Understand Your Finances
What, exactly, does the Federal Reserve do?
The following story is part of Money Matters, a series that explores financial and economic trends. It is brought to you by Chase.
The Federal Reserve System is in the news, especially with interest rates shifting. But, what is the Fed, as it's commonly known? But, it's worth asking: what, exactly, does the Fed do?
Here are some basics around how the Fed works and what it does:
1. What is the Fed?
The Fed is the central bank of the United States. It was created by Congress in 1913, hoping to end a series of financial and bank crises, particularly the Panic of 1907.
At the time, its primary purpose was to safeguard against people racing to their banks to withdraw money because they feared that the bank might become insolvent. Basically, the Fed was created to act as lender of last resort during difficult financial times.
Before the Fed was created, the nation's money supply and interest rates were set by individual private banks, and fluctuated often. The country needed a department to create stability in the financial sector. The Fed ensures that the economy has enough liquidity to keep moving and to minimize financial disturbances.
2. What does the Fed do?
Under the Federal Reserve Act passed by Congress, the Fed was given four main jobs:
- It influences the country's money supply and interest rates. The Fed sets a federal funds rate that banks use to borrow from each other. That becomes the underlying rate at which all other interest rates are set, such as the prime rate. The prime rate is important for individual borrowers, since it affects the interest rate that banks use for mortgages, home equity lines of credit and credit cards.
- The Fed essentially supervises banks and other financial institutions, making sure that they are financially sound. The Fed ensures that consumers rights are protected.
- The Fed preserves the stability of the financial system. When events threaten the financial health of the whole country, as it did in 2008, the Fed can step in and take steps to contain the crisis.
- The Fed provides financial services to the US government, financial institutions and foreign central banks. It makes sure the country's payment systems function smoothly.
3. What is the Federal Open Market Committee (FOMC)?
The Fed created a committee of government bankers and economists called the Federal Open Market Committee. They meet eight times a year to set the federal funds rate.
4. How does the Fed set monetary policy?
The Fed has what's called a "dual mandate." It aims to maximize employment and stabilize prices. Another key objective of the Fed is moderating long-term interest rates. When interest rates are low, people borrow more and spend more, and this stimulates the economy. For instance, after the financial crash of 2008, the Fed lowered interest rates to nearly zero, hoping that it would encourage people to spend.
When the economy is strong, people spend more, but the Fed also has to make sure that prices don't get out of control. If that happens, it's called inflation. When things are going well in the economy, the Fed raises interest rates to keep everything balanced.
The FOMC expects prices to increase around two percent each year. A mild inflation rate spurs demand, which is good for economic growth. It motivates consumers to buy now rather than later.
5. What else does the Fed do?
As the Fed showed after the 2008 financial crisis, it is adept at dealing with financial panics, which was one of the reasons it was created. Thanks to the Fed, we no longer have to worry about runs on banks.
The Fed sets monetary policy to promote the economic health of the country. That includes setting the discount rate, which is an interest rate that affects commercial banks and other institutions. The Fed also sets reserve requirements, which is how much a bank has to hold in reserves, and how much it can lend out.
The Fed also sets policies about Open Market Operations, which is when the Fed buys and sells government securities in the open market in order to expand or contract the amount of money in the banking system.
After the 2008 financial crisis, for example, the FOMC greatly expanded its use of open market operations during quantitative easing. During quantitative easing, the Fed purchased large amounts of Treasury notes and mortgage-backed securities in order to increase money supply.
Charles Wallace is a Chase News contributor. His work has appeared in Time, Fortune, and Money magazines, among other media outlets.