The US Federal Reserve is subject to intense scrutiny by governments and investors worldwide since its decisions can ripple throughout the global economy. But how does it really work?
Dual mandate
The Fed was created on December 23, 1913 under President Woodrow Wilson.
Unlike most central banks, such as the European Central Bank, that focus solely on keeping inflation low, the US Congress assigned the Fed a ‘dual mandate’ to promote maximum employment and price stability as it sets monetary policy.
It also is one of the agencies charged with regulating banks and ensuring the soundness and stability of the financial system, a function that was sorely tested during the 2008 financial crisis.
The Fed system
The Fed is led by the Board of Governors in Washington, made up of seven members nominated by the president and confirmed by the Senate, including the chairman, Jerome Powell (although there currently are only four members).
There also are 12 regional Fed banks throughout the United States to monitor local economies and banks and the presidents of those institutions are named by their boards of directors.
The Federal Open Market Committee meets eight times a year to discuss monetary policy – although in dire cases it can meet more often, even by telephone.
The FOMC is comprised of 12 voting members: the seven governors, the president of the New York Fed bank and four other Fed bank presidents who rotate onto the committee each year.
Fed independence
Congress created the Fed to operate as an independent government agency. The governors serve 14-year terms to check the influence of election cycles and Congress does not fund Fed operations.
While the Fed chair has to report to Congress twice a year, which allows for some sharp critiques of central bank policy, presidents in recent decades have refrained from commenting publicly on interest rates, again unlike other central banks such as the ECB.
Presidents in recent decades have refrained from commenting on the Fed decisions but Trump has done so repeatedly and with colorful language, saying the Fed had ‘gone crazy,’ and was ‘out of control.’
Interest rates
The Fed’s main tool to steer the economy is the benchmark interest rate known as the Federal funds rate, which is what banks charge for very short-term loans. That in turn affects the cost of mortgages, car loans, corporate debt and other borrowing.
As the target rate rises, it costs more for businesses to invest and for consumers to buy goods, which tends to slow the economy and reduce inflation. Lowering the rate, or ‘easing’ monetary policy, tends to boost spending and economic growth.
The rate was near zero from 2008 to the end of 2015 when the Fed first began to gradually increase it, ‘tightening’ monetary policy, something it has done three times so far this year.
Central bankers watch carefully for any signs inflation may be set to accelerate – including prices, wages and unemployment. Failure to act would undermine the Fed’s hard-won inflation-fighting credibility. The Fed had to raise the key rate to 20 percent after prices surged in 1979-1980.
The FOMC determines the target range for the funds rate and the New York Fed buys or sells Treasury securities to commercial banks to influence the rate by increasing or reducing the supply available.
The Fed also sets reserve requirements, or the amount of money banks are obliged to hold as a backstop at all times. If transactions on a particular day mean they will be short reserves at the close of business, they will ask for a short-term loan from the Fed or from another bank.
Other tools the central bank can use include raising or lowering the level of required reserves and the interest paid on bank excess reserves held by the Fed.