Federal Reserve FAQ

What is the job of the Federal Reserve System?

The Fed’s main job is to keep the economy strong through monetary policy–that is, managing the amount of money and credit available throughout the economy. When the president and Congress make decisions on taxes and government spending, they are affecting fiscal policy.

How exactly does the Fed move interest rates?

First a little background. Rules that govern the banking system dictate that banks cannot loan out all their money but have to keep a required amount in reserve. That money does not earn interest, but banks that find themselves with an excess of reserves can loan that money to banks that are short on reserves. The amount one bank charges to another for those loans is called the federal funds rate. When the Fed met on March 20 and cut its target for a key interest rate by half a percentage point to 5 percent, it was the federal funds rate that they were cutting. So, why should some technical transaction between banks affect average Americans? Because the target that the Fed sets–in particular whether they have raised or lowered interest rates–is the rate on which most other rates of credit are based. When the Fed acts, banks immediately adjust their prime lending rate, which affects mortgage rates, credit card rates, car loan rates, etc.

What is the mechanism by which the Fed changes the federal funds rate?

Eight times a year the Fed holds a meeting of the Federal Open Market Committee. The committee consists of the Board of Governors of the Fed–the chairman is Alan Greenspan–and the presidents of five of the 12 regional Federal Reserve banks. At this meeting they decide whether or not to loosen or tighten credit–that is, whether they want to lower or raise the federal funds rate. If they want to loosen credit, as was the case on March 20, because they feel the economy is slumping, the Fed will buy government securities on the open market. The mechanism through which these securities are purchased ends up injecting money into the banking system, making available more money to loan to businesses and consumers. If the Fed wants to head off an inflation threat by tightening credit, it will sell government securities, which takes money out of the banking system.

It seems like Alan Greenspan has been chairman forever. Isn’t there some limit on how long anyone can serve?

Yes. Members of the Fed’s Board of Governors are appointed by the president and confirmed by the Senate to a single 14-year term. However, someone appointed to fill an unexpired term can subsequently serve an additional full term. That is what happened with Greenspan. He first took office in 1987 and will end his full term in June 2006. He is now serving his fourth four-year term as chairman, which expires in 2004, the longest serving chairman since the Fed was founded in 1913. During his presidential campaign, Sen. John McCain suggested that in the event of Greenspan’s untimely demise, he would simply prop him up, put some sunglasses on him and keep him in office.

How many members of the Board of Governors are there?

There are supposed to be seven, but there are currently two vacancies. President Clinton proposed a replacement, but the Republican-led Senate refused to proceed with confirmation. Four members are required for a quorum.

Can anyone tell the Fed what to do about interest rates?

Neither the executive or legislative branch can change or veto a Fed decision. But Congress does have oversight of the Fed and can pass legislation to add to or modify its duties.

Let’s say the president really, really hates the Fed chairman. Can he fire him?

The president does have the power to remove a member of the Board of Governors, but only for cause. Cause in this case would mean something like the chairman got the keys to the vault and was found stuffing his pockets with bullion.

Next question?

Explainer thanks Doug Tillett of the Federal Reserve Bank of New York and David Humphrey of Florida State University. For more on the Fed, see their Web site