They are all over the news periodically. Politicians heap accolades or spit-fire at them depending on whether they like the results of The Fed’s actions… but what do they do?
A Brief History
The Federal Reserve System (what we normally just call “The Fed”) is the central bank of the United States and was created by The Federal Reserve Act and passed by Congress in 1913. Before the centralized banking system there were financial panics, or what we commonly hear called “bank runs”, meaning, for some reason or confluence of factors, the customers of a bank suddenly feel their money is not safe and attempt to take all it out of that bank. Now, if this were just a customer or two, the bank wouldn’t be hurt. But when enough customers decide to take out their money all at once, the bank can go under. The business of banking can be complicated, but basically a bank “holds” your money and hopes that you don’t take it all out at once. While they are holding it, they can be using it to make money for the bank. Fun fact: Banks do not have as much cash on hand as customers have deposited.
The Federal Reserve System was created to prevent these kinds of financial panics, but also to do things like set monetary policy, and ensure the stability of prices and promote full employment. Since The Fed was created its mandates have, of course, grown and changed, but one thing that hasn’t changed is its insulation from political or private influence. By being decentralized and having 12 Reserve Banks across the nation acting somewhat independently, and also the Chair of the Fed being appointed by the President of the United States but not beholden to that office or to Congress (though they do have to report to Congress) The Fed stays independent and can do its work without fear of retaliation.
But What Does It Do Again?
Probably the thing you hear about most often is The Fed setting what is sometimes called the Federal interest rate, but is actually called the Federal Funds rate. With the creation of The Fed came the mandate that banks must keep a certain amount of cash on hand. That amount is a percentage of what their depositors have put in their bank. These funds must be kept in a Federal Deposit account in one of those 12 Federal Reserve banks. What a bank has in their Federal Reserve bank account over their required percentage they can lend to one another. The percentage at which they can lend to one another is set by, viola, The Fed and that is the Federal Funds rate. (Why they need to lend each other money is a whole other post we can discuss on a different day).
It’s a sort of domino effect. While the Fed can’t tell a bank “you must lend at this exact percentage rate” it can adjust the money supply (the actual amount of dollars and coins that are floating around out there) and so this puts a little pressure on the banks to adhere to the rate The Fed has set. You can’t lend what doesn’t exist and if there will be less actual cash available chances are you are going to hold on to what you’ve got. And while the Federal Funds rate does not directly affect businesses and consumers it does influence the percentage rate at which banks are willing to lend to their customers.
What percentage businesses can borrow money for (and the amount of interest they will eventually have to pay back to the bank, thus lowering their profits) determines, in part, whether they are willing to do job creating things, such as, creating a new product line, opening a new retail store, building a factory, or adding another shift.
Also, the Federal Funds rate has an effect on inflation – that is the amount that prices of things rise over a period of time (when prices go down that is called deflation and can be equally bad if out of control – again a post for another time). If inflation is high that means your dollars don’t go as far as they used to, boo. If inflation is low, more bang for your buck! Yeah! However, ups and downs have a chilling effect on both business and personal economic decisions. Just as a business has to feel secure to know if they can safely open a new store, you need to know that you are going to have a job at that store going forward in order to buy that new car you need.
But of course…
As we know, especially if you are old enough to have lived through the Great Recession of about a decade ago, even The Fed can’t totally control the economy. The Great Recession was caused by a number of bad actors and bad policies put in place by a number of organizations both private and public and even though The Fed did lower the Federal Funds rate when it saw unemployment rising, the crisis was already snowballing. After the onset of the crisis The Fed, partly because of its independence and decentralization from government and business influence, was able to adequately prop up some financial institutions. Whether the Fed would be able to avert another such crisis is yet to be seen. Bad actors and bad policies are somewhat like whack-a-mole – they pop up where you can’t believe and then slip away before you can whack them – but they still left a hole in the (economy) ground!
In The Grand Scheme
All in all, the United States economy is stable relative to many other countries which have experienced terrible financial crises, such as Argentina and Greece which have had punishing inflation rates in the past. And though no one can foresee the future, the Federal Reserve System has been able to help hold our economy together and prevent the kind of collapsing inflation rates seen by other countries even in the worst of time thus far.