What is The Fed?
What is the Federal Reserve and what does it do?
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You’ve noticed it in your weekly groceries, filling up your gas tank, making travel plans, and just generally existing as a human. Inflation is rising fast and hitting hard.
Anytime inflation is surging, the Federal Reserve is mentioned often in the news—but many folks are unfamiliar with what the Fed is, and what their responsibility is. With this in mind, we've gone into detail on what the fed is, what they do, and why it's important for our everyday lives.
What is the Federal Reserve, or "the fed"?
Initially created in 1913 by the Federal Reserve Act, the Federal Reserve is a governmental body that monitors the United States economy with two mandates: keep prices stable and ensure maximum employment.
The Glass-Steagall Act of 1933 created the Federal Open Market Committee (FOMC), which has 12 members including seven representatives on the Board of Governors of the Federal Reserve System, the President of the Federal Reserve Bank of New York, and four presidents from other Federal Reserve Banks.
There are 12 total Federal Reserve Banks that serve different districts across the United States, so the Federal Reserve Banks rotate who is on the FOMC. However, all Federal Reserve Bank presidents join FOMC meetings and discussions.
What does the Fed do?
The Federal Reserve monitors how the United States economy is performing based on unemployment rates and inflation. It targets low unemployment and a 2% inflationary rate over time. Gradual inflation helps keep prices predictable.
The Federal Reserve uses several tools to change and implement monetary policy to shape the United States economy and respond to economic challenges:
- Interest rates
- Open Market Operations
- Reserve Requirements
The Fed controls several types of interest rates. These interest rates aren’t the rates you see on consumer loans, like mortgages. Instead, these interest rates affect how expensive it is for banks to loan money to consumers, businesses, or entrepreneurs. Since the banks are affected by these interest rates, it affects the interest rates banks attach to their loans.
These are the three interest rates the Fed controls:
- Interest On Reserve Balances (IORB)
- Overnight Reverse Repurchase Agreement (ON RRP)
- Discount Rate
Interest On Reserve Balances (IORB)
The IORB is how much interest banks earn on their reserve funds. Reserve funds are money banks set aside and do not lend.
A higher IORB interest rate discourages banks from lending since they can profit from setting the money aside instead. A lower IORB encourages banks to lend since it’s more profitable to lend the money rather than hold it in reserve.
Overnight Reverse Repurchase Agreement (ON RRP)
The ON RRP primarily affects loans and banks that aren’t allowed to earn interest, generally government-sponsored loans. To encourage these loans, the Federal Reserve will sell them to banks as securities one day, then buy them back at a higher rate the next day. This process keeps loans affordable for consumers and supports banks that offer these types of loans.
The IORB and ON RRP rates combined affect how privately operated banks determine interest rates on loans when they borrow from each other. These rates are called the federal funds rate, and may vary slightly by bank.
Banks can borrow from the Federal Reserve to meet their financial obligations. These loans are short-term loans, and are meant to tide banks over if they’re short on cash.
The interest charged on these loans is called the Discount Rate. Increasing the discount rate makes it more expensive for banks to borrow funds.
Open Market Operations (OMO)
OMO refers to a strategy for controlling interest rates. The Federal Reserve buys or sells United States Treasury securities, which affects the money supply banks have available to loan.
While OMO does not directly change interest rates, its effects on banks do.
To increase the supply (and lower interest rates), the Fed buys these securities or bonds from banks. Banks then have less money to loan, which raises interest rates.
Conversely, to decrease the money supply, the Fed sells securities to banks. In this case, banks will have more money to lend, which lowers interest rates.
The Federal Reserve can also set an amount of cash that banks must have on reserve. These funds on reserve can’t be used for loans, so these requirements are another way to indirectly affect interest rates.
Reserve requirements can be raised or lowered to affect the money supply in the system, similar to OMO strategies.
Reserve requirements were moved to $0 during the 2008 crisis and are currently at $0.
Monetary policy in the United States
In periods of inflation, the Federal Reserve typically increases interest rates to curb inflation.
Think about the shortages in early 2020. People were concerned about access to stores and how supply chains would be affected, so they overbought and in effect created the shortages they feared.
On a large economic scale, making it more expensive to spend money will discourage spending, which helps trigger price stability.
When the economy is slowing and people aren’t spending money, the Federal Reserve often lowers interest rates to make it easier for people to get mortgages, business loans, etc. Lowering interest rates helps encourage spending.
Consider how low gas prices were in 2020 compared to how high they are now. Low gas prices combined with other factors, made plane tickets and road trips cheaper. Some people took advantage of these prices to travel when possible.
A final word on the Fed
The Federal Reserve plays an integral role in our financial lives and it's important to understand what it does and how it works.