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You’ve likely heard of the Federal Reserve, but you may not understand how it works or affects your day-to-day life.
As the central bank of the United States, the Federal Reserve provides services that many of us rely on. It also sets policy that can affect things like mortgage interest rates, stock prices and even our personal finances.
What is the Federal Reserve?
The Federal Reserve’s purpose is to keep the U.S. economy healthy and the country’s financial system stable. The Fed consists of three key entities:
- The Federal Reserve Board of Governors. These seven board members oversee the Federal Reserve System.
- A network of 12 Federal Reserve banks around the country that do a lot of administrative work.
- The Federal Open Market Committee, or FOMC. This committee, whose job is to set monetary policy, is made up of the seven Board of Governors members and five Reserve Bank presidents.
What does the Federal Reserve do?
The Federal Reserve has four main functions:
1. Setting monetary policy
The Fed promotes a healthy U.S. economy through its monetary policy. The FOMC holds eight meetings per year to review economic trends and vote on new monetary policy measures.
Officially, there are two monetary policy goals that the Fed is striving to achieve:
- High employment
- Low inflation
The main way the Fed achieves these monetary policy goals is by setting a federal funds target rate. All depository institutions — meaning financial institutions that mainly receive funds through consumer deposits — need to hold a certain amount of money at Reserve Banks. If a bank or other depository institution doesn’t have enough in its reserves to meet their requirements, it can get an overnight loan from another financial institution. The rate of interest that an institution charges for such a loan is based on the federal funds target rate.
To fight inflation, the Fed can aim to raise the federal funds target rate. Alternatively, to fight off a recession, the Fed can aim to lower it.
While changes to the federal funds target rate don’t trigger changes in other interest rates automatically, it does directly impact them. This is because financial institutions generally watch and respond to the federal funds target rate in determining their own overnight lending rates, as described above. The prime rate — published by the Wall Street Journal and widely used as a benchmark for interest rates on everything from consumer credit cards to mortgage loans — is a reflection of those overnight lending rates.
This is how the Fed uses the federal funds target rate to help control interest rates over the long term and the amount of credit and money available in the market — factors that can eventually influence unemployment and inflation, the Fed’s two main concerns.
2. Supervising and regulating banks
The Fed supervises and regulates many banks and other financial institutions to promote stability in the financial markets.
The Board of Governors sets guidelines for banks through regulations, policy and supervision. A lot of these guidelines are created because of new legislation.
Each of the 12 Reserve Banks examines member banks to ensure they comply with laws and regulations. If a bank is state-chartered and not a member of the Federal Reserve System, the FDIC has supervisory authority.
3. Providing payment services
The Fed plays a part in how we use money daily by providing payment services. These services include:
- Ensuring there’s enough currency and coin in operation
- Clearing checks and processing electronic payments
- Acting as the government’s banker and maintaining the Treasury Department’s checking account
- Processing other transactions like Social Security payments and government payroll checks
Through these payment services, the Fed works to promote a safe and efficient system for our transactions.
4. Maintaining financial stability
Through the three functions above — monetary policy, supervision and regulation, and payment services — the Fed helps to maintain the day-to-day stability and operation of our financial system.
There are instances where these functions may not provide enough support. During these times, the Fed can take action to help prevent problems in the financial sector. For example, after the Sept. 11 terrorist attacks, the Reserve Banks made a huge number of loans directly to banks, credit unions and other financial institutions to ensure they could still operate.
A brief history of the Federal Reserve
Before the creation of the Federal Reserve, the U.S. was plagued by financial panics and bank failures. Banks usually didn’t keep a lot of cash on hand. If customers lost confidence in their bank — usually after hearing about a failure of another bank — they would rush to their bank to withdraw money. If the banks didn’t have enough cash around, they would end up going out of business. This panic could trigger multiple bank failures, which is what happened during a particularly severe panic in 1907.
After this panic, President Woodrow Wilson signed the Federal Reserve Act, and Congress established the Federal Reserve System in 1913. The goal of creating the Federal Reserve was to end the instability of the banking system.
Since then, there has been other legislation that has shaped the Fed into what it is today. It was after the Great Depression that the FOMC was established to set monetary policy for the country. When inflation was skyrocketing in the U.S. in 1977, Congress decided on price stability as the Fed’s first national monetary policy goal. A year later, the second monetary policy goal — for full employment — was set.
And after the financial crisis that began in 2007, the Wall Street Reform and Consumer Protection Act — aka the Dodd-Frank Act — was passed. Among other things, this law transferred most consumer protection duties that the Fed performed to the new Consumer Financial Protection Bureau.
Why is the Federal Reserve important?
Over the past 100 years, the Fed has worked to keep the U.S. financial system stable and soften the effects of financial disasters as much as possible. Its services and decisions affect our day-to-day lives, indirectly influencing everything from stock prices and interest rates on loans, like mortgages, to the employment rate and how much consumers spend.
The Federal Reserve’s operations and policy decisions are vital to a secure and stable financial system. A lot of what it does goes unnoticed but has a pretty big impact on our personal wealth, how we spend and even our employment.