The Federal Reserve and What It Does

How the Fed Affects Your Life Every Day

Image shows a picture of a large financial building. Text reads: "What the federal reserve does: manages inflation, supervises the banking system, maintains the stability of the financial system, provides banking services"

Image by Ellen Lindner © The Balance 2019

The Federal Reserve System is America's central bank. That makes it the most powerful single actor in the U.S. economy and thus the world. It is so complicated that some consider it a "secret society" that controls the world's money. They’re partly right. Central banks do manage the money supply around the globe, but there is nothing secret about it.

System Structure

To understand how the Fed works, you must know its structure. The Federal Reserve System has three components:

  • Board of Governors: The Board of Governors directs monetary policy. Its seven members are responsible for setting the discount rate and the reserve requirement for member banks. Staff economists provide all analyses, including the monthly Beige Book and the semi-annual Monetary Report to Congress.
  • Federal Reserve Banks: The Federal Reserve Banks work with the board to supervise commercial banks and implement policy. There is a Fed bank located in each of the 12 Fed districts.
  • Federal Open Market Committee: The FOMC oversees open market operations. That includes setting the target for the fed funds rate, which guides interest rates. The seven board members, the president of the Federal Reserve Bank of New York, and four of the remaining 11 bank presidents are members. The FOMC meets eight times a year.

What the Federal Reserve Does

The Federal Reserve has four functions. Its most critical and visible function is to manage inflation and maintain stable prices. It sets a 2% inflation target for the core inflation rate.

Managing inflation is so critical because ongoing inflation is like a cancer that destroys any benefits of growth.

Second, the Fed supervises and regulates many of the nation’s banks to protect consumers. Third, it maintains the stability of the financial markets and constrains potential crises. Fourth, it provides banking services to other banks, the U.S. government, and foreign banks.

The Fed performs its functions by conducting monetary policy. The goal of monetary policy is healthy economic growth. That target is a 2%-3% gross domestic product growth rate. It also pursues maximum employment. The goal is the natural rate of unemployment of 4.7% to 5.8%.

1. Manages Inflation

The Federal Reserve controls inflation by managing credit, the largest component of the money supply. This is why people say the Fed prints money. The Fed moderates long-term interest rates through open market operations and the fed funds rate.

When there is no risk of inflation, the Fed makes credit cheap by lowering interest rates. This increases liquidity and spurs business growth. That ultimately reduces unemployment. The Fed monitors inflation through the core inflation rate, as measured by the Personal Consumption Expenditures Price Index. It strips out volatile food and gas prices from the regular inflation rate. (Food and gas prices rise in the summer and fall in the winter, and that's too fast for the Fed to manage.)

The Federal Reserve uses what's known as expansionary monetary policy when it lowers interest rates. The intent is to expand credit and liquidity.

Expansionary policy makes the economy grow faster and create jobs. If the economy grows too much, though, it triggers inflation. When that happens, the Federal Reserve raises interest rates as part of contractionary monetary policy. High interest rates make borrowing expensive. Increased loan costs slow growth and lower the likelihood of businesses raising prices.

The Fed has many powerful tools at its disposal. It sets the reserve requirement for the nation's banks, telling them what percentage of their deposits they must actually have on hand each night. The rest can be loaned out.

If a bank doesn't have enough cash on hand at the end of the day, it borrows what it needs from other banks. The funds it borrows are known as the fed funds. Banks charge each other the fed funds rate on these loans.

The FOMC sets the target for the fed funds rate at its monthly meetings. To keep it near its target, the Fed uses open market operations to buy or sell securities from its member banks. It creates credit out of thin air to buy these securities. This has the same effect as printing money. That adds to the reserves the banks can lend and results in the lowering of the fed funds rate. Knowledge of the current fed funds rate is important because this rate is a benchmark in financial markets.

2. Supervises the Banking System

The Federal Reserve oversees roughly 5,000 bank holding companies, 850 state bank members of the Federal Reserve Banking System, and any foreign banks operating in the U.S. The Federal Reserve Banking System is a network of 12 Federal Reserve banks that both supervise and serve as banks for all the commercial banks in their region.

The 12 banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The Reserve Banks serve the U.S. Treasury by handling its payments, selling government securities, and assisting with its cash management and investment activities. Reserve banks also conduct valuable research on economic issues.

After the financial crisis of 2008, the Dodd-Frank Wall Street Reform Act strengthened the Fed's power over banks. Dodd-Frank said if any bank became too big to fail, it could be turned over to Federal Reserve supervision and required to have a bigger reserve to protect against losses.

In fact, the Fed was given the mandate to supervise "systematically important institutions," and in 2015, it created the Large Institution Supervision Coordinating Committee. This committee regulates the 16 largest banks, and most importantly, is responsible for the annual stress test of 31 banks. These tests determine whether the banks have enough capital to continue making loans even if the system falls apart the same way it did in October 2008.

In 2018, President Donald Trump signed a bill that weakened Dodd-Frank by easing regulations on smaller banks.

The law, the Economic Growth, Regulatory Relief, and Consumer Protection Act, rolled back a number of rules for small banks. The Fed can't designate these banks as too big to fail, and these banks no longer have to hold as much in assets to protect against a cash crunch. They also may not be subject to the Fed's "stress tests."

In addition, smaller banks no longer have to comply with the so-called Volcker Rule. Now banks with less than $10 billion in assets can, once again, use depositors' funds for risky investments.

3. Maintains the Stability of the Financial System

The Federal Reserve worked closely with the Treasury Department to prevent global financial collapse during the financial crisis of 2008. It created many new tools, including the Term Auction Facility, the Money Market Investor Funding Facility, and Quantitative Easing.

Two decades earlier, the Federal Reserve intervened in the Long Term Capital Management Crisis. Federal Reserve actions worsened the Great Depression of 1929 by tightening the money supply to defend the gold standard.

4. Provides Banking Services

When the Fed buys U.S. Treasurys from the federal government, it's called monetizing the debt. The Fed creates the money it uses to buy the Treasurys. It adds that much money to the money supply. Over the past 10 years, the Fed has acquired $4 trillion in Treasurys.

The Fed is called the "bankers' bank." That is because each Reserve bank stores currency, processes checks, and makes loans for its members to meet their reserve requirements when needed. These loans are made through the discount window and are charged the discount rate, one that is set at the FOMC meeting. This rate is lower than the fed funds rate and Libor. Most banks avoid using the discount window because there is a stigma attached. It is assumed the bank can't get loans from other banks. That's why the Federal Reserve is known as the bank of last resort.

History

The Panic of 1907 spurred President Woodrow Wilson to create the Federal Reserve System. He called for a National Monetary Commission to evaluate the best response to prevent ongoing financial panics, bank failures, and business bankruptcies. Congress passed the Federal Reserve Act of 1913 on December 23 of that year. 

Congress originally designed the Fed to "provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the U.S., and for other purposes." Since then, Congress has enacted legislation to amend the Fed's powers and purpose. 

Congress created the Fed's board structure to ensure its independence from politics. Board members serve staggered terms of 14 years each. The president appoints a new one every two years. The U.S. Senate confirms them. If the staggered schedule is followed, then no president or congressional party majority can control the board.

The Fed's independence is critical. With autonomy, the central bank can focus on long-term economic goals, making decisions based solely on economic indicators. No president can pressure members to keep interest rates low and overstimulate the economy.

President Trump was the first president in history to question the Fed's independence. In 2018, Trump publicly criticized the Fed for raising interest rates. He said higher rates slow growth and offset his attempts to spur the economy. When asked to name the single greatest threat to growth, he blamed the Fed.

This is despite the fact that Trump nominated six of the seven members. The Senate has confirmed three of them. Trump inherited this rare opportunity to stack the Fed board in his favor. The chair position came up for reappointment during his term. Three board positions were already vacant, including the vice-chair position. Two of them have been vacant since the financial crisis. 

Who Owns the Fed

Technically, member commercial banks own the Federal Reserve. They hold shares of the 12 Federal Reserve banks. But that doesn't give them any power because they don't vote. Instead, the Board and FOMC make the Fed's decisions based on research. The president, U.S. Treasury Department, and Congress don't ratify its decisions, although the board members are selected by the president and approved by Congress. This gives elected officials control over the Fed's long-term direction but not its day-to-day operations.

Some elected officials are still suspicious of the Fed and its ownership. They want to abolish it altogether. Senator Rand Paul wants to control it by auditing it more thoroughly. His father, former Congressman Ron Paul, wanted to end the Fed.

Role of the Fed Chair

The chairman of the Federal Reserve sets the direction and tone of both the Federal Reserve Board and the FOMC. The current chairman is Jerome Powell, who President Trump appointed to lead from February 5, 2018, to February 5, 2022.

The former chair is Janet Yellen. Her term ran from 2014 to 2018. Her biggest concern was unemployment, which made her more likely to want to lower interest rates. She was more "dovish" than “hawkish,” but ironically, she was the chair when the economy required contractionary monetary policy. 

Ben Bernanke was the chair from 2006 to 2014. He was an expert on the Fed's role during the Great Depression, which was very fortunate. He knew the steps to take to end the Great Recession, and he kept the economic situation from turning into a depression.

How the Fed Affects You

The press scrutinizes the Federal Reserve for clues on how the economy is performing and what the FOMC and Board of Governors plan to do about it. The Fed directly affects your stock and bond mutual funds and your loan rates. By having such an influence on the economy, the Fed also indirectly affects your home's value and even your chances of being laid off or rehired.

Article Sources

  1. Federal Reserve. "What Is the Purpose of the Federal Reserve System?" Accessed March 20, 2020.

  2. Board of Governors of the Federal Reserve System. “The Twelve Federal Reserve Districts,” Accessed March 20, 2020.

  3. Federal Reserve. “The Structure and Functions of the Federal Reserve System.” Accessed March 20, 2020.

  4. Board of Governors of the Federal Reserve System. “Large Institution Supervision Coordinating Committee.” Accessed March 20, 2020.

  5. Board of Governors of the Federal Reserve System. “Stress Tests and Capital Planning.” Accessed March 20, 2020.

  6. Congress.gov. “S.2155 - Economic Growth, Regulatory Relief, and Consumer Protection Act.” Accessed March 20, 2020.

  7. Board of Governors of the Federal Reserve System. “Dodd-Frank Act Stress Tests.” Accessed March 20, 2020.

  8. Board of Governors of the Federal Reserve System. “Why Does the Federal Reserve Lend Money to Banks?” Accessed March 20, 2020.

  9. Board of Governors of the Federal Reserve System. “Jerome H. Powell, Chair,” Accessed March 20, 2020.