

The second tool of monetary policy to keep money and credit in balance is the reserve

requirement. It set required percentage of certain deposits banks must have either in their vault or

at deposit at Fed. By law, the Fed can set reserve ratio from 8 to 14% on checking account

deposits. For example, if $100 is deposited into checking account, banks can only lend out $86

($14 in required reserve). This $86 is lent out and eventually deposited into another bank which

can lend out 86% of it again (73.96$). As the process goes on, one initial $100 deposit can add to

money supply total up to $714. So the reserve ratio affects the ability of creating money of the

banking system.

The reserve ratio remains at 10% recently and Fed rarely has changed it. The reason is to

give bankers more predictability to plan out lending activities. In addition, when Fed reduces

growth of money and credit, it will not increase reserve requirements because otherwise burden

of tax and extra costs are created on banks.

Another tool of monetary policy is the usage of discount rate, the interest rate Fed

charges banks on short term loans. When it raises discount rate, it discourages lending and

spending to avoid inflation. Opposite happens when it reduces discount rate. By law, directors of

each Federal Reserve Bank set its discount rate every two weeks (subject to approval of Board of

Governors). On the broad side, since the credit market is national, discount rate is relatively

homogenous among all 13 Federal Reserve Banks. However, Fed Banks implement more

changes in federal fund rate than changes in discount rate.

In order to come up with appropriate action of monetary policy, Fed closely pays

attention to variety of economic and financial data. For example, Fed focuses a lot on M1 money

supply in the nation, which is total of currency in circulation and checking accounts at depository

institutions. M1 supply and production of the economy have had strong and close direct

relationship. Fed also considers unemployment rate which is related to build-up of inflationary

pressures. CPI (consumer price index) or PCE (personal consumption expenditure) is another

indicator Fed pays attention to measure the core inflation 2%.

Additionally, Fed also closely observes prices of commodities such as lumber and copper

to get the signs and rates of inflation. Fed also considers international events which can cause

uncertainty, like recent Greece default or military activities. Fed also observes the fiscal policy of

the US government like subsidy programs, aerospace government contracts, tax policies to set

correspondent monetary policy.

In addition, Federal Reserve also intervenes in US Treasury Department activities in the

foreign exchange market. In fact, foreign exchange value of the dollar is important in

international trade, especially export increasingly gains more percentage out of entire GDP

production. Occasionally, Fed uses foreign currency to buy dollar to raise dollar value and vice

versa to keep dollar value in stability. If dollar value is too high, it is hard for US exporter to gain

business, if dollar value is too low, it could cause foreign made product in US rise in price can

cause domestic inflation.

Fed also provides banks with services to help run economy smoothly. For example, Fed

provides banks with cash in specific denomination to meet their customers’ needs. Each year,

Fed projects how much new currency is needed and places print order with the Bureau of

Engraving and Printing. It also orders coins from US Mint.

When banks have extra cash, they ship the excess to Fed for credits to their accounts. Fed

also shreds worn bills. Fed also supervises banks’ operation in order to ensure compliance to

laws and regulations. For example, Fed looks at banks’ financial statements to make sure banks

have enough liquidity to withstand downturns or risk of credit. Fed also examines banks’ internal

control and operating procedures to ensure no theft or fraud. If there is violation, fines can be

imposed on violating banks or even more seriously, banks can be closed. Fed also considers

application of bank mergers or new branch openings; it ensures competiveness within the

banking industry.

It also enforces consumer and community protection laws, such as Community

Reinvestment Act which encourages banks to meet credit needs of low to moderate income

neighborhoods. It also monitors compliance with the Equal Credit Opportunity Act which

prohibits credit denial based on race, religion or sex. Or it monitors Fair Credit and Charge Card.

Federal Reserve also plays important roles in US payment system, helping banks settle

non-cash transactions like checks or electronic payments. Fed operates as a check clearinghouse

and also Fed’s ACH (automated clearinghouse) handles electronic small payments such as social

security checks or direct payroll deposits. For large-dollar transfer of funds, such as real estate

transactions, Fedwire network handles the process. Fed charges for services but charges are only

enough to cover cost, not for profits.

Last but not least, Fed is also a very well-organized institution. First part of Fed is the

Board of Governors which consists of 14-year-term seven members, appointed by the US

president and confirmed by the Senate. The long term reduces the influence of politics.

Surprisingly, Fed does not get funding or appropriation from Congress. Its income mainly comes

from interest on its holding US government securities. The Fed usually earns more than its

spending and return surplus every year to the US Treasury. However, Fed independence has its

borders. By law, Federal Reserve’s chairman must testify before Congress at least twice a year

about its monetary policy.

Beside the Board of Governors, Fed also has 12 Banks spread out around the country in

San Francisco, Minneapolis, Kansas City, Dallas, St. Louis, Chicago, Atlanta, Cleveland,

Boston, New York, Philadelphia, and Richmond. Each bank supervises banks in their districts

and provides services such as cash storage, loans, and check processing. Noticeably, monetary

policy is determined by the FOMC, or the Federal Open Market Committee which meet in

Washington DC eight times a year. The meetings invite members of Board of Governors and 12

branch presidents. However, there are only 12 voting members, 7 governors and five branch

presidents.

Citations

All information and reflection in the paper are based on PowerPoint presentation and all the

tours’ information inside Federal Reserve of Dallas, Houston Branch on 12/3/2015.