Chances are that you’ve heard of the Federal Reserve, or “the Fed,” but aren’t exactly sure what it does. Touted as the shadowy strength behind our nation’s finances, the Fed always seems to be working in the background to keep us afloat. But what is the Federal Reserve, anyway?
The Federal Reserve System, AKA the Federal Reserve is the central bank of the United States. It’s the bank’s bank. Some of the national banking functions that the Fed controls are the following:
- They manage the nation’s fiscal policy in an effort to encourage employment, stable pricing, and reduced long-term interest rates.
- They are the backbone of the U.S. financial system and work to minimize and contain risk by actively monitoring our place in the international economic conversation.
- They improve the safety and soundness of individual financial institutions, like banks and credit unions, and advise their influence on our financial system as a whole.
- Their biggest, and perhaps most important, job is consumer protection and community development, which they foster through consumer-focused research, analysis of emerging consumer issues, community economic development, and the development of consumer regulations.
Federal interest rate changes
Before you can get into interest rate increases and decreases, it’s a smart idea to break down exactly what interest rates are. Basically, an interest rate is a price that a borrower pays to use a lender’s money for an agreed-upon period of time. When the borrower pays back the loan, they pay the original amount as well as the interest. So, if you borrowed $5,000 at 10% interest for one year, you would have to repay the original $5,000 plus the interest accrued, which in this case is $500, to total $5,500. The interest is what’s in it for the lender and the whole reason they lend money.
Though technically the Federal Reserve only sets the interest rate at which banks borrow from other banks, this federal rate does impact how much a bank will charge its customers. If the Fed sets a high federal interest rate, it is in effect forcing banks to in turn raise rates for their customers.
Why would banks need to borrow money from other banks? Because they must meet the federal mandate for banking reserves, which was set up after the Great Depression.
Just like financial experts suggest slotting away three- to a six-months worth of savings in case of emergency, the Fed advises banks to do the same. That is their reserve.
When a bank runs out of money, and it occasionally does happen, they can either borrow from another bank or from the Fed to meet their minimum reserve. Borrowing from another bank would be easier and cheaper, but since there aren’t too many banks left, they tend to run into difficulties (like being shut down by the Fed). Ever-changing regulations (set up by the Fed) coupled with mergers and little banks being swallowed up into big banks (okayed by the Fed) creates a situation where the Fed is the only place to turn to when reserves need to be met. Oh, and the Fed sets the reserve minimums.
Though it isn’t a bank that any of us can walk into, it is very much in control of all of the other banks that we do have access to. And that’s a good thing. Before the Fed was established, our US financial policy and procedure was much more disorganized.
The history of the Federal Reserve
The Federal Reserve was created via an act passed by Congress in 1913. As noted in a paper by the American Institute of Economic Research:
In its final form, the Federal Reserve Act represented a compromise among three political groups. Most Republicans (and the Wall Street bankers) favored the Aldrich Plan that came out of Jekyll Island. Progressive Democrats demanded a reserve system and currency supply owned and controlled by the Government in order to counter the “money trust” and destroy the existing concentration of credit resources in Wall Street. Conservative Democrats proposed a decentralized reserve system, owned and controlled privately but free of Wall Street domination. No group got exactly what it wanted. But the Aldrich plan more nearly represented the compromise position between the two Democrat extremes, and it was closest to the final legislation passed.
Who runs the Federal Reserve?
The Federal Reserve System is not “owned” by anyone, but they do have a spokesperson known as the chairman. The current chairman is Jerome Powell, appointed by Donald Trump in 2018. His main responsibility as chairman is to carry out the mandate of the Fed. He reports to Congress twice-yearly unless otherwise compelled by fiscal events.
The chairman also oversees the three key entities of the Fed. They are:
The Federal Reserve Board of Governors, seven board members who oversee the Federal Reserve System.The 12 Federal Reserve banks that work in different geographic locations covering the US. And finally, the Federal Open Market Committee, which sets monetary policy.
How do The Federal Reserve’s decisions impact the public?
There are a few key ways that the Fed’s decisions regarding interest rates impact you. Some are pretty visible, some are hidden but still impactful, and some are barely a blip on most people’s radar.
Consumer lending rates
Like we said, when the Fed raises interest rates, it makes it more expensive for banks to borrow money from them. Why would they do that? To make the supply of money smaller. With less money circulating, it becomes more valuable and people (you) will pay more for it in the form of loan interest for houses or cars.
Likewise, their decisions to lower interest rates make it less expensive for banks to borrow money, which they, in turn, pass along to you. By the Fed lowering interest rates to near-zero numbers, it encourages banks to lower their rates, which encourages consumers to borrow money. Those lower interest rates do not translate into lower standards for borrowers, but those who do qualify will enjoy paying less for borrowed money.
Consumer interest rates
Credit card interest rates are typically calculated by adding a variable (that the company calculates and chooses) to a prime amount. You may recall seeing the phrase “APR over prime” in the fine print of your credit card details. What this means is that the rate for borrowing money through your credit cards equals the prime rate plus whatever rate they’re offering you. The interest your credit card issuer charges in addition to the current prime rate are known as “the spread.” So, if the current prime rate is 5.50%, and the spread is 13%, the total interest on your variable-rate card would be 18.50%. While the Fed lowering and raising the prime rate should theoretically have an effect on consumer credit interest rates, companies typically do not adjust rates at all and people end up paying a pretty high-interest rate for all of their purchases regardless.
Savings account and CD rates
When the Federal Reserve raises or lowers interest rates, savings accounts likely adjust their yields as well.
The bottom line
Though it works behind the scenes, the Fed has more of a say in your finances than you may be aware of. They are the ones who increase and decrease the rates that impact your savings account and credit card interest rates, as well as shift the economy in subtle ways by encouraging consumer confidence and spending. Understanding how this huge organization operates is the first step in weaving that knowledge into your investing strategy.