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What is the Federal Reserve? A guide to the world’s most powerful central bank

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The banks’ bank. The lender of last resort. The orchestrator of the U.S. economy. These words are often used to describe the central bank of the U.S., officially known as the Federal Reserve System.

Investors and economists alike obsess over every word and sentence that comes out of the Fed, whether from public speeches or statements issued after meetings by its policymaking arm, the Federal Open Market Committee (FOMC).

But even though the Fed’s work seems so complicated that only financial experts should care, the Fed’s decisions impact your wallet and can influence your financial decisions, arguably more so than any other policymaker in Washington. Understanding the world’s most powerful central bank will be more important now than ever in a year when markets are now bracing for the most rate hikes since 2005.

“The decisions that the Fed makes ultimately impact the interest rates that are relevant for everything that we do,” says Eric Sims, economics professor at the University of Notre Dame.

Here’s everything you need to know about the Fed, including what it does and the purpose it serves.

Federal Reserve 101:

    1. What is the Federal Reserve?
    2. What does the Federal Reserve do?
    3. What does the Fed look at when deciding what to do with interest rates?
    4. How does the Fed change interest rates?
    5. Who controls the Fed?
    6. How does the Federal Reserve impact my finances?

1. What is the Federal Reserve?

The Federal Reserve System is made up of the board of governors, 12 regional reserve banks and the Federal Open Market Committee.
Riley Arthur / Bankrate

The Federal Reserve, frequently dubbed “the Fed” for short, is the central bank of the U.S. Whereas fiscal lawmaking is left up to the three branches of government, the Fed sets monetary policy, mainly by adjusting interest rates, the money supply and bank regulations to foster economic stability.

Other countries, such as Canada, India, the United Kingdom and Japan, have their own iterations of the Fed. The European Central Bank sets policy for the European Union.

After a panic stoked a lack of trust and confidence in the banks, Congress created the current version of the Fed (there have been two others) in 1913, tasking it with maintaining “a safer, more flexible and more stable monetary and financial system.”

The broader Fed system has three pillars: the board of governors, the 12 regional reserve banks and the FOMC.

Board of governors

The board of governors in Washington is a seven-member board that supervises the entire Fed system. The president appoints each official, and then they are confirmed in the Senate.

On top of that, the board houses about 1,850 other employees, all of whom conduct research on broader macroeconomic issues to help inform policymakers.

Regional reserve banks

The 12 regional reserve banks, on the other hand, are scattered throughout the country. Each has its own president and board of directors, who stay informed on their regional economies and report those findings back to the board.

The Federal Reserve System is composed of 12 regional reserve banks scattered throughout the country
Riley Arthur / Bankrate

Congress created these regional banks to ensure that the Fed was a “decentralized” central bank, meaning it didn’t just concern itself with what was happening on Wall Street or Capitol Hill.

FOMC

These two components combine to make the FOMC, the third tier and perhaps the most influential aspect of the Fed.

At eight meetings a year (sometimes more during emergencies), all seven governors and five of the 12 reserve bank presidents vote to decide whether to raise or lower interest rates and conduct monetary policy.

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2. What does the Federal Reserve do?

The Fed’s interest-rate decisions capture the most attention. During FOMC meetings, officials have three options: Raise interest rates, lower them or maintain them.

Think of the U.S. economy as having a speed limit. If it moves too fast, it risks overheating or crashing. The Fed will thus push on the brakes by raising interest rates, which makes borrowing costs more expensive and essentially encourages consumers and businesses to delay purchases, slowing down the economy.

On the contrary, when the U.S. economy faces a recession, the Fed will cut rates to prop it up. That prompts many consumers and companies to make those big-ticket purchases, cycling back into the economy and acting as a stimulus for growth.

The Fed has also occasionally lowered interest rates when storm clouds are on the horizon, in an attempt to shore up an economic expansion. The Fed in 2019, for example, reduced rates at three straight meetings amid slowing global growth and the U.S.-China trade war.

In times of severe economic stress, the Fed can also lend money to hard-hit corners of the financial system to prevent credit from drying up, just as it did during the 2008 financial crisis, as well as in the midst of the coronavirus pandemic.

As the virus swept the nation and roiled both businesses and markets around the globe, the Fed bought debt in virtually all corners of the market — from the Treasury and mortgage-backed securities that banks use to benchmark mortgage rates, to the never-before-touched corporate debt and municipal bonds.

Of course, the Fed has other duties, many of which came in the aftermath of the financial crisis. U.S. central bankers regulate and oversee big banks in the U.S. and maintain the nation’s payment system, through operations such as the discount window or its internal check clearinghouse.

The Fed also has a hand at maintaining financial stability during times of distress. After the Sept. 11 terrorist attacks, for example, then Fed Chairman Alan Greenspan made a swift announcement that the Fed’s discount window was open, hoping to quell panic.

“While politicians often take credit or blame for the performance of the economy and the job market, it is the Federal Reserve that is more directly responsible,” says Greg McBride, CFA, Bankrate chief financial analyst. “If the Fed raises interest rates too fast or too far, for example, an economic slowdown or a broad contraction could result. Similarly, by cutting interest rates they can give the economy a needed boost by making it cheaper for consumers and businesses to borrow.”

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3. What does the Fed look at when deciding what to do with interest rates?

The Fed doesn’t arbitrarily adjust interest rates. U.S. central bankers have a dual mandate: maximum employment and stable prices. In the Fed’s ideal economy, everyone who wants a job can find one, while inflation is tame enough that it doesn’t diminish consumers’ purchasing power.

That means officials keep a close watch on employment and inflation figures, such as the monthly jobs report, the consumer price index (CPI) and the personal consumption expenditures (PCE) index, the latter of which is officials’ preferred gauge for tracking price increases.

Officials have a specific inflation target of 2 percent, which they defined in 2012. It’s a goldilocks rate — one that’s neither too high nor too low.

But officials keep a close watch on other economic figures that could bring different outcomes for employment and inflation down the road. For example, fixed business investment as reported in gross domestic product — the broadest scorecard of the U.S. economy — could show whether employers are hesitant or enthusiastic about the future. If a business is feeling optimistic, they’ll likely hire more.

Average hourly earnings, on the other hand, is typically a strong indicator for inflation. If companies are having to pay workers more, they might pass along those increases in the form of higher prices to consumers.

The process often requires finesse. If officials raise interest rates too soon, they could risk slowing the economy down needlessly and keeping more people out of work. If the Fed waits too long, however, inflation could pick up. And just like it’s difficult to stop an airplane that’s already taking off on a runway, it’s hard to curb inflation once prices are lifting off.

The Fed also sets one uniform policy for the entire country, which is often difficult when some regions of the U.S. are faring better than others.

There’s no right answer for whether employment or inflation matters more, says Notre Dame professor Sims. As a result, many officials favor sacrificing one for the other. Inflation fearers, for example, are frequently referred to as “hawks.” They often dissuade against too loose interest rate policies in an attempt to keep price pressures under control. On the flip side, “doves” want unemployment to be as low as possible for as long as possible. They’re often willing to stomach higher inflation to get there.

“It’s a difficult problem to solve,” Sims says. “You have to balance different sectors of the economy, and some are more sensitive than others. If they’re deemed important to full employment, maybe the Fed is willing to tolerate some inflation to try to stimulate those sectors.”

The Fed’s job is to ultimately maintain low unemployment for as long as possible without letting the economy run too hot for too long, triggering inflation. The Fed uses interest rates to steer the economy toward that outcome.

But typically, Fed officials believe there’s a trade-off between both.

“If the labor market is too tight, it generates inflation,” Sims says. “If the labor market is too loose, this is going to generate deflation. Depending on how you weigh what’s going on in the labor market versus what’s happening to inflation, that sort of informs your opinions on how you want to adjust interest rates and what the potential consequences are.”

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4. How does the Fed change interest rates?

But when setting interest rates, the U.S. central bank doesn’t tell lenders to charge a specific rate. Most interest rates you see on consumer products are privately determined, including financial institutions’ own profit-making margins based on consumers’ creditworthiness.

Those rates, however, are influenced by the Fed’s decisions. The Fed has direct control over a short-term benchmark rate known as the federal funds rate. At the end of each meeting, the FOMC determines a target range for that benchmark rate that’s ideal for maximum employment and stable prices.

Currently, that target range is 0-0.25 percent, where it’s been since March 2020, when the coronavirus crisis first ripped a hole in the financial system. That’s the lowest level in history, where it’s been only once before: in the aftermath of the Great Recession. The Fed’s benchmark rate has soared to a target range as high as 15-20 percent.

The rate that the Fed sets then filters through to the rest of the economy in ways that are simpler than you might expect. Similar to how you keep money in accounts at a bank, financial institutions keep reserves in accounts at the Fed. And just as you’re often required to maintain a minimum balance, banks, too, are required to hold a certain level of reserves.

Many banks, however, choose to keep more than is required. To ensure that the fed funds rate is filtered out through the rest of the economy, the Fed pays banks interest on the reserves in excess of the minimum requirement. It adjusts that rate in-tandem with adjustments to the federal funds rate.

“If the Fed increases the rate that they’re paying banks to hold reserves, it’s going to reduce the incentive for banks to lend out funds,” Sims says. “If I can earn 4 percent by holding reserves at the Fed, it’s not a good deal to lend it out to you at 4.5 percent, given that you’re a little risky.”

That ultimately raises interest rates in the broader economy because there’s less credit in circulation.

On the flip side, if the Fed wants to incentivize banks to lend out their excess reserves (rather than keeping them at the Fed), the FOMC will lower the interest rate that it pays on them. That increases the amount of available credit in the economy, thus lowering interest rates.

It’s a common misconception that the Fed prints money when it wants to lower interest rates and shreds money when it wants to raise interest rates. While untrue, influencing the amount of credit in an economy has a similar effect to influencing the money supply.

“When the interest rate on reserves falls, this incentivizes banks to create more credit, resulting in an increase in the money supply,” Sims says.

It’s worth noting that today — nearly two years into the coronavirus pandemic — the Fed has completely eliminated reserve requirements. It’s another way of incentivizing banks to lend out the capital they’ve already built up, a step to ensure that credit continues flowing freely.

These are the more conventional tools that the Fed can use to adjust short-term interest rates. When the Fed wants to adjust longer-term borrowing, such as the cost of buying a home, officials can institute an unconventional program: quantitative easing. With this process, the Fed typically purchases Treasurys or mortgage-backed securities, to lower longer-term rates.

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5. Who controls the Fed?

The Fed doesn’t have to seek presidential or congressional approval when deciding what to do with interest rates. Instead, it’s given complete authority. The idea is, if the president has control over the Fed’s decisions, it will likely only approve a policy that supports a political interest, rather than what’s best for the broader economy. (Presidents, for example, have historically preferred low interest rates to keep the economy booming).

That’s not to say, however, that the Fed doesn’t have oversight. The Fed is audited every year by an independent accounting firm, as well as the Government Accountability Office. Results are then published in March of the following year on the board’s website. In addition, Congress acts as its overseer, with the Fed chair having to report to Capitol Hill twice a year on how monetary policy is progressing.

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6. How does the Federal Reserve impact my finances?

The Fed’s work is so complicated that it often gets misunderstood — or outright ignored. But it isn’t something to gloss over.

You’ll feel all of these decisions in your wallet. When the Fed lowers interest rates, it reduces yields on consumer products, such as savings accounts and certificates of deposits. Auto loan and credit card rates also tend to fall in line with Fed cuts, though they still hold well above the fed funds rate. Mortgage rates aren’t directly impacted by Fed decisions, but they’re influenced by the same external market factors that guide the Fed. Vice versa, those rates and yields rise when the Fed hikes rates.

Not to mention, inflation has enormous implications for U.S. consumers. If inflation picks up, households lose their purchasing power. And if it falls, the dollars in their wallets aren’t worth as much as they used to be.

“If you want to get a loan, the interest rate you pay on the loan is influenced by what the Fed is up to,” Sims says. “If you are a senior citizen living on fixed income payments, you care a lot about what’s happening to prices in the economy. If you’re a creditor of someone who’s borrowing or if you’re a borrower, you care about what the Fed is doing. [The Fed] directly influences the decisions you make.”

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Written by
Sarah Foster
U.S. economy reporter
Sarah Foster covers the Federal Reserve, the U.S. economy and economic policy. She previously worked for Bloomberg News, the Chicago Tribune and the Chicago Daily Herald.
Edited by
Wealth editor