How the Federal Reserve Moves the Economy
If you follow the news, you’ve probably heard references to “the Fed” as in “the Fed held interest rates,” or “market watchers are predicting what the Fed will do next.” So what exactly is the Fed and what does it do? I learned about the intricacies of central banks when I was studying at Columbia Business School, and here are some of the basics.
The Federal Reserve is the central bank of the United States. The Fed was created in 1913 to provide the nation with a safer and more-stable monetary and financial system than what had existed. Today, the Federal Reserve has responsibilities in four general areas:
- Conducting the nation’s monetary policy by influencing money and credit conditions in the economy with the goal of full employment and stable prices.
- Supervising and regulating banks and financial institutions to ensure the safety and soundness of the nation’s financial system and to protect the credit rights of consumers.
- Maintaining the stability of the financial system and containing any systemic risk that may arise in financial markets.
- Providing certain financial services to the U.S. government, U.S. financial institutions, and foreign official institutions, and playing a major role in operating and overseeing the nation’s payments systems.
Organization of the Fed
The Federal Reserve has three key entities:
- the Board of Governors (Federal Reserve Board),
- Federal Reserve Banks – 12 of them, and
- the Federal Open Market Committee.
The Board of Governors has seven people who are nominated by the U.S. president and approved by the Senate. Each person is appointed for a 14-year term (terms are staggered, with one beginning every two years). The Board of Governors conducts business in Washington, D.C., and is headed by the Fed Chair (currently, Jerome Powell), who is perhaps the most visible face of U.S. economic and monetary policy.
The 12 regional Federal Reserve Banks are responsible for day-to-day bank operations. They are in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Each regional bank has its own president and oversees thousands of smaller member banks in its region.
The Federal Open Market Committee (FOMC) is responsible for setting U.S. monetary policy. When people say markets are anxiously waiting to see what the Fed will do next, they are usually referring to the FOMC. It is made up of the Board of Governors and the 12 regional bank presidents. The FOMC typically meets eight times per year.
Does the Fed Impact the Economy?
One of the most important responsibilities of the Fed is to set the federal funds target rate, which is the interest rate banks charge each other for overnight loans. The federal funds target rate is a benchmark for many short-term interest rates, such as rates used for savings accounts, money market accounts, and short-term bonds. The target rate also serves as a basis for the prime rate. Through the FOMC, the Fed uses the federal funds target rate as a means to influence economic growth.
To stimulate the economy, the Fed could lower the target rate. When interest rates are low, the presumption is that consumers can borrow more and, consequently, spend more. Lower interest rates on car loans, home mortgages, and credit cards make them more accessible to consumers. Also, lower interest rates can weaken the value of the dollar against other currencies. A weaker dollar can make some foreign goods costlier, so consumers might tend to buy American-made goods. An increased demand for goods and services often increases employment and wages. This is essentially what the FOMC did following the 2008 financial crisis in an attempt to spur the economy.
On the other hand, if consumer prices rise too quickly, bringing higher inflation, the Fed can raise the target rate, making money more costly to borrow. Because loans are harder to get and more expensive, consumers and businesses are less likely to borrow, which slows economic growth and reduces inflation.
People often look to the Fed for clues on which way interest rates are headed and for the Fed’s economic analysis and forecasting. Members of the Federal Reserve regularly conduct economic research, give speeches, and testify about inflation and unemployment, which can provide insight about where the economy might be headed. All of this information can be useful for consumers when making borrowing and investing decisions.
