What Is the Federal Reserve and What Does It Do?

The Fed affects your life every day—here's how

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 the central bank of the U.S. It conducts monetary policy to manage inflation, maximize employment, and stabilize interest rates. The Fed supervises the nation's largest banks and provides financial services to the U.S. government. It also promotes the stability of the financial system.

Although its members are appointed by Congress, its structure makes it independent from political influences. That makes it the most powerful single actor in the U.S. economy and thus the world.

The Federal Reserve System Structure

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

  1. The Board of Governors' seven members guide the entire Fed system. They direct monetary policy and set the discount rate and the reserve requirement for member banks. Staff economists provide all analyses.
  2. The 12 regional Federal Reserve Banks work with the board to supervise the nation's commercial banks and implement policy.
  3. The Federal Open Market Committee (FOMC) oversees open market operations. The seven board members, the president of the Federal Reserve Bank of New York, and four of the remaining 11 regional bank presidents are members. The FOMC meets eight times a year.

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.

What Does the Federal Reserve Do?

The Federal Reserve has four functions:

  1. Its most visible function is to manage inflation. As part of this function, the Fed also promotes maximum employment and ensures interest rates remain moderate over time.
  2. The Fed supervises and regulates the nation’s largest banks to protect consumers.
  3. It maintains the stability of the financial markets and constrains potential crises.
  4. The Fed provides banking services to other banks, the U.S. government, and foreign banks.

1. Manages Inflation

The Fed manages inflation while promoting maximum employment and stable interest rates. The Fed sets a 2% inflation target for the core inflation rate. The core rate strips out volatile food and gasoline prices. On Aug. 27, 2020, the Fed announced it would tolerate inflation above 2% in the short-term if it maximized employment. The Fed uses the Personal Consumption Expenditures Price Index (PCE) to measure inflation.

Managing inflation is so critical because, over time, it reduces your standard of living.

The Fed has many powerful tools at its disposal. The Fed's most powerful tool is setting the target for the fed funds rate, which guides interest rates.

The Fed also sets the reserve requirement for the nation's banks. It tells them what percentage of their deposits they must 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.

Knowledge of the current fed funds rate is important because this rate is a benchmark in financial markets.

The Federal Reserve uses expansionary monetary policy when it lowers interest rates. This makes loans cheaper, spurs business growth, and reduces unemployment.

The opposite, when the Fed raises interest rates, is known as contractionary monetary policy. High interest rates make borrowing expensive and increased loan costs slow growth and keep prices low.

The FOMC sets the target for the fed funds rate. Banks set their own effective fed funds rate. 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 the Fed printing money. That adds to the reserves the banks can lend and results in the lowering of the fed funds rate.

2. Supervises the Banking System

The Federal Reserve Banking System is a network of 12 Federal Reserve banks under the supervision of the Board of Governors. These 12 banks both supervise and serve as banks for commercial banks in their region.

The 12 Federal Reserve regional banks are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis, 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.

3. Maintains the Stability of the Financial System

The 2008 financial crisis revealed regulations on individual banks weren’t enough. The financial system had become so interconnected that the Fed and other regulators needed to look at it as a whole.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 strengthened the Fed's ability to maintain stability. Each bank with over $50 billion in assets had to submit a "living will" to the Fed. It outlined how the bank would safely wind down if facing a financial crisis. This was to prevent another bankruptcy on the scale of Lehman Brothers.

In 2018, Congress waived Dodd-Frank regulations on banks with less than $10 billion in assets.

The Fed's Large Institution Supervision Coordinating Committee (LISCC) regulates the largest and most systematically important banks. It conducts stress tests to determine whether the banks have enough capital to make loans even in a financial crisis.

4. Provides Banking Services

The Fed is called the "bankers' bank" 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.

Banks are charged the discount rate, which is a little higher than the fed funds rate. 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 and that's why the Federal Reserve is also known as the bank of last resort.

When Was the Federal Reserve Created?

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 then passed the Federal Reserve Act of 1913.

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 expand the Fed's powers and purpose. 

Who Owns the Fed?

Member commercial banks own the Federal Reserve by holding shares of the 12 Federal Reserve banks. This ownership doesn't give them any power because they can't vote.

The Board and FOMC make the Fed's decisions based on research.

The president, U.S. Treasury Department, and Congress don't ratify the Fed's 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.

What's the Role of the Fed Chair?

The Federal Reserve chair sets the direction and tone of both the Federal Reserve Board and the FOMC. The current chairman is Jerome Powell, a Fed board member. His term as chair is from Feb. 5, 2018, to Feb. 5, 2022.

The former chair is Janet Yellen. Her term ran from 2014 to 2018. Yellen's biggest concern was unemployment, which made her more likely to want to lower interest rates. 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 since it helped him take steps to end the 2008 financial crisis. This helped keep 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.