What Is the Federal Reserve?
The Federal Reserve is the U.S. central bank system. The Fed implements monetary policy in order to stabilize the economy, monitor interest rates, and keep unemployment low. It is the most powerful economic institution in the country, and one of the most important in the world.
You’ve probably heard a lot about the Fed thanks to higher-than-normal inflation in 2022 and 2023. Notably, the Fed raised interest rates rapidly in these two years, using a series of small increases designed to tamp down inflation.
The Federal Reserve System does far more than manage inflationary pressures, however. That’s just a start.
Why Was the Federal Reserve Created?
Throughout the 19th century, there was no central bank in the U.S., and the banking system was fraught with bank failures and “bank runs,” where depositors would rush to banks to withdraw all of their money. To create a safer and more stable bank system, President Woodrow Wilson signed the 1913 Federal Reserve Act.
The Fed is actually an intricate system that consists of several different parts. These are the three bodies of the Fed:
The Federal Reserve Board of Governors
There are seven Federal Reserve board members that oversee the Federal Reserve System. This includes the chairman and vice chairman. Jerome Powell has been chair of the Fed since 2018. Before him, the chairman of the Federal Reserve was Janet Yellen.
The Board of Governors, which is made up of seven governors, is based in D.C. and reports to Congress. Board members are appointed by the U.S. president and serve staggered 14-year terms (so the entire board isn’t replaced in a single year). The chairman and vice chairman serve four-year terms and may be reappointed at the end of their term.
Federal Reserve Branches
There are 12 Federal Reserve districts in major cities throughout the country that act as the operating arms of the Federal Reserve.
You wouldn’t walk into a Federal Reserve bank and open up a checking account, though. Rather, Federal Reserve banks work with other institutions, such as banks and credit unions, and the U.S. Treasury. They provide services like holding deposits for banks, processing payments, and issuing and redeeming government securities.
The Federal Open Market Committee (FOMC)
The committee comprises all members of the Board of Governors and five rotating Reserve Bank presidents. Although not all Reserve Bank presidents vote, all participate in policy discussions.
The FOMC meets eight times a year to review economic trends and vote on new monetary policy measures. During these meetings, the committee will set a federal funds rate. The FOMC may also take steps to control the money supply.
What Does the Federal Reserve Do?
The Federal Reserve has several primary functions:
Setting Monetary Policy
One of the primary roles of the FOMC is to set monetary policy. With monetary policy, there are typically two primary goals: Maximum employment and stable inflation.
Often, we hear about monetary policy in terms of the setting of the federal funds rate. This is the rate at which banks charge each other on an overnight basis.
A bank might need to borrow money from another bank in order to meet the Fed’s minimum reserve requirement, or how much cash the bank has available in its reserves.
Recommended: What Is Fractional Reserve Banking?
The federal funds rate as set by the FOMC may influence other interest rates. In this way, the federal funds rate can be used as a tool to encourage or restrict borrowing. For example, the Fed may attempt to fight inflation by raising the federal funds rate. Conversely, the Fed may lower that same rate in an attempt to ward off a recession.
But this isn’t the only monetary policy that the FOMC is engaged in. According to the Federal Reserve, its main tool for controlling the money supply is “open market operations,” which is the buying and selling of government securities, like treasury bills. They may do this in conjunction with a rate change or other strategies.
Regulating Banks
To ensure the safety and solvency of the nation’s banking and financial system, the Fed regulates banks and other financial services institutions. This is done not only for the protection of the consumer but to promote stability within the banking system.
The Board of Governors typically sets guidelines for member banks through policy regulation and supervision. The Reserve Banks then examine member banks to ensure that they comply with existing laws and regulations. Often, new guidelines are created because of legislation that has been passed through Congress.
Overseeing Payment Systems
The Fed provides financial services to the U.S. government, major financial institutions, and foreign official institutions. The Fed acts as the depository institution for the U.S. Treasury — essentially, the Treasury’s checking account.
The Fed also plays a major role in operating and overseeing the nation’s payment systems. In addition to making sure there is enough currency in circulation, the Fed clears millions of checks and processes electronic payments. Social Security checks and the payrolls of government institutions are processed by the Fed.
Limiting Risk
At the end of the day, the Federal Reserve wants to control risks to the economy and financial markets (such as the stock market) as best they can. They utilize a number of measures, including those discussed above, in order to best achieve this stability.
How Does the Federal Reserve Affect You?
Although you might not always feel it, the Federal Reserve enacts policies and makes decisions that affect the lives of everyday Americans.
Although the Fed does not set rates like mortgage rates and credit card interest rates, those rates can shift as the Fed Funds rate does.
An increase or decrease in interest rates can affect consumers in plenty of ways. If overall rates increase, then it becomes more expensive to be a borrower. Variable interest rates may rise, and any new debt will be issued at higher rates.
The rates at which money is flowing freely throughout an economy may also have rippling impacts. For example, when rates are low and access to money is cheap, businesses may borrow money in order to invest in development or expand operations. If there is too much money in circulation, inflation may increase. This could cause the prices of everyday goods, like groceries, to increase as well.
The Takeaway
One of the Fed’s goals is an economy with full employment. If they are not able to succeed using the tools at their disposal, people may lose jobs, and unemployment may increase. This could also have effects throughout the greater economy, such as decreased consumer spending and overall slowed economic growth.
Keeping an eye on what the Fed does and why they’re doing it can provide valuable information for investors. Issues like unemployment and inflation can affect the markets, which in turn can have an impact on your financial plans.
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