What is "the Fed" and Why Does It Matter When It Comes to Debt?
This guide answers why the Federal Reserve was created, what it does, and why you should care about "the Fed."
September 10, 2021
If you’ve ever flipped through the Wall Street Journal or tuned into a national news network, you’ve probably seen coverage of the Federal Reserve’s latest activities. “The Fed” is constantly implementing new monetary policies, adjusting interest rates and doing a whole lot of financial “stuff” that sounds official and important.
If you want to know more about the Fed and what all the fuss is about, we’ve got you covered. This guide answers questions like "why was the federal reserve created?," "what does it do?," and "why should I care?"
What is the Fed?
The Fed is short for the Federal Reserve System, and it’s the central bank of the United States of America. As our central bank, it's responsible for setting our monetary policy, managing our money supply and adjusting interest rates to keep our economy stable.
The Fed consists of three primary groups:
12 regional Federal Reserve Banks, each of which covers a section of the country
The Federal Reserve Board (FRB), which includes seven members who are nominated by the President and approved by the Senate
The Federal Open Market Committee (FOMC), which consists of the seven Federal Reserve Board members and five rotating Federal Reserve Bank presidents
Each of these three groups has unique responsibilities:
The FRB is in charge of setting the prime interest rate and the bank reserve requirements. The prime interest rate is the interest rate on loans that the Fed makes to other depository institutions (banks). The reserve requirement is the amount of money that banks must keep on hand to cover their liabilities instead of investing in securities or lending to consumers.
The FOMC is in charge of investment activities. Primarily, that means they decide whether the Fed spends money to buy securities or sells securities to increase their cash holdings.
The 12 regional Federal Reserve Banks carry out the FRB and the FOMC's monetary policies in their respective regions. That includes ensuring banks have access to current lending rates, supervising member institutions and collecting and distributing cash as needed.
Why was the Federal Reserve created?
The government created the Federal Reserve to foster a stable economic environment, which includes two primary responsibilities:
Maintaining maximum sustainable employment
Promoting stable prices and moderate long-term interest rates
Together, these are known as the Federal Reserve’s dual mandate, as set forth by Congress in the 1970s.
Maximum sustainable employment is the level of employment that's reasonably acceptable in a time when the economy is neither booming nor in recession. People commonly express it through its inverse - the natural level of unemployment due to the percentage of people quitting jobs and looking for new work at any given time. That amount is around 4.4%, according to Congressional Budget Office estimates.
The Fed promotes maximum sustainable employment with an expansionary monetary policy. Generally, that means it decreases interest rates or increases the money supply to stimulate economic growth.
As financing becomes more available to businesses, they’ll be more likely to spend money, hire more workers and expand their operations. If this goes too far, though, it can be harmful to the stability of prices. Increasing the money supply too much and making borrowing too available can devalue the dollar, leading to inflation.
To counteract that, the Fed would implement a contractionary monetary policy. That could include decreasing the money supply or increasing interest rates. Both would make money harder to come by, reining in inflation at the price of limiting economic growth.
The Fed is constantly engaged in a balancing act between these two goals, attempting to minimize employment and inflation through monetary policy.
Why the Federal Reserve matters to you
The Fed manipulates American economics on a national scale, and their decisions inevitably trickle down to affect consumers. Its monetary policy affects your job security, the costs of your goods and services and the interest rate on your debts.
An expansionary policy will generally promote employment and decrease the interest rate on your debts, at the risk of increasing the cost of goods and services too quickly.
A contractionary policy can lead to greater unemployment and increase the interest rate on your debt, but it will help keep inflation below undesirable levels. Keeping track of the Fed’s actions through this lens can help you make financial decisions and set goals for the future.
For example: the Fed implemented an expansionary monetary policy to counteract the effects of the pandemic on the economy. It lowered interest rates, purchased securities and relaxed reserve requirements.These actions served to promote employment and help the economy recover, but there are now concerns about price instability running rampant in the aftermath.
Consumers who observe these changes could take measures to protect themselves. They might consider refinancing their debts to take advantage of low-interest rates while they last, and investing in assets that hedge against inflation.
Frequently Asked Questions
When was the Federal Reserve created?
The collapse of several highly speculative investments caused a banking crisis in 1907, during which J.P. Morgan and other leading banks (instead of a central bank) had to bail out Wall Street. As a result, Congress proposed the Federal Reserve Act to create the Federal Reserve, and President Woodrow Wilson signed the bill into law on December 23, 1913.
What happens when the Fed buys bonds?
The Fed buying bonds is part of an expansionary monetary policy: paying consumers cash liquidates the bonds, increases the supply of money, stimulates economic growth and promotes maximum sustainable employment.
How does the Federal Reserve make money?
The Federal Reserve is designed to be self-sustaining and profitable, which helps make it independent from the rest of the government. Its primary sources of income are:
Interest returns on stocks, bonds, and foreign currency
Fees for the services it provides to depository institutions like check clearing and fund transfers
Interest on its loans to various depository institutions (set at the prime rate)
After paying its expenses, the Fed’s net profit goes to the U.S. Treasury.
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