The Federal Reserve Explained

The Federal Reserve, the central bank of the US, increased its total assets from $4.17 trillion in January 2020 to $8.33 trillion as of August 2021, in an effort to stabilize the economy since the COVID-19 pandemic.

This is the second time in history that the Federal Reserve took extraordinary steps to stabilize the financial markets and stave off economic disaster. The first time was during the Great Recession. The Fed now owns $6 trillion more in assets than it did during the peak of its response to the 2008 recession.

This powerful independent agency plays a vital role in the US economy, in both good times and bad. Understanding the way it works is essential to understanding its policy decisions.

What is the Fed?

The Federal Reserve (more commonly called, the Fed) is the central bank for the US. The Fed is an independent body and is not tied to an administration or partisan agenda. The system has three key entities: The Board of Governors, the Federal Reserve Banks, and the Federal Open Market Committee (FOMC).

The Fed oversees five key functions. These five key functions laid out by the Fed are “...to conduct the nation’s monetary policy, promote the stability of the financial system, promote the soundness of financial institutions, facilitating US dollar transactions, and promoting consumer protection.”

The president appoints the Board of Governors, pending Congressional confirmation. The Board of Governors is tasked with supervising the five functions, overseeing 12 Federal Reserve banks, and creating financial regulations.

The 12 Federal Reserve banks are divided by geographic regions with economic similarities. Each collects data on their region and tailors interest rates and other policy decisions to meet the needs of their respective areas. The 12 banks supervise state member banks, lending to institutions, providing financial services, and examining financial institutions to enforce compliance with policies and regulations,” according to the Fed’s guidelines.

The most recognized of the Fed’s functions is the job of the Federal Open Market Committee. The committee impacts the entire US economy through its Congressionally mandated goals of maximizing employment and achieving price stability.

How does the FOMC achieve its dual mandate?

The Fed uses monetary policy to achieve both maximum employment and stable prices. Monetary policy affects short-term interest rates, which in turn affect long-term interest rates, stock prices, the value of the dollar, and other assets. By changing monetary policy, the Fed can affect spending, investment, production, employment, and inflation.

For example, when the Fed lowers loan interest rates, it anticipates people will be more likely to spend on long-lasting manufactured goods, like a car or washing machine. Increased demand for goods boosts employment across many industries. As a result, the Fed expects employment and wages to increase.

The FOMC’s main monetary policy tool is setting a target for the federal funds rate. This is the benchmark interest rate that banks charge each other when lending their money held at the Federal Reserve. The current target for the federal funds rate is near zero. The market sets the individual rates for each transaction, but it uses the federal funds rate as a starting point. When the Fed increases this rate, it makes it more expensive for banks to borrow from each other. Banks then pass on the costs to consumers by increasing their interest rates. When it is more expensive to get a loan, fewer loans are taken out, taking money out of the economy. If the Fed decreases the rate, the opposite happens. It becomes cheaper to lend money. When loans are cheaper, more loans go out and more money goes into the economy.

The Fed also sets goals for employment and inflation in order to reach its dual mandate. The Fed’s long-term goal for inflation is 2% annual growth. There isn’t a specific numeric target the Fed tries to match for maximum employment. Instead, it creates policy to address problems affecting the labor market.

In economic emergencies, the FOMC has used another monetary policy tool: the buying and selling of assets backed by the Treasury Department. The assets are owned by US banks, like bonds or other securities. When the Fed buys assets, it adds money to the economy by freeing up banks to make more loans to people or businesses. This is called quantitative easing. When the economy recovers and inflation rises, the FOMC can then sell those assets, reducing money in the economy. The expectation is this will reduce inflation.

The Fed used quantitative easing during the 2008 recession and again in 2020. The scale of the Fed’s efforts to combat the economic costs of the COVID-19 pandemic can be seen in the value of its total assets.