The Fed: Its History, Function, and Tools

The Fed is raising interest rates. If you’ve been following the news, you’ve likely heard that ad nauseum over the past couple of months.

The Fed. The name conjures images of some faceless Big Brother figure a la 1984, or a mid-century Americana illustration of Uncle Sam pointing an accusing finger at you. But what exactly is the Fed?

In this post, we’re going to dive into the history of the Fed — when and why it began, what it does, and the tools it uses to direct the largest economy in the world.

 

What is the Fed?

The Fed is short for the U.S. Federal Reserve, otherwise known as the central bank of the United States. As a governmental body, it’s one of the most independent in the country. It’s functions include:

• Creating monetary policies to promote employment, stabilize prices and moderate interest rates
• Stabilizing the country’s financial system
• Managing the money supply
• Regulating financial institutions to ensure their soundness and impact on the economy
• Researching and analyzing consumer trends
• Acting as a lender of last resort during economic crises — bailouts, stimulus, etc. 

The U.S. central banking system—the Federal Reserve, or the Fed—is the most powerful economic institution in the United States, perhaps the world. Its core responsibilities include setting interest rates, managing the money supply, and regulating financial markets. It also acts as a lender of last resort during periods of economic crisis, as demonstrated during the 2008 financial meltdown and the COVID-19 pandemic. As the U.S. economy recovers, concerns about high inflation have refocused attention on the central bank. 

 

Why did the Fed start?

In the olden days, the banking system was completely decentralized, meaning that they functioned (and failed) independently. At the turn of the 20th century, this system’s weaknesses intensified and became more obvious each time people panicked and did a run on the bank. Because most banks didn’t keep enough cash on hand for all their customers to get their money, they’d often have to shut down, leaving customers empty handed. 

Panics spread like wildfire. News of a bank shutdown got around quickly, inciting more panic runs and bank closures. 

If contained to a few small banks, the damage was relatively localized. But if it reached a larger scale, it could lead to massive bank failures and bring the whole economy to a halt. 

After a particularly bad panic in 1907, people were asking for reform. 

In 1913, Congress established, and President Woodrow Wilson signed into law, the Federal Reserve System, whose task would be to oversee the country’s money supply and provide a currency that could respond to the economy’s fluctuating demand for credit and money. 

The Federal Reserve System comprises twelve public-private regional banks.

Though it has changed according to the changing needs of the country in the 109 years since its inception, the Fed has two primary objectives: maintaining stable prices (through moderating inflation) and helping the country achieve full employment, which is around 4-5%.

 

So, how does the Fed influence the economy?

Oh, the Fed has a few tricks up its sleeve when it comes to steering the economy. This is an extremely simplified and non-exhaustive list of the tools the Fed uses. The full magnitude and scope of the levers they pull would be challenging to fit into a simple blog post. 

Nonetheless, it’s helpful to have at least a foundational understanding of what the Fed’s main instruments of economic regulation are. 

 

Interest rates

By setting the federal funds rate, the Fed can encourage or discourage interbank lending. When the rates are lower, it’s cheaper to borrow money, so more borrowing happens, and vice versa. 

But what exactly is the federal funds rate?

The federal funds rate governs the overnight lending rate between banks. Here’s how it works: 

1. You and other customers deposit your money at a bank.
2. Your deposits are what banks use to give loans and credit to other customers.
3. By law, banks must keep a certain percentage of their total money in reserve.
4. Because of customer withdrawals and deposits, the amount of money banks must keep in reserve changes from day to day.
5. In order to keep up with their changing reserve requirements, banks often have to borrow money from other banks.
6. The interest rate at which those interbank loans lend each other money is called the federal funds rate.

So, when the Fed raises interest rates, they’re really just raising the interest rate at which banks can loan each other money. But it has a domino effect and when interest rates go up, banks are less inclined to borrow from each other, and they raise the rate at which they lend to customers. It becomes more expensive to borrow and more prudent to save. 

When they lower interest rates, the opposite happens, spurring a flush of lending, borrowing, spending, and general economic activity, the side effect of which is inflation.

Over done, both raising and lowering the federal funds rate can have negative effects of economic downturn and recession or high inflation, respectively. 

While the federal funds rate doesn’t determine other interest rates like credit card interest, mortgage rates, or savings deposit rates, it is a benchmark for them. So when the federal funds rate rises, you’re likely to see the others rise as well.

 

Open Market Operations

Through Open Market Operations (OMO), the Fed regulates the money supply. They do it by buying and selling Treasury bonds in the open market. 

If they want to increase the money supply, they purchase Treasury securities. This makes interest rates go down and loans easier to get. If they want to decrease the money supply, they sell securities, and interest rates rise while lending decreases. 

If the federal funds rate determines the rate at which banks lend each other money, OMO is the tool by which the Fed makes it happen. 

During the process of buying or selling Treasury securities on the open market, the Fed can put new money into or take money out of circulation.

 

Reserve Requirements

You know that reserve requirement that causes banks to borrow from and lend money to each other? Well, the Fed can also change that. They merely lower the percentage of total capital banks must keep on hand in order to give banks more lending ability, or raise it to curtail lending.

The current rate is 0%. Yes, you read that right. In March of 2020 (gee, that date rings a bell), they lowered if from 10% for banks with more than $127.5 million on deposit, and 3% for banks with between $16.9 million up to $127.5 million. 

 

Why it matters to Nesters

If you’re a NESTer, then education and financial literacy is important to you. And that extends beyond retirement planning, sticking to a budget, or managing your portfolio. The way Gloria helps you plan for your financial future and Sean actively manages the NEST portfolios has everything to do with what the economy is doing at a macro scale. The Fed and its functions are a huge part of that. They are a very big cog in a dizzyingly complex system. And if you neglect to understand their role in the economic system as a hole, you’re going to be making financial decisions with huge blind spots in your knowledge.

So now when you read a headline about the Fed raising interest rates, you’ll know exactly what that means, why they’re doing it, and how you can prepare for the potential positive and negative effects of it. 

 

If you’re interested in hearing our thoughts on the Fed’s recent decision to raise the federal funds rate, check out June’s NEST Edge newsletter, where Sean gets into inflation and the Fed’s response to it. 

We spend hours each day, poring over and analyzing financial and macroeconomic data from around the world. At NEST, we learn, reflect, adjust, and thrive. If you’d like to learn more about our responsive strategies, or chat with an expert on how you can steer your boat in the ever-changing economic seas, schedule a no-obligation call with us. We are passionate about learning, teaching, and helping our clients reach their financial goals. Reach out to us at info@nestfinancial.net. 

 

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DISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.