Federal Reserve

Background

No institution wields more power in US finance than the Federal Reserve—but opinion polls indicate most Americans don’t know what it does.

Known casually as “the Fed,” the century-old independent central bank sets the interest rates determining how much ordinary people pay for mortgages, car loans, and more, all to achieve its dual mandate of price stability and maximum employment (read 101).

Consisting of a central board of governors working in tandem with 12 regional banks, the Fed also acts as the nation’s currency reserve and lender of last resort.

The Origins of the Fed

Throughout the 19th century, the US faced periodic economic downturns, which resulted in financial panics. Customers raced to withdraw their cash before their neighbors, draining the system of its liquidity during so-called bank runs.

A major reason behind this volatility was the lack of a central bank, where small-government-minded Americans had long resisted concentrating on financial power. Early efforts, including Alexander Hamilton’s First National Bank, met with broad populist resistance.

But after the panic of 1907, major financiers and lawmakers worked to draft a uniquely American plan for a so-called Federal Reserve system. A central board would consist of appointed leaders from regional banks to blend central administration with decentralized control.

To avoid public backlash, these efforts were shrouded in secrecy. In 1913, the Federal Reserve Act was signed into law by President Woodrow Wilson.

How it Works

The Fed controls the supply of money in circulation by adjusting the interest rate it pays banks to deposit their reserve funds with it—thus the name, Federal Reserve. The Fed does this by purchasing or selling securities on the open market, operations conducted by the New York Fed.

When it raises rates, the Fed effectively outbids other banks to broadly chill borrowing and slow the economy. Conversely, this rate can be lowered as a means of stimulating more lending and, in turn, growth.

Rate adjustments are made by the Federal Open Market Committee, a group of 12 voting policymakers—the seven central governors, the New York Fed president, and a rotation of four of the remaining 11 regional bank heads. The FOMC meets roughly every six weeks to determine the federal funds rate.

When the Fed wants to slow the economy due to rising prices—known as inflation—it increases this rate until inflation drops to an average of roughly 2% amid robust employment.

The Fed’s Impact

Despite its independence—that is, its ability to operate without requiring government approval— the Fed is often a political lightning rod due to its significant impact on both national and household economies.

Higher federal fund rates slow the gross domestic product by design, slowing markets and hampering business. They also elevate rates consumers pay on credit cards, mortgages, and cars. This inevitably affects the political climate.

Although Congress delegated its power to regulate currency to the Fed in 1913, some critics argue this was unconstitutional and advocate for more Fed oversight.

In recent decades, Fed chairs have sought to increase transparency at the bank via regular reports to Congress and the public.