Markets Explained

Understanding the Federal Reserve: A Beginner’s Guide

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Understanding the Federal Reserve: A Beginner’s Guide

How much do you really know about how the Federal Reserve works?

Sure, you’ve seen the Federal Reserve (usually shortened to “the Fed”) in the news. During the 2007-2009 financial crisis and recession and thereafter, the Fed’s policy moves played a vital role in helping forestall an even more severe economic slowdown, setting the stage for a gradual recovery.

But how did they do it? Like many people, you may be unsure of exactly what the Fed is or how it works. That’s understandable-the Fed deals in a realm of economics — monetary policy — that can be daunting to non-experts.

This primer on the Fed will help you better understand how this essential entity is a key player in the U.S. financial system and economy.

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What is the Federal Reserve?

Established by Congress in 1913, the Federal Reserve System is the central bank of the United States, which in its own words “provides the nation with a safer, more flexible, and more stable monetary and financial system.”

Importantly, the Federal Reserve System was established as an independent agency, so the Fed decisions do not have to be approved by the president or Congress. However, the Fed does consult with other branches of government through a variety of avenues, like Congressional testimony, sharing forecasts and other means, and Fed experts develop and publish a wide range of research products on regional and national economic issues.

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What does the Fed do?

The Federal Reserve System has three primary functions:

  1. Managing the nation’s monetary policy by overseeing the money supply and adjusting interest rates;
  2. Providing and maintaining an effective and efficient payments system between financial institutions; and
  3. Supervising and regulating banking operations.
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How is the Fed organized?

The central bank is built around a two-part structure that comprises the Federal Reserve System:

  • The Federal Reserve Board of Governors, located in Washington, D.C., is a seven-member board appointed by the president and confirmed by the Senate. This board, supported by a staff of economists and administrative professionals, works as an independent agency to oversee all Fed operations.
  • There are 12 regional Federal Reserve banks (located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco) that handle the central bank’s daily operations across the country.

This  two-part structure means the Fed is both centralized, through the Board of Governors in the nation’s capital, and at the same time decentralized, through the 12 district banks. The structure helps strike a balance between the centralized role and responsibility of government and the interests of local banks and consumers. At the same time, the structure allows for overall management and direction initiated out of the Board of Governors while also allowing for local day-to-day operation.

Since 2014, the Fed has been led by Chairwoman Janet Yellen, who serves essentially as the CEO of the central bank.

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What is monetary policy?

One of the Fed’s primary responsibilities is to oversee the nation’s monetary policy, discussed in more detail below. (It’s important to distinguish monetary policy from “fiscal policy,” which focuses on issues of taxes and spending. Fiscal policy is controlled by the Congress and executive branch).

In 1977, Congress issued what is known as the “dual mandate” to guide Fed decision-making, which states that the two primary goals of monetary policy should be to achieve maximum employment and stable prices within the economy:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

Thirty-eight years later, that mandate still guides Fed policymaking, and the central bank uses tools like interest rates, reserve requirements and other policy adjustments to meet that mandate. We’ll discuss some of those tools, like adjustments to the federal funds rate, in more detail in a subsequent installment.

Federal Reserve’s monetary policy is determined by the Federal Open Market Committee (FOMC), which is made up of the seven members of the Board of Governors along with five rotating members from the leadership of the regional banks. The FOMC meets several times a year to discuss and vote on the direction the Fed will take on monetary policy.

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What kind of economic issues does the Fed consider when crafting monetary policy?

In order to meet the dual goals of maximum employment and price stability, the Fed  takes a broad spectrum approach, weighing a wide range of economic trends and indicators-like employment data,  inflation rates, consumer confidence, business investment, health of the housing sector and much more-to get a fuller sense of the health and direction of the economy.

For example, consider the inflation rate. The Fed pays close attention to inflation-that is, the rise in prices and parallel loss of purchasing power of a dollar-as a barometer of economic conditions.

Many economists today would prefer to see a higher inflation rate in the U.S. economy, as it would reflect a better economic growth picture-modestly rising prices are often associated with a rising standard of living. The Fed has identified a 2% inflation rate as the preferred target rate, although in recent years the actual number has been significantly below that target.

For younger readers, talk of rising prices may seem strange, since the inflation rate has been unusually low for the last decade or more. But talk to older relatives and friends who remember the rampant inflation of the 1970s and early 1980s and you’ll understand why it matters.

Recently, you’ve likely seen that the Fed is considering raising interest rates from their current historic lows (in our next installment, we’ll look at how the Fed managed interest rates in greater detail). Typically, the Fed considers raising interest rates to reduce activity when the economy is seen to be growing too quickly or prices rising too quickly.

But in today’s environment, interest rates and inflation have been unusually low for the last several years. The Fed is expected to implement modest and gradual rate increases in the near future in an effort to reflect more normal economic conditions as the economy steadies after the financial crisis.

The Fed’s leaders and staff experts recognize that many economic indicators are interrelated, and that an action taken by the central bank, like changing interest rates, may have unpredictable consequences. So they seek to take a judicious, balanced and gradual approach to any changes to monetary policy, to ensure a measure of stability in the wider economy.

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This summary only scratches the surface of the Fed’s activities and responsibilities as a key player in the U.S. economy and financial system. But by understanding these essential facts about the Fed, you’re better prepared to understand the central bank’s role-and why policymakers, business leaders, journalists and economic experts pay such close attention to the Fed’s moves.

In a future installment, we’ll look more closely at how the Fed implements monetary policy through the target federal funds rate to respond to changing economic conditions.

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