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August 24, 2016
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IntelDigest returns from a Summer hiatus, and will be published on a new schedule, appearing in your inbox every Wednesday. Today, we provide an outline of The Federal Reserve, an organization which has an influential role in all our financial futures.
The Federal Reserve is not a single central bank, but a system of twelve regional reserve banks under the supervision of a board of governors in Washington, D.C. The current chairperson of the Fed Board of Governors is Janet Yellen. Recent past chairmen have included Ben Bernanke, Alan Greenspan, Paul Volcker, and Arthur Burns. The current vice chairperson is Stanley Fischer.
There are, typically, five other governors, so that the Board of Governors would normally have seven people; however, there are currently two vacancies, so the Board of Governors currently consists of Janet Yellen, Stanley Fischer, and governors Jerome Powell, Daniel Tarullo and Lael Brainard. All governors are nominated by the president of the United States, and are subject to confirmation by the U. S. Senate.
All governors are nominated for 14-year terms; nominees for chair and vice chair serve four years in those positions. The chair and vice chair typically serve for the full four year term, although most governors resign before serving full 14-year terms.
The board of governors oversees the “system,” but they are not in charge of any particular bank. There are twelve regional reserve banks located in major cities: Boston, New York, Philadelphia, Chicago, and San Francisco, plus Atlanta, Cleveland, Dallas, Kansas City, Minneapolis, Richmond, and St. Louis.
The reserve banks are privately owned by the commercial banks in each district. For example, Citibank and J.P. Morgan Chase are shareholders in the Federal Reserve Bank of New York because those banks have their headquarters in the Fed’s Second District, which includes New York.
The regional reserve banks are privately owned, and they elect their own boards of directors based on voting by the private member banks. In turn, these boards hire the president of each Reserve Bank. Note: this means that the bankers hire their own regulator.
As an example, William Dudley is now President of the Federal Reserve Bank of New York. He is a former partner with Goldman Sachs. The New York Fed has direct supervisory authority over Goldman Sachs. Further, Stephen Friedman, another former Goldman partner, was Chairman of the Board of Directors of the New York Fed at the time Dudley was hired.
This is “business as usual” at the Fed.
The twelve regional reserve bank presidents come to Washington for each meeting of the Fed Board of Governors to offer their opinions on monetary policy, but most have little power. The exception is the president of the Federal Reserve Bank of New York. While interest rate policy decisions are made in Washington, they are carried out by the open-market trading desk in New York, which gives the New York Fed unique power to affect money markets.
So, you have a Board of Governors in Washington holding power, but having no bank. And eleven regional reserve banks around the country which are privately owned, but have little power. And one regional reserve bank in New York – controlled by the largest private banks and wielding considerable market power – which implements the policies of the Board of Governors of The Federal Reserve.
Now, the true power resides with the Federal Open Market Committee (FOMC). Monetary policy is not set directly by the Board of Governors or the regional reserve banks; policy is set by the FOMC, which is comprised of representatives from the Board of Governors in Washington and the regional reserve banks. The current regional representatives come from the reserve banks at New York, Boston, Cleveland, Kansas City and St. Louis.
The FOMC has a standing membership of twelve voting members, although it currently stands at only ten because of the two vacancies on the Board of Governors. Typically, seven votes come from the Board of Governors and five are presidents of certain regional reserve banks. Four of the five regional votes are selected on a rotating basis each year, while the fifth vote is a permanent seat which belongs to the Federal Reserve Bank of New York. In summary, there are twelve votes on the FOMC, seven from the governors, four from the regions, and one from New York.
This arrangement is clearly designed to keep power in Washington and New York. If the Board of Governors and the Federal Reserve Bank of New York agree on policy, they have eight votes to four from the other regions.
That describes the structure and power blocs of the Federal Reserve. Now, we’ll look at the primary responsibility of the Fed, which is to set “monetary policy” – the availability and cost of money and credit. Its primary weapon, to put it simply, is setting interest rates.
Interest rates are not just the cost of borrowing liquid capital; ultimately, interest rates are the “price” of money. Rates tell us a lot about confidence among lenders, borrowers, and consumers. The state of interest rates at this time (low) illustrates a failure to restore growth in the U.S. economy and around the world.
One can argue that the failure was inevitable. The Fed and other central banks have implemented monetary “solutions” to the problems in the world economy, but these problems are “structural,” having to do with demographics, taxation, regulation, and a host of other factors beyond the abilities and mandate of a central bank. Policymakers cannot solve structural problems with monetary tools.
Interest rates are near Zero or Negative in many places around the world. Central bankers postulated that reducing rates would encourage spending and produce inflation; instead, low and negative rates appear to induce more saving (to compensate for lost interest) and deferred spending (in anticipation of lower prices due to deflation).
Unfortunately (for us all), central bankers have extolled the virtues of low rates for years, but do not seem to have paid attention to the facts on the ground. “However beautiful the strategy, you should occasionally look at the results.” (an apt sentiment incorrectly attributed to Winston Churchill). Low interest rates are disastrous for banks, insurance companies, pension plans, and fixed-income investors.
Again, governments and central banks have been throwing monetary solutions at structural problems, thereby exacerbating the problems. The inescapable fact is that economies are cyclical, and they include recessions. For the last 15 years, we have been plagued by a Federal Reserve which has tried to disavow the business cycle and a Congress which has steadfastly refused to do its job.
The Fed’s efforts to avoid small, cyclical recessions have created bubbles in the debt and equity markets, skewed the economy, encouraged consumers and investors to engage in extremely risky behaviors, and resulted in larger, more dangerous recessions, such as 2008. There is a high probability that a recession in the next year will dwarf the 2008 downturn.
The Congress and Administrations over that same time period have failed to address the serious structural issues involving government spending and debt, restructuring Social Security to extend its efficacy, military spending, unfunded liabilities, et al.
Structural solutions are not likely because of political gridlock, so the best case scenario is a U.S. economy which remains stuck in a low-growth, Japanese-style pattern indefinitely. But a more likely scenario is a serious economic downturn, a global liquidity crisis, and financial panic.
Our goal today is to give you a better understanding of the Federal Reserve and how it operates. When you read about and hear references to Fed actions (or other central banks), either here in IntelDigest or in the general media, you may have a more clear context and perspective for analyzing that information.