The Federal Reserve System (“the Fed”) is the central bank of the United States. It was founded in 1913 with the signing of The Federal Reserve Act. The idea was introduced after several banks had failed in order to restore the confidence of the people in their nation’s banks. One difference between The Fed and other countries’ national banks is that it is not run by the government, but it is an independent and relatively autonomous institution within the government. This separation was implemented in order to remove political influence from the shaping of monetary policy. Although it is independent in function, the bank is occasionally reviewed and audited by Congress

The Federal Reserve is actually spread throughout the United States in 12 different regions. Some cities with Regional Banks include New York, San Francisco, Boston and Kansas City. The Bank’s headquarters are located in Washington D.C. the capital of the United States.

The Fed’s responsibilities generally fall under four categories. The most important is conducting the nations monetary policy. Monetary policy is conducted by the Federal Open Market Committee (FOMC), which contains the seven members of the governing board and five regional bank presidents. This is accomplished by influencing money and credit conditions in the economy in pursuit of full employment and stable prices. Specifically, the FOMC controls the required reserves all commercial banks must hold and they conduct open market operations which control the Federal Funds Rate (the interest rate at which banks lend funds held at the Fed to other banks). This rate is the basis for bond yields, mortgage rates and will also ultimately affect the United States’ exchange rate, unemployment rate and price stability. The FOMC meets eight times a year to discuss the state of the economy and to decide whether to change the interest rate.

Other responsibilities of the Fed include supervising and regulating banks to ensure the safety of the United States banking and financial system and to protect the credit rights of consumers. This includes protecting our banks from panics and ‘runs’ (where everyone withdraws their money at once) that were made famous during the Great Depression in the early 20th century and protecting consumers from being cheated by their banks. The Fed maintains the stability of the financial system and provides financial services to the U.S. government, the public, financial institutions, and foreign official institutions. It also controls the amount of U.S. Dollars printed.

How the Fed Affects the Markets

As mentioned above, the FOMC’s interest rate decisions have a profound effect on the markets. A good example to illustrate this point is the stock market. Investors prefer to receive the same return on stocks as they do on bonds, while taking into account the greater risk of stocks. Therefore, if rates are increased by the Fed then returns on bonds will usually be greater then those on stocks (usually). This encourages investors to look towards bonds, which in turn drops the prices of stocks until the point that their expected risk-adjusted returns are aligned again. Furthermore, higher interest rates can signal a slow-down of the economy and reduced profits which would drive stock prices down even further. Alternatively, if interest rates are lowered by the Fed the opposite scenario would occur (returns on stocks would exceed bonds etc.).

Additionally, the Fed’s interest rate decisions affect our exchange rate. For example, if the Fed decided to raise the interest rate, then returns on dollar assets will appear more favorable to investors and the dollar will appreciate in value. This will create a situation where imports are cheaper for U.S. citizens and our exports are more expensive to the rest of the world. On the other hand, if the Fed chose to lower the interest rate, then our assets will not be as appealing to investors and the dollar will depreciate in value. This scenario causes imports to be more expensive for U.S. citizens but our exports are more appealing to other nations.

Due to these effects, it is important for investors to have an idea of the bank’s philosophy and to pay close attention to the news for any changes. In fact, it is a rather common occurrence that when a Fed Governor or the Chairman of the Federal Reserve (especially) speaks, for the markets to react.

Chairman of the Federal Reserve

The Chairman of the Federal Reserve is selected by the President and then must be approved by the Senate. By law, the chairman must be selected from among the sitting governors. The term for the chairman is four years and he may be reappointed. Essentially, the Chairman is the public spokesperson and representative of the Board. He also runs the meetings where the important decisions are made. The previous chairman, Alan Greenspan, had been reappointed by three different presidents (Republican and Democrat) demonstrating the separation of monetary policy from politics.

Current Chairman: Ben Bernanke

Ben Bernanke was sworn in as the Chairman of the Federal Reserve by

President George W. Bush on February 1, 2006. His chairmanship marked the end of the Alan Greenspan era of the previous 18 years. Mr. Bernanke’s ascension signaled the next big step in his already impressive career. After growing up in Augusta, Georgia and receiving the highest SAT score in his state that year (1590), he attended Harvard University where he graduated summa cum laude in 1975. Afterwards, he received his Ph.D. in economics from MIT and began an academic career by teaching at many illustrious universities including Stanford, NYU and Princeton. In 2002, he served as a member of the Board of Governors at the Fed and most recently was the chairman of the President’s Council of Economic Advisors (CEA).

One of Mr. Bernanke’s plans as chairman is to increase the transparency of the Federal Reserve – in other words he plans on making the Fed’s intentions clearer to investors. Previously, the Fed was shrouded in mystery and Mr. Greenspan was famous for his use of cryptic language that often confused the public. Along those lines is the idea of setting a hard target for inflation of 1-2% (similar to the European Central Bank) that would provide the public with a clear definition of price stability. However, Mr. Bernanke has inherited a tough situation resistant to changes and is faced with a declining dollar, rising oil prices and increased inflation worries.

Critics are concerned about Mr. Benanke’s ‘soft’ position (not aggressive in fighting it) on inflation, and often refer to him as “Helicopter Ben”. The unflattering nickname comes from a speech he gave about deflation (a topic of one of Mr. Bernanke’s authored books). In the speech he suggested that one way to combat deflation would be to drop money from a helicopter. However, his idea of an inflation target suggests that this belief about him is not true and in fact he has raised rates the last few meetings to the current 5.00% rate (to combat inflation) despite signs of a slowing economy.

The control over interest rates is the biggest tool any one authority has to influence the markets. Simply speaking of plans to alter interest rates in either direction makes markets move. Regardless of the way in which he is perceived by critics, this privilege gives Mr. Bernanke an extreme amount of power and responsibility.