What is the Federal Reserve?

The Federal Reserve is often referred to as simply “The Fed.”

It is the central bank of the United States of America.

A photo of the Federal Reserve building.
Eccles Federal Reserve Building – photo from Wikipedia

It is the second central banking system the nation has had.

The first, The Bank of the United States, was established under Alexander Hamilton in 1791 and lasted only 20 years.

The second, The Federal Reserve, was established in 1913 under President Wilson.

How Does The Federal Reserve Work?

The central bank is a system of 12 member banks. Each bank is a private corporation, and the board of directors elects its president.

The 7-member Board of Governors, aka “The Board,” oversees the network of banks.

Each member of The Board is appointed by the President of the United States, confirmed by the Senate, and serves a 14-year term.

Each Presidential term gets two picks as the assignments are staggered. One member’s term expires every two years.

The Board oversees the member banks and must approve their selection of presidents.

The Board and the Banks work together “to serve the public interest.”

Diagram showing the link between Congress, The Fed, the memeber banks, and the FOMC.
Image by The Federal Reserve

Next, let’s talk about who’s in charge.

Who is The Fed Chair, and How Did They Get the Position?

The Chair of the Board of Governors of the Federal Reserve, aka the “Fed Chair,” is currently Jerome Powell.

Powell is a Republican. Prior to serving on The Board, he was a private equity banker. He was assigned to the Board in 2012 by President Obama.

Powell is serving his second four-year term as the Fed Chair.

He was nominated for the position by President Trump in 2018. Then renominated by President Biden and reconfirmed by the Senate in 2022.

The Fed Chair is the face of the Federal Reserve.

The Fed Chair is often summoned to Capitol Hill to answer lawmakers’ questions. And is responsible for delivering remarks at a press conference after each FOMC meeting.

In some ways, the Fed Chair is similar to the U.S. President. They are in a visible role, receive much of the criticism when things don’t go well, but have limited powers.

In general, the markets tend to like Powell, even if the media rags on him.

Now that we have an understanding of what The Fed is. Let’s take a look at their responsibilities…

The Federal Reserve’s Job

The bank has a dual mandate given to it by Congress in 1971. And several tools at its disposal.

The mandate is simple:

  • Price stability
  • Maximum sustainable employment
The dual mandate bullseye
Image by the Chicago Federal Reserve

Price stability means keeping inflation down. Its target inflation rate is 2%. 

The target unemployment rate is about 4.2%.

The Fed works towards these goals with several tools. We’ll look at the biggest two.

  • First, it sets the interest rates that it loans money to commercial banks.
  • Second, it determines the best use of the balance sheet. More on those two items in a bit.

Next, let’s look at everyone’s favorite meeting … The FOMC.

What is the FOMC?

FOMC is short for “Federal Open Market Committee.”

This committee meets ten times per year and sets the policy of The Fed.

The committee is composed of all seven members of The Board and the presidents of the 12 member banks.

All seven Board members get a vote at each meeting. But of the 12 member banks, only four vote at each meeting. The voting positions rotate on a set schedule.

The main policy that the FOMC decides is the interest rate at which The Fed will loan money out. And what action it plans to take in regards to the balance sheet.

Let’s look at each of these one by one.

Interest Rates

Banks make money like most businesses. They provide a product to customers at a cost marked up from its own.

Car dealers buy cars from the manufacturer, mark up the price to cover overhead and turn a profit.

Banks operate in the same regard, but they sell money.

The cost of money for the bank is the interest rate set by The Fed. If the interest rate is 0%, banks can turn a profit on mortgages with a 3% interest rate.

But when The Fed increases the rate to 1%, mortgage rates will climb to 4% or more.

The lower the interest rate set by The Fed, the cheaper it is to borrow money for everyone else.

Lower rates are widely believed to promote economic growth. In contrast, higher rates are thought to hinder growth.

Interest rates are one of two big tools The Fed has at its disposal. The other is…

The Balance Sheet

It’s also known as the “money printer.”

The Fed doesn’t have money. It creates it by adding new money to its balance sheet.

From time to time, The Fed decides it’s in the public’s best interest to add to the balance sheet.

For example, in 2008, amid the mortgage-housing crisis, foreclosures skyrocketed, and people were losing their homes at a record pace.

The Fed stepped in and began buying failing mortgages to help keep people in their homes and stabilize the economy.

In 2020 the world began to shut down in response to the COVID-19 pandemic. The Fed began buying bonds from private institutions to stabilize the financial markets.

The Fed has the power to add to the balance sheet (create money) and reduce the balance sheet (sell assets) as it sees fit.

At writing in 2022, The Feds balance sheet is about $9 trillion. Before the pandemic, it was about $4 trillion.

That’s your bare-bones crash course on the Federal Reserve.

We leave with a final note about the magic of The Fed … Something, many of the nation’s leaders, fail to grasp…

The Magic of The Fed

Political pundits love to scream about “runaway spending” and “unsustainable debt.” 

The Fed, the ones with the ability to create unlimited amounts of money, see it differently.

In 2011, Fed Chair Alan Greenspan told NBC News, “The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.” 

And in a 2011 blog post, the Federal Reserve Bank of St. Louis wrote, “As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent, i.e., unable to pay its bills.”

Some economists have used Modern Monetary Theory (MMT) to explain this concept.

MMT bucks traditional thinking about money, debt, and the role of government.

Trading For Keeps explored MMT in a podcast in 2021. Click here to listen to it now. It’s available everywhere podcasts are.

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