The Federal Reserve and Its Impact

Infographic that explains what the Federal Reserve is, its key characteristics, its structure, and what its main functions are.

Economists and investors are always on high alert when the Federal Reserve comes out with its regular reports. Especially when special announcements are planned. The Federal Reserve, also called the Fed, is often referred to as the orchestrator of the economy. That is why investors pay such close attention to the Fed. Generally, when the economy is doing well, more people will invest, and stock prices will increase.

This article will discuss the Federal Reserve, its history, structure, what it does, and its importance.

What Is the Federal Reserve?

Most people have heard of the Federal Reserve, but many do not know exactly what the Federal Reserve does and the impact its actions have on their daily lives. The Federal Reserve is the central banking system in the United States. Its purpose is to keep the U.S. economy healthy and its financial system stable. To reach this goal, it follows a dual mandate.

This mandate includes keeping inflation in check and maximizing employment as well as regulating long-term interest rates. The target inflation rate is currently set at 2%, and the target unemployment levels are currently between 3.6% and 4.5%. This framework of actions is called monetary policy.

The Federal Reserve Bank also operates as an agency internationally, setting policy, brokering trades, and controlling interest and inflation rates. With so many important duties, most people think that the Fed is a government institution. However, it is not. Although it reports to Congress, its decisions do not have to be approved by Congress or the President. In addition, it does not rely on tax dollars for funding but instead earns money from its transactions.

Because of its independent status, it has gained high credibility and has therefore become a powerful institution.

The Federal Reserve and Its History

Before creating the central banking system, banks in the colonies did not give credit or take deposits. It was the rich merchants that were the main loan providers. Instead, the banks issued paper currency backed by land or precious metals. This system was highly ineffective, and paper currency was often not allowed by the British.

The beginning of the central banking system started in 1789 with the Constitution. Alexander Hamilton, Treasury Secretary, developed a plan for a central banking system to solve the existing credit problems and provide credit to the government and businesses. The Central Bank controlled the printing of paper money, also called “continentals” back then. This quickly ballooned into the start of the United States’ federal financial system.

However, the banking system became dominated by a small group of corporate bankers that many Americans felt did not represent them. For the next century, people started pushing for a more representative banking network. Several severe banking and financial crises caused panic during the next century. That is when Americans started to desire a stable, reliable system that could withstand temporary economic instability. They needed oversight, guidance, and a resilient currency to adapt to current global economic trends without inflating or devaluing.

Then, in 1913, Congress officially passed the Federal Reserve Act, creating the board now known as the Federal Reserve.

Structure of the Federal Reserve

Today, the Federal Reserve is a three-pronged system that provides support locally and internationally. It is made up of three major components:

  • The Federal Reserve Board of Governors – This board oversees the Federal Reserve System and the 12 Federal Reserve Banks.
  • Federal Reserve Banks – These 12 banks are regional federal reserve banks, each overseeing a specific geographical region within the United States.
  • The Federal Open Market Committee (FOMC) – This committee guides the nation’s open market operations and manages interest rates and the money supply.

The Board of Governors is the governing body of the Federal Reserve System and is located in Washington, D.C. The Board is an agency of the U.S. government and reports to and is directly accountable to Congress. Each board member is nominated by the President of the United States and confirmed by the U.S. Senate. Each member also serves on the FOMC, which is the Federal Reserve body that sets monetary policy.

Map that show the location of the 12 Reserve Banks and their regions.

The Board of Governors oversees each of the 12 member banks and supervises and regulates certain financial institutions and activities. The 12 Federal Reserve Districts are Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The Board also provides general guidance, direction, and oversight, including reviewing and approving each of the Reserve Banks’ budgets.

The Board of Governors guarantees that consumers’ opinions and concerns are heard. They conduct consumer-focused research and promote a fair and transparent consumer financial services market.

What Does the Federal Reserve Do?

The Federal Reserve tackles five different functions as an important part of their fiscal responsibilities.

1. Sets Monetary Policy

Monetary policy is a tool to support the overall economic health of a country. When the US economy is struggling, the Federal Reserve will take certain actions to stabilize the economy. The goals of monetary policy are to promote maximum employment, stable prices, and moderate long-term interest rates. The Fed will also ensure an adequate supply of paper currency around the country.

The Fed’s most effective tool, and the one it uses most often, is buying and selling of government securities in the open market. For example, the Fed will buy securities when it wants to increase the flow of money and credit. This policy decision will ultimately stimulate the economy. When it wants to slow the economy down, the Fed will sell securities to reduce the money flow.

The Fed also clears checks, processes direct deposit transactions, money transfers, and online payment transactions. It facilitates larger monetary transactions and acts as an additional bank to the federal government.

2. Supervises and Regulates Financial Institutions

The Federal Reserve has two other nicknames: “the Fed” and “the Bankers’ Bank.” The Federal Reserve and its 12 regional reserve banks act as backup banks for regular commercial banks. Each reserve bank stores currency, processes checks and makes loans to its members to meet their reserve requirements (the amount of money they must have on hand when needed).

Banks are charged a discount rate which is slightly higher than the federal funds rate. Most banks avoid using the discount rate window because it’s often assumed that when banks do, they cannot get loans from other banks. That is why the Federal Reserve is also known as the bank of last resort. It tries to prevent bank failures by offering loans to banks in serious trouble.

Please note that the Federal Reserve does not regulate credit unions. The National Credit Union Administration regulates them at the federal and the state level.

3. Provides a Secure National Payments System

The Federal Reserve plays a critical role in creating a secure payments system. It serves as a major provider of paper and electronic services to depository institutions. The Fed processes approximately 75 percent of all the items handled by ACH clearing houses in the United States.

The Federal Reserve is called the banker’s bank because its network of regional Reserve Banks supports thousands of local banks. They provide the same services to their member banks that those banks offer their customers. They store and distribute currency, process electronic payments and checks, and provide loans to their members. The Federal Reserve also acts as a bank to the U.S. government.

4. Maintains the Stability of the Financial System

Another major responsibility of the Federal Reserve is to stabilize the domestic financial system. The Fed requires that banks (and other financial institutions under its jurisdiction) hold a certain amount of capital in reserve. When a bank does not meet its reserve requirements, it can borrow money from other banks overnight to meet those requirements. The Federal Reserve controls this type of exchange. The interest rates they set are a major supporting factor in regulating and stabilizing national currency rates. This interest rate is known as the federal funds target rate.

FEDERAL FUNDS TARGET RATE 2000 – 2021

Graph that shows the federal funds rate between January 2000 and January 2021

When the U.S. economy is healthy and growing, the Fed might raise the federal funds target rate, effectively raising interest rates across the nation. This is to help keep inflation in check, prevent the cost of living from skyrocketing, and prevent a financial crisis. When the economy is shrinking or when economic growth is slowing down, the Fed will often lower the federal funds target rate. This makes debt less expensive for everyone and encourages the borrowing of money to help boost the economy. In the chart above, you can see a major interest drop in 2008, from a little over 5% to a near-zero level. The Fed decided on this reduction of the federal funds target rate to stimulate the economy during the 2008 financial crisis.

5. Protects Consumers and Communities

The final role of the Federal Reserve is to promote community support and consumer protection through fiscal policy. The Federal Reserve works to strengthen trust between consumers and the U.S. Treasury by acting as a go-between in fiscal and monetary matters. It works closely with national and international relations boards to help manage inflation, investment, and other financial trends. The Fed keeps the interests and integrity of working-class Americans at the center of domestic and international monetary policy, protecting consumers and communities nationwide.

Why the Fed Is Important and How It Affects Us

Many people do not realize that the Federal Reserve can, directly and indirectly, impact our daily lives and our money.

Infographic that explains how the Federal Reserve affects our lives. It enables easy payments, Affects the price you pay for loans and the money you make in interest, influences the prices you pay for goods and services, affects the economy you work in, and provides a safe place for your money.

If you have a mortgage, a car loan, use a credit card, or have a savings account, the Fed impacts you because it sets and regulates interest rates. This means that it impacts the interest rates that you end up paying for your loans. When the Fed fears a downturn in the economy, it will lower the interest rate it charges other banks. This is called the discount rate.

Because the banks pay less for the money they borrow from the Fed, they will lower the interest rates on loans to their customers. This will increase consumer demand, which leads to an increase in production and, eventually, an expanding economy.

A change in interest rate also affects you when you have a savings account. For example, when the Fed feels that the economy is overheating, it can increase interest rates to discourage spending. This might result in you spending less and saving more because of the higher interest you get in your savings account.

Another way the Federal Reserve can affect you is by increasing or decreasing the money supply. This can influence the ability of companies to hire employees. In a slow economy, the Fed can increase the money supply so banks can lend more money to companies to hire more people. It can also lower the interest rates, so borrowing money for consumers will get cheaper.

The Federal Reserve also plays an important role in how we pay our bills. It provides us with a secure payment system that has made it pretty easy for us to pay our bills. From providing currency to clearing checks to money transfers and processing electronic payments, today’s payment system would not exist without the help of the Federal Reserve.

As customers of banks, we all want to make sure that the money we have at the bank is secure. Luckily the Federal Reserve supervises and regulates U.S. financial institutions. It ensures that banks have enough reserves on hand, and it will help banks in need by lending them money. It has also implemented all kinds of rules to prevent bank failures.

The Federal Reserve’s Response to the Covid 19 Crisis

The Federal Reserve plays a vital role in maintaining the health of the U.S. economy, especially in times of crisis. The Covid 19 crisis has caused widespread disruptions and has left the economy in turmoil. From the recession in February 2020 to the start of a bear market in April 2020. Another major problem has been the massive increase in unemployment since the pandemic started. At one point it was almost up to 15%. Luckily, in May 2021, it went down to about 6%. However, this is still well above the Federal Reserve’s goal of 3.6%.

Both the U.S. Government and the Federal Reserve have responded to the crisis by stabilizing the economy, stimulating the economy, and offering funding and support. The federal government has issued various executive actions to provide aid during the pandemic. It has provided fiscal stimulus to the economy and relief packages worth trillions of dollars.

To add to the fiscal stimulus, the Fed has implemented various monetary policy measures to provide stimulus and aid to those who need it. They have done this by lowering interest rates such as the federal funds and the discount rate to near-zero levels. This decrease in interest rates has lowered consumer mortgages, car loans, and interest on credit cards. To increase liquidity in the market, the Fed implemented various purchasing and repo programs.

Besides these asset purchasing programs, the Federal Reserve created various emergency lending programs.  The Primary and Secondary Market Corporate Credit Facilities and the Main Street Lending Program ensured that corporations and small businesses could get credit.

The Covid 19 crisis has made it clear how important the Federal Reserve is in maintaining the health of the U.S. economy.

Conclusion

The Federal Reserve does a lot of things. However, most of its work usually occurs behind the scenes, and many of us do not understand the day-to-day impact the Fed has on our lives. Besides setting the federal funds interest rates that directly affect consumer interest rates, the Fed also indirectly influences our daily lives. Its decisions affect the stock market indirectly because a growing economy is a good sign for the stock market and typically results in a bull market. Another example of the Federal Reserve’s indirect impact on our daily lives is its decisions that affect employment. A growing economy creates jobs.

Although it is not always obvious, the Covid 19 pandemic has made it clear that the Federal Reserve works hard to preserve the health of our economy, prioritizes American interests, and stabilizes fiscal policy around the world.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.