Image of the The Federal Reserve Bank.

The Federal Reserve is the central bank of the United States. It was formed by Congress in 1913 to help make the national economy and financial system safer and more stable. But just what does The Fed do? Let's find out.

What exactly does the Federal Reserve Bank do?

"The Fed" influences the money supply and credit conditions in order to accomplish several goals: to promote steady prices and full employment, to promote stability in the financial system, and to facilitate sustainable economic growth. Other duties include regulation of the banking industry and making sure consumers have access to the information they need in order to participate in the financial system.

Although the Fed is the central bank of the United States, it is not really a true government institution. The Fed is not funded by tax dollars, and its decisions do not have to be approved by the President or either house of Congress. The governing body within the Fed is the Board of Governors. This is a seven-member committee whose members are chosen by the President and confirmed by the Senate. To ensure fair representation, there may not be more than one governor from each of the twelve Federal Reserve Districts across the nation. Members of the Federal Reserve Board of Governors have terms that last fourteen years. The Federal Reserve is subject to Congressional Oversight and any changes in the law that Congress passes.

Interest: The price of money

One way the Fed accomplishes its goals is through the use of monetary policy. In simple terms,monetary policy is the manner by which the Fed controls the supply of money in the economy. The manipulations of the money supply affect interest rates, which in turn influence the economy and the financial system. For example, throughout the year 2001, the Fed increased the money supply dramatically. This increase in the money supply lowered the interest rates of 30-year Treasury bonds. Mortgage rates are influenced by the rate of the 30-year Treasury. So, as the Treasury rates fell, so did interest rates on mortgages. The result has been a boom in the housing market and the refinancing of many existing mortgages to take advantage of the lower rates.

It is important to have a basic understanding of what interest rates are and the influence they have on the overall economy. An interest rate is the price of money. For example, the interest you pay on a loan or credit card is the price the lender charges you to use their money. The price of money, like any other good, is determined by supply and demand. The Fed influences interest rates by controlling the money supply.

Sometimes it is difficult to understand how the supply of something can be such an important part of its price. In general, a good that is plentiful, such as loaves of bread, will be inexpensive. Goods that are scarce, like diamonds, are expensive.

The same principle applies to the cost of most goods, including money. If money is plentiful, it becomes inexpensive as interest rates fall. If it is scarce, it is more expensive when interest rates increase. By changing the supply of money in circulation, the Fed changes the price of money.

The Federal Open Market Committee (FOMC)

The Federal Open Market Committee (FOMC) is in charge of controlling the money supply. This committee is made up of the seven members of the Board of Governors and five Reserve Bank Presidents from around the nation. The President of the Federal Reserve Bank of New York is always a member of the FOMC. The Fed changes the price of money through the use of monetary policy. In simple terms, monetary policy is the manner by which the Fed controls the supply of money to the economy.

The FOMC controls the money supply in the following three ways:

  • Buying and Selling Treasury and Federal agency securities on the open market. If the Fed feels that lower interest rates will benefit the economy, they will buy large amounts of Treasury Bills and other government securities. By purchasing these securities, the Fed injects large amounts of cash into the economy. They make money more plentiful. Just like most goods, when money becomes plentiful, it becomes less expensive. By contrast, if the Fed wants to increase interest rates, they sell large amounts of securities and the money that is paid by the buyers is taken out of circulation. Money becomes scarce and therefore, more expensive.
  • Changing reserve requirements for banks. Banks are required to keep a percentage of their clients' deposits on reserve to facilitate orderly withdrawals. If the Fed increases the reserve requirement, it increases the amount of money kept out of circulation, which pushes interest rates higher. If the Fed decreases reserve requirements, rates tend to fall.
  • Changing the Discount Rate. The Discount Rate is what the Fed charges banks that borrow directly from it. These are very short-term loans, usually overnight, meant to cover shortfalls in reserve requirements. The Fed sets this rate directly instead of through supply and demand. When banks need to borrow money to supplement their reserves, they will generally borrow from each other. Banks typically will only borrow directly from the Fed as a last resort.

The FOMC bases their interest rate decisions on many different economic and financial statistics. They consider factors such as inflation, consumer confidence, GDP growth and the general health of the overall economy. There are many reasons, some quite complex, that would cause the Fed to change the money supply. The following are a couple of simple but common examples:

  • If economic growth is slow, the Fed would reduce interest rates by increasing the money supply to make more money available to businesses and consumers in the hope it would stimulate faster growth. This is sometimes referred to as "easing."
  • If the prices of goods and services begin to rise at a faster rate than is desirable, the Fed would tend to raise interest rates by decreasing the money supply to slow the economy down. This is sometimes referred to as "tightening."

How the FED affects you

Changes in the money supply affect a host of variables. It does take some time for a change in the money supply to affect the entire economy. Most consumers do not feel the results of monetary policy changes for between 8-18 months, depending on economic conditions at the time. Any changes in the money supply will influence the amount of credit that is available and the interest rates charged, as well as prices, employment, exchange rates, and consumer spending. The following points describe how decisions at the Fed affect you:

  • The moves the Fed makes influence how much interest you will earn on a savings account, CD, or money market fund.
  • Changes in monetary policy often have an effect on stock prices, which may affect your retirement plan.
  • Monetary policy influences interest rates on auto loans and credit cards.
  • Rates in the bond markets are influenced, which in turn will influence the interest you pay when applying for a mortgage. If you have an adjustable rate mortgage, Fed policy may even cause your monthly payment to change.
  • The Fed can affect your job situation. Changes in interest rates influence when businesses expand and hire or cut costs and fire.

By controlling the money supply, the Federal Reserve System can have a significant impact on our financial well-being. Having an understanding of what the Fed does and how it can affect us is important for everybody. Click here for more information on the Federal Reserve.

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