The United States Federal Reserve System turned 95 on December 23, 2008. It has never been more active and visible - marching out a parade of stunningly ambitious initiatives in the last few months. Yet illiquidity persists. Despite widespread news coverage, most of us find the Fed a little mysterious. What is the Federal Reserve System, how does it work and does it have the power to restore the financial system?

Composition & Structure

After a particularly acute series of bank failures in 1907, a group of influential financiers sought to implement a centralized banking system in the US. "In late 1910, a secret meeting of those advocating a central bank met in Jekyll Island, Georgia, to draft a bill for a central bank... Most of the work was [Paul] Warburg's, a German-born investment banker; he wanted to disguise the idea of a central bank by having decentralized regional banks," reports Ronald Wells in his book The Federal Reserve System; A History. The attendees put forward a proposal for one centralized bank with 15 regional banks. After many compromises the legislation was formally proposed.

Chartered by the Federal Reserve Act and signed into law by President Woodrow Wilson on December 23, 1913, the Federal Reserve System is the central bank of the United States. According to the ninth edition of The Federal Reserve System: Purposes and Functions, a publication of the Federal Reserve Board of Governors, "The Federal Reserve sets the nation's monetary policy to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates." The Fed's role also includes supervising and regulating banks, providing services to depository institutions, and attempting to stabilize the financial system.

The Federal Reserve System consists of the Board of Governors and 12 regional banks. The board's seven members, each appointed by the president of the US to a staggered 14-year term, lead policy and supervise operations of the 12 banks. These regional banks (and their 25 branches) administer the nationwide policies of the board and serve as the primary reserve depository for commercial banks. They also operate a nationwide payments system (check clearing), distribute the nation's currency and coins, bank the US Treasury, and supervise and regulate member commercial banks.

The Fed's operating expenses are covered by interest earned on its portfolio of US government securities—typically Treasury bonds. It uses only about 5% of that income and pays the remainder to the US Treasury, approximately $34 billion in 2007, according to the Fed's Annual Report.

While Congress chartered the Federal Reserve Banks for a public purpose, the Fed is a private institution. Thus the Fed is an "independent" central bank. Decisions made by the Board of Governors and regional banks are not ratified by either the President or Congress.

Monetary Policy Levers

The Federal Reserve System has evolved dramatically throughout the 20th century. More than 12 major acts of congress have supplemented the original legislation. It now controls the nation's entire monetary policy, influencing the "availability and cost of money and credit, as a means of helping to promote national economic goals," according to The Federal Reserve System; Purposes and Functions.

According to Goldman Sachs' US Economic Research Group in its December 5 Issue No: 08/49, "The Fed's special power as the central bank is that it can make purchases with its own IOUs, rather than by selling other assets or borrowing funds from some other institution." The Fed doesn't actually print money (that's left to the US Mint) but it can dramatically expand and contract the money supply to similar effect based on its unique ability to flex its balance sheet.

The Fed typically uses three primary tools to affect monetary policy:

Discount Rate: The most direct tool in the Fed's kit is the discount window, a "facility that extends credit directly to eligible depository institutions," according to The Federal Reserve System; Purposes and Functions. Funds lent from the discount window are brought into existence by the Fed as needed. The Fed influences demand for Discount Window funds by adjusting the rate of interest charged. Most banks reserve Discount Window borrowing for emergencies, because the rate is usually relatively high.

Federal Funds Rate: The Federal Funds Rate is the "rate charged by a depository institution on an overnight loan of federal funds to another depository institution," according to The Federal Reserve System; Purposes and Functions. The rate varies according to supply and demand. However, the Fed indirectly controls the Federal Funds Rate through its open market operations, buying and selling securities (usually US Treasury Bonds) to member banks.

According to Goldman Sachs' US Economic Research Group report, "when the Fed buys Treasuries from a bank, it credits that bank with a corresponding amount of reserve balances (bank funds held on account at the Fed, redeemable for currency). These appear as an asset on the balance sheet of the bank, and a liability on the balance sheet of the Fed. The Fed has exchanged its IOUs – Federal Reserve currency or in this case, reserve balances – for the bank's Treasuries." Sale of Treasuries absorbs bank reserves, while buying Treasuries releases them. Thus, by managing the supply of reserves, the Fed indirectly controls the rate banks charge each other for overnight reserve loans.

Reserve Requirements: The Fed also dictates reserve requirements for member banks—the percentage of bank deposits that must be held on deposit at the Federal Reserve. Reserve requirements have a dramatic impact on money supply, due to the multiplying effect of lending; loans are deployed by borrowers through purchases, like buying a house, which creates more deposits, which creates more loans. For example, under a very conservative 20% reserve rule, an initial $100 deposit ultimate generates $457 in total bank deposits and $357 in bank loans. Such is the stunning "money multiplier effect" of fractional reserve lending. Reserve requirements are actually closer to 10%. The Fed can expand the money supply by lowering reserve requirements or buying Treasuries through Open Market Operations.

Extraordinary Actions

The Federal Reserve System's tool kit is not restricted to these standard monetary policy levers. As demonstrated recently, its activities are limited only by the imagination of policy makers. It can wield expansive powers in crisis situations.

The list of recent Fed initiatives is dizzying. With the Fed Funds rate at 0.00%, the Fed is deep into the most expansive implementation of quantitative easing (increasing the supply of currency) in history.

A February 10, 2009 article in the New York Times by Andrews and LaBaton commented that a centerpiece of the Obama Administration's bailout plan relies on the Federal Reserve "to create money, in effect, out of thin air". Current plans call for creating about one trillion dollars to infuse into the banking system. Such scale was incomprehensible six months ago.

An important change facilitating this boost went little-noticed in October 2008; the Fed began paying interest on reserve balances. While apparently just an innocuous gratuity to banks, this change is in fact a powerful and expansive move. "The ability to pay interest [on reserves] allows the Fed to expand its balance sheet, and hence provide liquidity, essentially without limit…", according to Goldman Sachs' October 6, 2008 US Daily Financial Market Comment. It essentially decouples the Fed's capital infusions into banks from the Fed Funds rate and the Fed's supply of Treasury securities. Thus, the Fed is now free to create liquidity – "out of thin air" – without driving down the Fed Funds rate, and without being capped by the assets it has available to sell.

The Future

According to Chairman Bernanke in a December 1, 2008 speech in Austin, TX, we can expect a continued and dramatic expansion of the Fed's balance sheet. "[Inflation] is an issue for the future. For now the goal of policy must be to support the financial markets and the economy." Most economists seem to agree. Debt and inflation are better than a depression.

The Federal Reserve System is deploying every weapon in its considerable arsenal. With an unrestricted balance sheet and few bureaucratic constraints, the Fed has the tools and the authority to be bold and, hopefully, effective. There is some evidence to support this conclusion. Money markets are improving. But more and cheaper money are likely insufficient.

So, we must hope that the second phase of this bailout – the $787 billion stimulus - has some lasting impact. With our monetary policy administrators printing currency as fast as they can and our fiscal policy administrators borrowing and spending at a similar pace, we're in the midst of the greatest test of Keynesian economics ever undertaken. Let's hope Keynes was right. One thing is sure; 2009 will be an interesting and historic ride.