What Is the Federal Reserve? Structure and Functions of the Fed

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The Federal Reserve, usually called the Fed, is the central bank of the United States. It is a system with three parts: a Board of Governors in Washington, D.C., which is a federal government agency, 12 regional Federal Reserve Banks that are each responsible for one district of the country, and the Federal Open Market Committee (FOMC), which sets monetary policy. Together they manage the supply of money and credit, supervise banks, keep the financial system stable and run much of the plumbing that moves dollars between banks.

What Is the Federal Reserve System?

A central bank is the institution a country gives special control over the creation and distribution of its money and credit. It typically sets monetary policy, regulates banks and acts as lender of last resort when private funding dries up. The Federal Reserve System performs all three roles for the United States.

Before 1913, the U.S. was the only major financial power without a central bank. Repeated 19th-century banking panics saw depositors rush to withdraw cash, sound banks fail alongside weak ones, and businesses lose access to credit. After the Panic of 1907, which private bankers had to stop on their own, Congress passed the Federal Reserve Act, signed by President Woodrow Wilson on December 23, 1913. It created an institution that could supply cash to banks during a run and an “elastic” currency that expanded and contracted with the economy’s needs.

The resulting design was deliberately decentralized. Rather than one bank in New York or Washington, the Fed was built as a network of regional banks overseen by a central board, a compromise between those who wanted government control and those who wanted bankers in charge.

How the Federal Reserve Is Structured

Board of Governors. The Board has seven members nominated by the president and confirmed by the Senate. Terms run 14 years and are staggered so one begins every two years, which means no single president normally appoints a majority of the Board in one term. The chair and vice chair are chosen from among the governors for four-year terms, also with presidential nomination and Senate confirmation.

Twelve Federal Reserve Banks. Each regional bank serves a district and has its own president. The banks are headquartered in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco. They supervise banks in their districts, lend to depository institutions, distribute currency and gather local economic information that feeds into policy discussions. The New York Fed has a special operational role because it carries out the FOMC’s market transactions.

Federal Open Market Committee. The FOMC has 12 voting members: the seven governors, the president of the New York Fed, and four of the remaining 11 regional bank presidents, who rotate into voting seats. Nonvoting presidents still attend and take part in the discussion. The committee holds eight regularly scheduled meetings a year and can meet in between when conditions require it.

Member banks. All nationally chartered banks must join the system, and state-chartered banks may choose to. Members must hold stock in their regional Reserve Bank, which is the source of the “privately owned” confusion: the stock cannot be sold or traded, pays a dividend capped by law, and gives no control over monetary policy.

What the Federal Reserve Does

The Fed’s responsibilities fall into four broad areas:

1. Monetary policy. Influencing money and credit conditions to pursue maximum employment, stable prices and moderate long-term interest rates. Since 2012 the Fed has defined price stability as 2% inflation over the longer run, measured by the personal consumption expenditures (PCE) price index. The more familiar Consumer Price Index is a separate measure that runs on a different basket and method.
2. Bank supervision and regulation. Overseeing the safety and soundness of member banks and bank holding companies, and enforcing consumer credit protections.
3. Financial stability. Monitoring and containing systemic risk, including acting as lender of last resort through its discount window.
4. Financial services. Serving as a bank for banks, the U.S. government and foreign official institutions, and operating core payment systems.

The payments role is easy to overlook. The Fedwire Funds Service moves trillions of dollars a day between banks with same-day settlement, and since July 2023 FedNow has let participating banks settle instant transfers around the clock instead of waiting for traditional batch settlement.

How the Fed Sets Interest Rates

The FOMC’s main policy lever is a target range for the federal funds rate, the rate banks charge each other for overnight loans of reserves. The Fed does not dictate that rate deal by deal. It keeps the market rate inside the range with a set of administered rates:

• Interest on reserve balances (IORB): the rate the Fed pays banks on money they keep in their Fed accounts. A bank has little reason to lend reserves overnight to another bank for less than it earns risk-free from the Fed, so IORB pulls the market rate toward itself.
• Overnight reverse repurchase agreement (ON RRP) rate: the rate offered to a broader set of firms, including money market funds, that cannot earn IORB. It acts as a floor, because those firms will not lend in the market below what the Fed offers them.
• Discount rate: the rate the Fed charges banks that borrow at the discount window. It sits above the range and works as a ceiling, since a bank that can borrow from the Fed at that rate has no need to pay much more elsewhere.

Open market operations, buying and selling U.S. government securities, keep enough reserves in the banking system for these administered rates to work. Before 2008 the Fed relied mainly on adjusting the quantity of reserves through such operations. Since the crisis, with reserves far more plentiful, the administered rates do most of the work.

Worked Example (Hypothetical)

Suppose the FOMC sets a target range of 4.25% to 4.50%. To support it, the Fed might set the ON RRP rate at 4.25%, IORB at 4.40%, and the discount rate at 4.50%.

• A money market fund with cash to invest overnight can get 4.25% from the Fed, so it will not lend to a bank at 4.10%. Market rates are held up near the bottom of the range.
• A bank with excess reserves earns 4.40% simply by leaving them at the Fed. It will lend those reserves to another bank only if offered something close to or above that.
• A bank short of reserves can borrow from the discount window at 4.50%, so it has little reason to pay 4.80% in the market.

The effective federal funds rate settles inside the 4.25% to 4.50% band. If the FOMC cuts the range by a quarter point, it lowers all three administered rates by the same amount and the market rate follows. The change then passes, with varying speed, to Treasury bill yields, the prime rate, credit card rates and adjustable loans. Longer-term rates such as 30-year mortgage rates depend on expectations about future policy and inflation, so they do not move one for one.

The Fed also has balance sheet tools. During the 2008 crisis and again in 2020, it bought large amounts of Treasury and mortgage-backed securities (quantitative easing) to push down longer-term rates once short-term rates were near zero. Reducing those holdings, often called quantitative tightening, works in the other direction.

Independence and Accountability

The Fed is described as “independent within the government.” Its monetary policy decisions need no approval from the president or Congress, and it funds itself rather than relying on congressional appropriations. The rationale is that elected officials face pressure to keep rates low before elections, boosting short-run growth at the cost of later inflation. The president’s main power is appointment. Staggered 14-year terms and the rule that governors can be removed only “for cause,” generally understood not to include disagreement over interest rate decisions, shield policy from that cycle.

Independence is not the absence of oversight. Congress created the Fed, sets its goals and can change the law that governs it. The chair testifies to Congress twice a year on monetary policy, and the Board’s financial statements are audited. Critics argue that an unelected body with this much influence over jobs, asset prices and credit should coordinate more closely with elected government.

How the Fed Makes and Spends Money

The Fed’s main income is interest on the government securities it holds from open market operations, plus interest on foreign currency investments and loans to depository institutions, and fees for services such as check clearing and fund transfers. After expenses, including interest paid on reserves and dividends owed to member banks, it sends the rest to the U.S. Treasury. When interest paid out exceeds interest earned, as can happen after rapid rate increases, the Fed records a “deferred asset” and pauses remittances until earnings recover, rather than receiving money from Congress.

Federal Reserve vs. Related Institutions

Fed vs. FOMC. The Federal Reserve System is the whole structure: the Board, the 12 banks, the FOMC and all of its programs. The FOMC is the committee inside it that sets monetary policy. A headline that says “the Fed raised rates” means the FOMC voted to raise the federal funds target range.

Fed vs. Treasury. The Treasury Department is the government’s finance ministry: it collects taxes, borrows by issuing Treasury securities and manages federal spending, which together form fiscal policy. The Fed handles monetary policy and acts as the Treasury’s bank. Paper currency is printed by Treasury’s Bureau of Engraving and Printing but issued as Federal Reserve notes and distributed through the Reserve Banks. Coins come from the U.S. Mint.

Federal funds rate vs. discount rate vs. prime rate. The federal funds rate is a market rate between banks that the FOMC targets. The discount rate is what the Fed itself charges banks. The prime rate is set by commercial banks for their customers and typically moves when the federal funds target changes.

Limitations of the Federal Reserve

• Policy works with lags. A rate change can take many months to affect hiring and inflation, so the Fed must act on forecasts that can be wrong.
• Blunt tools. Interest rates affect the whole economy at once. The Fed cannot target one sector, region or cause of rising prices, and raising rates to fight inflation can slow GDP growth and raise unemployment.
• Supply shocks. When inflation comes from supply disruptions or energy prices, higher rates reduce demand but do not fix the underlying shortage.
• Conflicting goals. When inflation is high and unemployment is rising, price stability and maximum employment pull in opposite directions.
• No control over fiscal policy. Spending, taxes and deficits set by Congress and the president can work with or against the Fed’s policy.
• Limited reach outside the banking system. Much lending happens through nonbank lenders and markets the Fed does not directly regulate.

The Bottom Line

Anyone with a loan, credit card, savings account or job feels the Fed's decisions, because FOMC rate changes pass through to Treasury bill yields, the prime rate and adjustable loans. Longer-term rates such as mortgages depend on expectations and do not move one for one. The Fed's tools work with lags and affect the whole economy at once, so its policy cannot target one sector or fix supply shortages.