An Essay on The Four Capabilities of The Federal Reserve
“Let there be light.”
— GENESIS 1:3
The Day The Dollar Floated Away
In order to see where we’re going in this financial evolution, we have to first grasp where we’ve been and where we are. The first chapter in this series, “The Evolution of Money”, discussed the watery nature of money itself, the argument that money is a medium of exchange that people have to agree to pay attention to, and the basic explanations of what bitcoin and ethereum are and could be. The second chapter, “Gold, The Standard, and How The Dollar Floated Away”, was an exploration into that mysterious metal, the thousands of years for which it has been seen as a store of value and demonstration of societal strata, and the last few hundred years that the Western world journeyed into, through, and out of the use of gold as a backing for national currencies. The U.S. closed the gold window in 1971. The actual paperwork didn’t pass into law until April 1, 1978, affectionately coined, the day the dollar floated away. With a wink from fate, and a nod from irony, it happened on April Fools Day. So where has the dollar floated away to?
Origins of The Federal Reserve
The Fed came into existence with The Federal Reserve act of 1913.¹ Its planning began at J.P. Morgan’s Jeckyll Island resort, in November of 1910, off the coast of Georgia.² This essay isn’t angled to be conspiratorial or to list names of co-conspirators. However, if you’ve read The Creature from Jeckyll Island, it has one take on the origins, intentions for, and purpose of creating The Federal Reserve. Whatever the case, The Federal Reserve (The Fed) is in charge of managing fiscal policy in the United States. The main point worth underscoring from Jeckyll is that, “[The Federal Reserve] is not federal and it has no reserves.”³
The Fed Is Neither Federal Nor Has Reserves
The Fed is not a federal institution; it is a private corporation. It does have a Board of Governors who report to Congress, and a presidentially appointed chairman who speaks fiscal prognostications from podiums in Jackson Hole, Wyoming, but, in no confusing terms, The St. Louis Fed notes that, “The Federal Reserve Banks are not part of the U.S. Government.”⁴ What this means is its leaders aren’t subject to the same winds of election cycles, and The Fed doesn’t “receive its funding through the Congressional budget and appropriations process.”⁵ Instead it makes its own money, and we’ll discuss how in a bit.
The second horn to this impressively paradoxical bull is that The Fed does not have any real reserves. According to The Fed’s website, Federal Reserve notes — those are the dollars in our pockets — have not been redeemable for gold since 1934, or silver since the 1960s.⁶ An American used to be able to go to the Treasury Department in D.C. or their nearest Federal Reserve bank with cash and get proper value returned in precious metal.⁷ ⁸ This is no longer the case. We saw in a previous chapter how the U.S. Government seized gold, made it illegal to hold, and then significantly debased the dollar shortly after doing so.⁹
Today, The Fed’s main collateral is in the form of U.S. Treasury Bills. U.S. Treasuries aren’t reserves per se, they are instead a debt instrument backed by the U.S. Government, a simple promise for future payment. So The Fed is neither federal nor does it have any reserves. In this sense the name “The Federal Reserve’ is truly a brilliant piece of inverted branding, a marketing flourish reminiscent of a campaign composed by Edward Bernaise like Freedom Torches, which made cigarettes popular to women as a form of patriotism.
Now let’s look at what The Fed does, and how it does it.
Triptych by Ab_Colours
The Four Capabilities of The Federal Reserve
According to their website, “The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system.” So the Federal Reserve is charged with the task of shepherding U.S. monetary policy. But how does it do that?
In plain terms, The Fed does four things:
Settles transactions between banks.¹²
Determines banks’ reserve requirements.¹³
Gives loans to banks and charges interest.¹⁴
Buys and sells treasury bills on the open market.¹⁴
Let’s go through each of these one by one.
1. The Fed Settles Transactions Between Banks
The Fed settles transactions between banks and collects a fee for it.¹⁶ ¹⁷ It handles two main kinds of transactions, one is the Automated Clearing House (ACH) transaction, which processes a high volume of low figure amounts — approximately 70 million transactions a day at an average of $2,000.¹⁸ The other kind of transaction is called The Fedwire, which processes a low volume of high figure amounts — less than 700,000 transactions a day at an average of $4 million.¹⁹ To put the two in perspective, the Fedwire does less than 1% of the number of transactions done by the ACH.
Both of these are commercial services used to settle credit and debits for transactions between two parties in the U.S. When you transfer money from one bank to another you may notice that it has an ACH on it, that’s because it’s being processed by the Automated Clearing House, a for-profit service provided by The Federal Reserve. If parties want to send larger amounts they can call or contact Fedwire, as it is also a commercial for-profit service with a website offering money transfer services.²⁰
In short, The Fed runs all modern payment systems in the U.S. By handling payments and charging fees, The Fed makes money.
2. The Fed Determines Bank Reserve Requirements
The second thing The Fed can do is determine reserve requirements. Another way to say this is that The Fed tells banks how much cash they need to keep in the vault overnight (or at the nearest Federal Reserve bank). This is called the reserve requirement. The purpose of the reserve requirement is to ensure banks are solvent enough to handle bank withdrawals, that is, a reasonable amount of cash to cover the fact that depositors may request to withdraw funds at any given time. The reserve requirement historically has not changed much, and has been about 10%.²¹
This is a generalization, as there are exceptions depending on how much money a bank holds. For a small amount of money there has been no reserve requirement, for a medium amount (called a low tranche), about 3% in reserves were required, and for money that is considered a large amount there has been a 10% requirement. To give you an idea of how this has grown, 3% reserves required by banks in 1985 was just about $30 million. That same 3% in January of 2021 was more than $180 million. Many banks hold a lot more money than this, and the reserve requirement ensures that banks holding more money than this have to keep 10% readily available. As of March 2020, The Fed dropped reserve requirements for all three tranches to zero, where they remain to this day.²²
“Effective March 26, 2020, the Board reduced reserve requirement ratios on all net transaction accounts to zero percent, eliminating reserve requirements for all depository institutions.” ²³
— FEDERAL REGISTER NOTICE
3. The Fed Gives Loans to Banks and Charges Interest
The third thing The Fed can do is give banks loans and charge interest. Perhaps you’ve heard of The Fed Funds Rate. It sounds a little opaque, but basically it means how much interest The Fed is charging on the loans it makes to member banks.²⁴ When The Fed raises interest rates it means borrowing money costs more. When they lower interest rates it means borrowing money costs less. The Fed makes money offering these loans to banks and charging interest. So why do banks want these loans? The Fed is loaning them that money at a lower interest rate than they can charge a commercial customer who also wants that money, say for a house, a new car, or a small business venture.
So, the rate that The Fed charges the bank is lower than what the bank charges us. This difference is called the discount rate. The Fed loans money to banks at a discount rate, and banks lend money to customers at a little bit higher rate, and this keeps the circulation of credit lending afloat, which increases spending on things like cars, homes, and businesses. This is supposedly good for the economy because people are buying things, which leads to more jobs and greater productivity. Stimulating this activity is part of The Fed’s duty to the economy.
4. The Fed Buys and Sells Securities on the Open Market
The fourth and final maneuver The Fed can do is buy and sell securities. These are called Open Market Operations, or OMOs. Specifically, all OMOs are conducted from the trading desk at The Federal Reserve Bank of New York. This is where The Fed buys and sells securities on the open market.³³
Treasury Bills — perhaps the most important liquid instrument in the global financial system — are hawked and bought from a desk in New York to accredited buyers. Theoretically, even you or I can open a TreasuryDirect account²⁵ and buy T-Bills from a dude sitting at “the Desk” at 33 Liberty Street NY, NY.²⁷ Most people don’t go through that hassle and decide to use a broker instead., but what are these debt securities they sell?
These debt securities can be sold to mature at different intervals. There are 4-week, 8-week, and 12-week Treasury Bills (called T-Bills) that promise a specified return over a given time period. T-Bills are a crucial form of liquidity because they provide a known rate of return which is guaranteed at a specific date in the future. In addition to buying and selling T-Bills, The Fed offers Overnight Reverse Repurchase Agreements, called Repos.²⁸ These are conducted on a 24-hour basis, and basically mean The Fed will buy a T-Bill from another bank back quickly to get them some cash, and sell it back to them the next day for a little bit more, hence “repurchase agreement”.
The Fed buys or sells securities not from the U.S. government, but from private business enterprises on the open market, which helps contract or expand the monetary supply (money in circulation) in order to maintain “maximum employment, stable prices, and moderate long-term interest rates”.²⁹ So the trading desk at the central bank of New York buys and sells T-Bills on the open market to keep people employed, prices stable, and temper long-term interest rates. This is where we get all the talk about the price of groceries, whether unemployment is going up or down, and whether we’re dealing with more than 2% inflation a year (currently clocking in at 6.9%).³⁰ The Fed tries to take care of all of this by buying and selling T-Bills in New York, and adjusting the Federal Funds rate, to stay in line with the fiscal projections they forecast.
Maybe this helps explain why it’s a big deal when The Fed issues its prognostication on interest rates.
Whether Jerome Powell wants to raise or reduce interest rates is an indicator as to how much buying or selling they’re planning on doing in the open market to help the economy hit those goals.
When The Fed ‘raises rates’ it means they charge banks more to borrow money, which reduces lending to consumers, in turn reducing spending; when they ‘lower interest rates’ it means they charge banks less to borrow, which expands lending to the consumer, and increases spending. Doesn’t the fact that The Fed — a private non-federal institution — decides the health of our economy constrict the sentiment of a free market? Regardless, it’s billed as a service for public good.
Now we know what The Fed does — it’s these four primary things: a) settle transactions b) tell banks how much capital to hold c) set the price of loans, and d) buy and sell T-Bills on the open market. That’s it. Voila. You understand The Fed. But where does the money actually come from?
Triptych by Ab_Colours
Where Does the Money Come From?
Interestingly, The Federal Reserve doesn’t print money. Money, in its paper form, is only printed by the U.S. Treasury, specifically, The Bureau of Engraving and Printing (BEP).³¹ Fun fact: the majority of paper money printed today is solely to replace decayed, damaged, or outdated bills.
According to The Fed, there are $2 trillion worth of paper federal reserve notes in circulation. But The Fed’s balance sheet is $9 trillion.³² This gives you an idea about how little paper money is in circulation. Money in the U.S. is largely digital; most of it was created by buying securities, (aka bonds or T-Bills), which are financial instruments that represent a promise to pay a fixed sum to the buyer.
When The Fed buys bonds or T-Bills it has the authority to deposit digital credits into the member banks from which they bought securities on the open market. This bank credit isn’t the same as earned money, or existing money, but it is treated as money nonetheless.³⁴ But this is how The Fed “prints” money. Once “printed”, member banks use this as a basis to lend out more money and charge interest, which adds money into circulation and expands the economy. When The Fed sells securities they previously acquired on the open market, it withdraws capital from the financial system, and contracts the economy.
So when Crypto Twitter starts meme-ing about money printer go brrrrr… and people rant about how The Fed, in a sense, “pulls money out of thin air” it’s actually putting credit reserves in its own member banks (authorized by a guy at the trading desk at 33 Liberty St.) representing loans from them, for being the banker of the company that sold the T-Bill on the open market. This loan goes on The Fed’s balance sheet and money printer goes brrrrrr. The proper term would be instantiated credit deposits are occurring frequently at Federal Reserve member banks. But this doesn’t have the same ring.
To break it down a bit further these credits represent The Fed borrowing from commercial banks, credit unions, or other FDIC-insured institutions. Never mind the fact that they’re the one that put the credit there that they can borrow against.These are short term, payable-on-demand loans, and it is what makes The Fed’s balance sheet increase — currently in excess of $9 trillion.³⁵ From Jan 1, 2020 until Jan of 2023, The Fed’s balance sheet more than doubled.³⁶ Roughly speaking, that means there is twice as much money in circulation and it has half the purchasing power. This isn’t dissimilar to what happened in the 1930s for the dollar in relation to gold, where gold was recalled during Executive order 6102 and the dollar was devalued shortly thereafter. Today, however, it is on a far worse scale, because it’s not pegged to anything except tanks and bank notes.
So these credit deposits from The Fed aren’t the U.S. government money printer shop (BEP) running the paper mill non stop. They are simply digital reserve deposits held in member banks on their balance sheets as evidence of The Fed having bought securities using loans from member banks to cover the cost.
What’s out of order here is typically the lender decides who to lend to. “You want $450,000 for a house? Let me see your credit score, proof of reserves, and work history.” But it doesn’t work like that for The Fed. In this case the operator at The Desk of The New York Fed decides when they get a loan based on when they choose to purchase T-Bills. They can purchase T-Bills and sell T-Bills ad infinitum. This is because the person selling the T-Bill is getting immediate liquidity (in the form of his checking account receiving a spike in deposits). While the owner of that checking account, the commercial bank or credit union that is in the FDIC club and operates it, gets a benefit because they have more money to work with, even more so because reserve requirements are zero, so they don’t mind providing the loan.
In short, The Fed’s formula for buying T-Bills is to increase its balance sheet. What’s the limit to the balance sheet? None. This method of prestidigitation is not unlike how a magician presents a previously non-existent rabbit from the depths of a top hat.
The Federal Reserve Conclusion
The Federal Reserve is headquartered in Washington D.C. at 2051 Constitution Avenue NE. It’s an independent agency from the U.S. Government though its head employee receives a salary from them.³⁷ The Federal Reserve elects its own Chair as laid out in The Federal Reserve Act of 1913³⁸, but this can also be an appointment by the President of the United States if confirmed by the Senate as per the Banking Act of 1935. For example, President Trump appointed Jerome Powell and the Senate confirmed it.
D.C. stands for The District of Columbia, which is not a sovereign state persay, but a federal territory that retains some sovereign immunity,³⁹ and is not legally located in the continental United States, though it is geographically wedged in-between Maryland and Virginia. Incidentally, the etymology of the sovereign comes from 13th century France, meaning, “King, Queen, or ruler of the realm.”⁴⁰ How can one properly rule over a body of land or class of people if they were to be on the same level, located within that same territory, or bound by those same laws which they deemed to define, espouse and control?” Does the King not rule from the Castle? Does the Crown not address the proletariat from above? Does the Judge not sit in a vaulted position above the court? Clearly, to be separate, apart, exempt, higher than, does matter. Historically we’ve seen this in the God-appointed nature of rulers and its irrevocable grasp upon a people who accepted it. I believe it was Mark Twain who said, “Divine Right of Kings works Divinely, so long as the Kings agree.” It would seem fair to say, given what we now understand about the economy, that The Fed in some ways, sits above the rest of the economy, making decrees about our fiat system as it deems fit to do so. Fiat is, “an authoritative or arbitrary order”,⁴¹ and it comes from Latin meaning, “let it be done”,⁴² as well as from The Book of Genesis, fiat lux meaning “let there be light”. Whosoever makes the decree by fiat, therefore it is.
In 2009, just after the housing market crashed in the U.S., and Bernie Madoff was charged with the largest fraud in known history, a pseudonymous man named Satoshi Nakamoto made his own fiat, and called it bitcoin.
Stay tuned for Ch. 4, ‘Bitcoin & The Byzantine Generals’...
Frank America is an author, researcher, comedian, and musician. He has a background in English Literature, Philosophy, and Communications. Frank is a Editor-in-Chief of The Rug News, and content manager at Bankless Publishing.
Hiro Kennelly is a writer, editor, and coordinator at BanklessDAO and the Editor-in-Chief at Good Morning News. He is also helping to build a grants-focused organization at DAOpunks.
Trewkat is a writer and editor at BanklessDAO. She’s interested in learning as much as possible about crypto and NFTs, with a particular focus on how best to communicate this knowledge to others.
ab_colours is a versatile designer with over seven years of experience. He specializes in doing product design, UX design and brand identity. He has been DAOing for the past eight months and has been able to amass quite a lot of knowledge about the fascinating blockchain space.
BanklessDAO is an education and media engine dedicated to helping individuals achieve financial independence.
This post does not contain financial advice, only educational information. By reading this article, you agree and affirm the above, as well as that you are not being solicited to make a financial decision, and that you in no way are receiving any fiduciary projection, promise, or tacit inference of your ability to achieve financial gains.
More Like This
The Evolution of Money by Frank America
Gold, The Standard, and How the Dollar Floated Away by Frank America
² Griffin, Edward G. The Creature From Jeckyll Island, 5th ed. American Media, 2002.
⁷ The Federal Reserve Act. Sec. 16 pg. 68 https://fraser.stlouisfed.org/title/federal-reserve-act-1913-962/fulltext
⁹ America, Frank. “Gold, The Standard, and How The Dollar Floated Away”, Bankless Publishing, Oct, 2022.
¹⁰ Hayes, Adam, “Treasury Bills (T-Bills): What You Need to Know to Invest” https://www.investopedia.com/terms/t/treasurybill.asp, Accessed 2 Feb 2023.
¹¹ McNamara, Robert, “Edward Bernays, Father of Public Relations and Propaganda” https://www.thoughtco.com/edward-bernays-4685459, Accessed 2 Feb 2023.
²⁴ Chen, James, “Federal Funds Rate: What It Is, How It’s Determined, and Why It’s Important”, investopedia.com https://www.investopedia.com/terms/f/federalfundsrate.asp Accessed 2 Feb 2023.
²⁸ Chen, James, “What Is a Reverse Repurchase Agreement? How They Work, With Example”, investopedia.com https://www.investopedia.com/terms/r/reverserepurchaseagreement.asp Accesseed 2 Feb 2023.
³⁰ Iacurci, Greg, “Here’s the inflation breakdown for December 2022 — in one chart”, cnbc.com, https://www.cnbc.com/2023/01/12/heres-the-inflation-breakdown-for-december-2022-in-one-chart.html Accessed 2 Feb 2023
³² Baccardax, Martin, “Fed Minutes Detail Plans To Trim $9 Trillion Balance Sheet, ‘Expeditiously’ Lift Interest Rates” thestreet.com, https://www.thestreet.com/markets/fed-minutes-detail-plot-for-9-trillion-balance-sheet-rate-hikes Accecssed 2 Feb 2023.
³⁴ Amadeo, Kimberly, “What Are Open Market Operations?”, thebalancemoney.com, https://www.thebalancemoney.com/open-market-operations-3306121 Accessed 2 Feb 2023.
³⁷ See Level One Chairman of Fed Reserves Agencies: https://www.federalpay.org/ses/level-1
³⁸ The Federal Reserve Act, 1913.
The post What the F is The Fed? appeared first on Bankless Publishing. In this third chapter by Frank America we unpack what The Federal Reserve actually does, and answer the perennial question, “What the F is The Fed?”
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