What Is the Federal Reserve?

The Fed Explained

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 is the central bank of the U.S. The Fed supervises the nation's largest banks, conducts monetary policy, 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 is intended to keep it independent from political influences. Let's look at what the Fed is, how it works, and how it affects you.

The Federal Reserve Defined

The Federal Reserve is the central banking system of the United States, and it has been around for over a century.

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. Today, the Fed enacts monetary policy to manage inflation, maximize employment, and stabilize interest rates. It also oversees the banking system to protect consumers. We'll look at these tasks in greater depth below.

How Does the Federal Reserve Work?

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

  • 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.
  • The 12 regional Federal Reserve Banks work with the board to supervise the nation's commercial banks and implement policy.
  • 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, and 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 main functions:

  • Manage inflation: This is the Fed's most visible function. As part of this function, the Fed also promotes maximum employment and ensures interest rates remain moderate over time.
  • Supervise the banking system: The Fed supervises and regulates the nation’s largest banks and enacts laws to protect consumers.
  • Maintain the stability of the financial system: It maintains the stability of the financial markets and constrains potential crises.
  • Provide banking services: The Fed provides services to other banks, the U.S. government, and foreign banks.

Let's look at each of these in turn.

Manage 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 because they have a wider range of volatility. 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.

The Fed has many powerful tools at its disposal for this purpose. Its most powerful tool is setting the target for the federal funds rate, which guides interest rates. The Fed also sets the reserve requirement for the nation's banks, which 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 federal funds. Banks charge each other the federal funds rate on these loans.

Knowledge of the current fed funds rate is important because this rate is a benchmark in financial markets. Many interest rates are based upon the fed funds rate.

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.

Supervise 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 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.

Maintain 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 outlining its financial health and ability to handle a 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.

Provide 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—that's why the Federal Reserve is also known as the bank of last resort.

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 independently 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 runs from Feb. 5, 2018, to Feb. 5, 2022.

The previous chair was Janet Yellen, who is now the Secretary of the Treasury. 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 served as chair from 2006 to 2014. He was an expert on the Fed's role during the Great Depression, which 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 Federal Reserve has a significant impact on the lives of all Americans. 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, as well as 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.

Key Takeaways

  • The Federal Reserve is the central bank of the United States.
  • The Fed manages inflation, regulates the national banking system, stabilizes financial markets, protects consumers, and more.
  • Although the Fed board members are appointed by Congress, it is designed to function independently of political influence.
  • The Fed plays a significant role in financial concerns that affect the lives of all Americans.