The current economic crisis in the U.S. and around the world has thrust the Federal Reserve System, or “the Fed” as it is commonly referred to, into the forefront of the news. It has played a critical and often heavily criticized role in the economic crisis and the efforts to help recover from it. It is a good idea to have a basic understanding of what the Federal Reserve System is, what its role is and why it is in the news so often. Having this understanding can help you make sense of the news and make better financial decisions.

What is the Federal Reserve System?

The Federal Reserve is the central bank of the United States. Most countries have their own central banks that perform similar roles in their economies. The Feds role is to act as a bank for other banks and for the government itself. It was created to provide the nation with a safe and stable monetary system. It consists of 12 regional Reserve Banks and a number of branches that are run under the direction of a Board of Governors. The regional Reserve Banks are located in:

• Boston
• Philadelphia
• New York
• Richmond
• Cleveland
• Atlanta
• Chicago
• St. Louis
• Minneapolis
• Kansas City
• Dallas
• San Francisco

The Federal Reserve System was created in 1913 when President Woodrow Wilson signed the Federal Reserve Act. The Board of Governors consists of seven members who are appointed by the President and confirmed by the U.S. Senate. Each board member is appointed to a 14 year term. The appointments are staggered such that one member’s term expires on each even-numbered year.

The Chairman and the Vice Chairman lead the Board. The current Chairman is Ben Bernanke and the Vice Chairman is Donald Kohn. You will hear their names frequently on the news and in the newspapers. The Chairman and Vice Chairman are also nominated by the President and must be approved by the U.S. Senate. They must also have already been on the Board of Governors or be simultaneously appointed to the Board when they are nominated for their posts. They serve four year terms but may be reappointed for additional terms as long as their original 14 year term is still active.

Whether or not the Federal Reserve System is a part of the federal government or a privately owned and controlled entity is open to debate. Arguments can, have and are being made for both sides but this debate is not the topic of this hub. You can search for other hubs on HubPages or Google the topic to find more material than you can read in a lifetime on this hotly-debated subject.

What Does the Fed Do?

The Federal Reserve System is tasked with maintaining a safe and stable monetary system for the United States. It does so by administering its “monetary policy”. The term “monetary policy” refers to actions taken by a central bank, such as the Federal Reserve System, to help encourage a healthy economy. By doing so it hopes to maintain employment, keep interest rates low and prices stable. The monetary policy in the U.S. is set by the FOMC or Federal Open Market Committee.

It also supervises and regulates banking institutions. In theory, to make sure they are safe places for people to keep their money. This has been a hot topic of late as many have criticized the Federal Reserve for failure to adequately oversee many banking institutions, particularly in the area of mortgage lending and sub-prime mortgages. Many believe the Feds inadequate oversight has resulted in bank and brokerage failures that precipitated the current economic crisis and necessitated the multi-hundred billion dollar federal bailout we’ve seen in the past year.

The Federal Reserve System also provides financial services to depository institutions, foreign central banks and the U.S. government. It plays a major role in many banking functions like clearing checks and electronic payments and distributing physical currency to banks, credit unions and savings and loans.

The Federal Reserve is constantly trying to keep the economy and the inflation rate in balance. One of the primary tools the Federal Reserve uses to do so is to control key interest rates. The interest rate the Fed charges to loan money to banks and other financial institutions is called the “federal funds rate”. The Federal Reserve is apt to move this rate up or down, depending upon the economy and the inflation rate. If the economy is down, like in the current recession, or the inflation rate goes up, then the Fed may raise the federal funds rate. If the economy is growing well and the inflation rate is reasonable, then the Fed will either maintain the current interest rate or lower it.

Why are Interest Rates Important?

Simply put, interest rates are the price that people will pay to borrow money. When interest rates are high, people and businesses tend to borrow less and save more. When interest rates are low, the opposite is true because the cost to borrow is lower. When interest rates rise businesses are less likely to invest more money in their business and consumers are less likely to make major purchases like homes and cars because the cost to borrow is higher. As demand for goods and services drops, so will production which may be followed by increased unemployment.  By raising or lowering the interest rate that the Federal Reserve charges banks on the money it lends them, they can ultimately affect the interest rate that consumers and businesses pay to borrow money.

By lowering rates it can attempt to encourage consumers and businesses to borrow and spend more thus pumping dollars into the economy, increasing production, encouraging employment, and lifting a waning economy. By increasing interest rates, it can slow down an economy that is growing too quickly or lower an inflation rate that has gotten too high.

What is the FOMC?

The acronym FOMC stands for the Federal Open Market Committee. The FOMC is the group that determines the nation’s monetary policy. The FOMC is made up of twelve members that include the entire Federal Reserve Board of Governors, the president of the Federal Reserve Bank of New York, and four presidents from the other eleven Reserve Banks. The president of the Federal Reserve Bank of New York is a permanent part of the committee due to New York's critical role in the U.S. financial markets. The other four presidents serve 1 year rotating terms.

The FOMC holds eight meetings each year in Washington, D.C and review current economic and financial conditions and set monetary policy. Their actions influence the cost and availability of money and credit, which ultimately affects a number of other economic factors including employment, production and the prices of goods and services.

At these meetings, the FOMC decides whether or not to change its target for the federal funds rate and by how much. They issue a statement after each meeting explaining their view of the current state of the economy, where they think the economy may be headed and their justifications for the actions they will be taking. You will frequently hear of these meeting on the news and that the markets anxiously await the report of the FOMC. If the actions of the FOMC were anticipated the market will usually take it in stride. However, if the actions of the FOMC were not anticipated, the markets may react suddenly and violently.

The Federal Reserve plays a very important role in the U.S. economy and in the U.S. and world financial markets. However, it also has many critics. Some say it plays too important a role and that too much power is placed in the hands of the Chairman and the Board, all of which are not elected officials. Some critics espouse that the Federal Reserve should not exist at all and that it has been granted powers that in the U.S. Constitution are reserved to the U.S. Congress alone.  Whether or not these criticisms are valid is a matter of opinion but the Fed is the central bank of the United States and, barring radical changes in this country, is here to stay. You can take a virtual tour of the Federal Reserve, if you want to learn more. Also, check out some of the questions in the 'Related Questions' box to the right to get differing opinions on the Fed.