According to the Bank of International Settlements, the Federal Reserve, created during Woodrow Wilson’s tenure in 1913, “is a curious hybrid, a privately owned, quasi-public institution whose sole function is central banking.”
The Federal Reserve System has three components established by the original act: The Board of Governors, 12 regional Federal Reserve Banks and national and state-chartered banks that choose to be members. Members own shares in the Federal Reserve, but shares are neither saleable nor transferable and may not be used as collateral.
Member shareholding banks appoint 72 of 108 regional directors, who in turn appoint the 12 regional presidents. The U.S. president appoints, and the Senate confirms, the seven member Board of Governors, established in the original act as a “federal agency.” These governors together with five of the 12 regional presidents form the Open Market Committee (FOMC) and conduct monetary policy through open market operations. Congressional oversight is limited to semi-annual hearings and “dialogues.”
The Fed, which is a not-for-profit organization, netted $22.3 billion in 2005, twice as much as Wal-Mart. It makes this money off the interest on its Treasury holdings. The Fed's 2005 audit reveals that it dumped $18.1 billion of profit into the Treasury and is legally required to pay member banks a 6% dividend, using the remainder to cover expenses.
Charged with creating monetary stability and a sound economy with high employment, the Fed wields three primary tools: setting the Fed Funds rate (the overnight interest rate it charges member banks) and buying and selling Treasury notes and bonds (to alter the money supply). It can also change the fractional reserve level banks must maintain relative to loan portfolios, but it does so rarely.
If the Fed wishes to increase the money supply in the banking system, it buys securities. Using its limitless checkbook to make purchases, the Fed creates offsetting credits to the institutions selling it the bonds. The increased money supply generates more credit and lending. Conversely, selling securities by the Fed constricts the money supply and credit.
Inflation
Since one of the explicit goals of the Fed is to guard against inflation, it is important to examine a key index that guides its decisions — the Consumer Price Index (CPI), an amalgam of 200 plus prices of goods and services. The index is divided in two — CPI and core CPI. Core CPI excludes food and energy under the theory that these items are too volatile to determine the state of inflation. The CPI also contains certain assumptions about consumer behavior — such as goods substitution. If steak gets too high, then consumers will trade down to hamburger. The fact that they have an inferior product and have lowered their standard of living is not factored.
Another CPI adjustment price tool is “hedonics.” If the latest computer, priced the same as the old model, can store and play endless videos, then its price becomes discounted due to the extra pleasure it affords.
The CPI number also does not distinguish between tradable and non tradable goods. Tradable (or importable) goods — e.g., electronics or textiles, have generally become more affordable due in large part to cheaper labor costs in the emerging export countries such as India and China. However, non tradable goods and services from healthcare to haircuts, have moved up in price canceling out the low prices attributable to imports.
Significantly, unlike the European Central Bank, the Fed is adverse, at least publicly, to tackling asset inflation. Arguing that targeted bubble popping of a single asset class would be a threat to the broad economy, Bernanke warned, “One might as well try to perform brain surgery with a sledgehammer.”
Ann Berg has spent 30 years in commodities and capital markets as a trader, consultant and writer.
