What is the Federal Reserve, What Does it do, and How do Its Actions Affect my Personal Finances?

August 4, 2020

The Federal Reserve, a.k.a., “the Fed,” is one of the more headline-making institutions in the United States. It’s also one of the least understood. Since the Fed’s creation over a century ago, its decision-makers have helped our nation emerge from financial crises, recover from recessions, and achieve historic levels of prosperity.

That said, connecting the dots between the Fed’s broad economic policies and your bank balance isn’t exactly child’s play. But it’s important to understand that a connection exists. Read on to learn more about the Fed, how it operates, and how understanding its priorities can empower smarter spending and saving.

What is the Federal Reserve?

The Federal Reserve System was established in 1913 in response to the Panic of 1907. During that event, demand for liquid assets outstripped supply, leading to what is known as a bank run. Bank runs can entirely deplete a bank’s cash reserves, causing it to fail. Any single bank’s failure will have a ripple effect on other banks for which it serves as a lender or borrower — not to mention the bank’s account holders. 

Via the Federal Reserve Act, Congress created the Federal Reserve System to help prevent bank runs. In case bank runs did occur, the Fed was also authorized to serve as a “lender of last resort.” That means the Fed can make loans and extend credit to any other bank in the nation’s financial system. 

The Federal Reserve System consists of three main components.

First, the Federal Reserve System is a network of one dozen regional federal banks. These Federal Reserve Banks are located in the following cities.

  • Boston, Massachusetts.
  • New York, New York.
  • Philadelphia, Pennsylvania.
  • Cleveland, Ohio.
  • Richmond, Virginia.
  • Atlanta, Georgia.
  • Chicago, Illinois.
  • St. Louis, Missouri.
  • Kansas City, Missouri.
  • Dallas, Texas.
  • San Francisco, California.

Each Federal Reserve bank focuses on its respective region’s economic environment to ensure that the Fed’s monetary policy takes regional differences into account. Each Federal Reserve bank employs its own researchers and analysts. Their work informs the Fed’s policy deliberations.

Secondly, the seven-member Federal Reserve Board (FRB) of Governors oversees these regional banks, led by the Chair of the Board of Governors of the Federal Reserve System. Jerome Powell currently occupies that position. Past Fed Chairs include Alan Greenspan and Ben Bernanke. The members of the FRB are Presidential appointees who must be approved by the Senate. Each one serves a 14-year term.

Finally, the Federal Open Market Committee (FOMC) is the system’s monetary policymaking body. 12 members comprise the FOMC: the seven FRB governors, the president of the New York Federal Reserve Bank, and four other regional presidents who serve on a rotating basis.

Perhaps the easiest way to understand the Fed’s mission is to view it as the central bank of the United States.

What does a central bank do?

Central banks are responsible for guiding their nation’s economy and financial systems. Congress modeled the Federal Reserve, in part, on the Bank of England, which has functioned as the United Kingdom’s central bank since 1694. In addition to acting as a lender of last resort to other financial institutions, the Fed issues currency, manages interest rates, sets banking rules and regulations, and conducts economic research.

Central banks have traditionally been independent entities. For that reason, the Fed is often described as both a quasi-governmental and apolitical agency. The Federal Reserve’s actions are not subject to either Congressional or Presidential approval. Nor is the Fed publicly funded. However, as noted, its leaders are appointed by the President, and they work closely with members of both the legislative and executive branches to administer monetary policy.

What is monetary policy?

Monetary policy refers to the measures a central bank takes to increase or decrease the money supply.

The money supply is the amount of liquid capital — cash — currently circulating through the economy. The money supply also includes funds held in checking and savings accounts, for reasons we’ll explain shortly. The money supply can be a useful indicator of the economy’s overall health. For example, an overabundance of money relative to a market’s available goods and services can be an early warning sign of inflation. 

What are the Fed’s monetary policy goals?

In everything the Fed does, it seeks to:

  1. Control inflation.
  2. Keep unemployment low.

In a growing economy, rising prices can become a runaway train that derails growth. Meanwhile, high unemployment is usually characteristic of a lagging economy.

The Fed prefers to keep the inflation rate at about 2 percent. If the inflation rate exceeds 2 percent, the Fed will impose policies designed to tighten credit and slow the economy’s pace.

The Fed deems an unemployment rate of between 3.5 and 4.5 percent most acceptable. If unemployment spikes – as it has due to the economic effects of COVID-19 — the Fed will use its policy-making power to promote consumer spending and encourage corporate borrowing.

How does the Fed achieve these monetary policy goals?

The Fed has several monetary policy tools it can use to right-size the money supply. Those tools include reserve requirements, the federal funds rate, the federal discount rate, and open market operations.

What are reserve requirements?

Banks are more than vaults. Banks are hives of economic activity. Bankers are constantly making transactions — opening lines of credit, collecting payments on loans, paying accrued interest to their customers, and processing those same customers’ withdrawals and deposits. In other words, money is hardly ever at rest in a bank environment.

The Fed recognizes this fact. It, therefore, requires that banks keep a minimum amount of cash on deposit at a regional Federal Reserve bank to cover their financial obligations to their customers.

Reserve requirements adhere to a sliding scale. The more money a bank has on deposit, the higher its reserve requirement. Entering 2020, the reserve requirement for banks holding more than $127 million in cash was 10 percent. In response to the economic slowdown triggered by the COVID-19 pandemic, and to ensure that banks can continue borrowing and lending, the Fed has effectively eliminated the reserve requirement for the time being.

What is the federal funds rate?

Reserve requirements are comparable to the minimum required balances. But many banks maintain balances much higher than the minimum. Why? So that they can lend out that capital and generate income via interest.

Interbank lending has a significant influence on the money supply. Many of the loans banks make to each other have very short terms. Some of them are overnight loans made at the close of one business day and repaid at the open of the next. Banks most frequently make these overnight loans to ensure that they can meet their reserve requirements.

The federal funds rate is the interest rate banks can charge each other on these loans. The FOMC meets regularly to review and adjust — if necessary — the federal funds rate.

When commentators discuss interest rates or the benchmark rate in the context of the Fed’s actions, they are most often talking about the federal funds rate.

What is the federal discount rate?

The federal discount rate is the interest rate the Fed charges on the loans it makes to depository institutions: commercial banks, community banks, savings and loan associations, and credit unions.

The FRB determines this discount rate. Generally speaking, the FRB will set this rate higher than the federal funds rate. For most of 2019, the discount rate was 3 percent. It is currently 0.25 percent. Again, this adjustment reflects the Fed’s efforts to alleviate the economic stress caused by COVID-19.

What are open market operations?

Sometimes the Fed believes an expansion of the money supply is in the economy’s best interest. At other times, it believes the better approach is to shrink the money supply. In either case, the Fed will become a participant in the open market for securities, such as government bonds.

By acting as a seller, the Fed adds to the available money supply. By buying up securities, the Fed removes funds from the money supply. If the economy is a car driving down a highway, selling is analogous to pressing down on the accelerator, while buying is the equivalent of pumping the brakes.

Because they affect the money supply, the Fed’s open market operations also influence the federal funds rate.

How do the Fed’s actions affect my ability to save?

The Fed primary customers are not individuals like you and me. It is the bank’s bank. Nevertheless, when the Fed changes its fund's rate, commercial banks will adjust theirs accordingly. Consumers feel those rate fluctuations in several ways.

Many short-term interest rates are tied to the fund's rate in some form or another. That includes the variable interest rates charged by credit card providers, personal loan rates, auto loan rates, and — to a lesser extent — mortgage rates. (Treasury yields have a greater influence on mortgage rates.) The lower the fed funds rate, the “cheaper” forms of credit become for consumers.

However, those same low rates translate into low yields on interest-bearing accounts, including your savings accounts.

When the Fed drops the fund's rate, that maybe your cue to:

  • Begin shopping for a home.
  • Explore refinancing your existing home loan.
  • Apply for a home equity loan or home equity line of credit (HELOC).
  • Upgrade your vehicle.
  • Consolidate your debt.
  • Apply for a new credit card to fine-tune your credit utilization rate.
  • Transfer credit card balances.
  • Aggressively pay off your credit card debt.

When the Fed increases its fund's rate, you may want to save more and generate as much passive income as possible while keeping your assets liquid.

How do the Fed’s actions affect my purchasing power?

Unless you lived through the 1970s and early 1980s, you probably don’t have firsthand experience of how destructive inflation can be to your personal finances. But consumers of that era well remember having to stretch their dollars to cope with the rapidly rising cost of groceries (especially meat). In fact, it was not uncommon for inflation rates to double or triple year-over-year in the mid-1970s. Consequently, by 1980, the Fed’s funds rate reached a high it’s never since approached: 20 percent.

This drastic move managed to curb the core inflation rate, which does not include the price of volatile commodities such as oil. But it did not reverse inflation. This is an important distinction. Inflation will always be an economic force to be reckoned with. Moreover, inflation can spur demand. If consumers believe that prices will go up tomorrow, they are more likely to buy low while they can. Therefore, the Fed’s job is to tame inflation, not exterminate it.

In addition to monitoring the Fed’s decisions on interest rates, you can keep an eye on inflation by consulting the Consumer Price Index (CPI). The CPI also serves as a useful reminder that not all inflation is created equal. Although no one looks forward to paying more for their morning cup of coffee, even a 5 percent bump in the price a what’s already a big-ticket item — such as a major home appliance, a car, a home, or healthcare — can have a tremendous impact on your cost of living.

How do the Fed’s actions affect the job market?

When unemployment is high, recessionary conditions threaten. In those instances, the Fed’s response typically involves cuts to the fund's rate and cash injections to the money supply. For the Fed, spurring economic growth means giving businesses the financial resources they need to keep their doors open. Chief among those resources is affordable credit.

In other words, the Fed does not create jobs directly. Instead, it incentivizes hiring and disincentivizes the scaling back of production that can contribute to layoffs. Some industries, such as construction, manufacturing, and energy, are more likely to respond to these incentives and disincentives than others. The same is true of some regional markets. But the fact remains that more money equals more opportunities for investment. That’s as true for big businesses and banks as it is for you.

Get the greatest return on your investment in your financial literacy by opening an account at Guaranty Bank & Trust. We offer a full range of personal banking services, from high-interest money market accounts to tools that help you save with every purchase you make. Call our Customer Care Center at (888) 572-9881 or book a video appointment today to learn how our friendly, collaborative, and community-minded bankers grow to help you grow.

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