What is the Fed?


The FBI, CIA, DEA, IRS — you certainly don’t want the feds coming after you. It’s not good to be running from an organization with a three letter acronym. This article is not about the feds, plural, but the Fed, singular. The “Fed'' is not an acronym, but an abbreviation for the Federal Reserve System, or the Federal Reserve. It serves as the central banking system for the United States, and it manages US monetary policy, regulates the banking system, and promotes consumer protection (1).


The Fed was founded by the Federal Reserve Act in 1913 during the presidency of Woodrow Wilson (2). The US had not had a national bank since 1836, and a financial crisis in 1907 led to the establishment of the National Monetary Commission in 1908, which examined and recommended possible changes to the US financial system. Eventually, the bill now known as the Federal Reserve Act passed in the House of Representatives on December 22, 1913. The next day, it passed the Senate, and President Wilson immediately signed it into law.


As the bill became law, three primary components of the Federal Reserve System were set in motion (3). The first is the Board of Governors, a federal agency which reports to Congress and oversees the twelve banks of the system. The twelve banks, the second component of the system, are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. And third is the Federal Open Market Committee, or the FOMC. The FOMC is made up of the seven members of the Board of Governors, the president of the New York Federal Reserve bank, and four presidents from the remaining eleven banks (4). The FOMC is in charge of the monetary policy for the system.


What is monetary policy? One piece of monetary policy is dictating the supply of money in the economy. When the money supply increases, the value of the currency generally drops, and inflation ensues. When the money supply decreases, the currency is more valuable, and prices of goods and services will probably not drop, but will at least not increase as rapidly as before. To accomplish the former, the Fed can buy bonds or other securities owned by banks to give them more money to make loans to consumers, thus increasing the money supply (5). The purchase of a bond gives money to the one selling it — in this case the banks. To accomplish the latter, the Fed can sell those assets to decrease the money supply. When selling a bond, the seller gets the money — in this case the Fed. Thus, the money flows away from the private banking system back to the Fed and is taken out of the general money supply.


The main monetary policy, though, is setting the Federal Funds Rate. This is the interest rate banks charge when they lend money to each other (6). With a lower federal funds rate, it’s cheaper for banks to borrow from each other, which means the interest rates they set on their own loans to consumers will be lower, which will lead consumers to take out more loans, which means a higher money supply, which means more inflation. With a higher interest rate, the reverse happens. To summarize, a lower cost to borrow money leads to more money in the economy and more economic activity. In mid-March 2022, the Fed hiked interest rates by 0.25 percentage points to try to fight the inflation rampant in the economy (7). In March 2020, the Fed did the opposite to support the flow of money into the economy during the early days of the COVID-19 pandemic.

So what are the Fed’s goals? The first goal is to keep inflation at a 2% annual rate (8). That became the Fed’s target inflation rate in 2012. The second is to attain maximum, or full employment. This does not mean an unemployment rate of 0% — that never happens. This is the dual mandate, and these goals are related to each other. With stable inflation, the overall economic environment is more stable, which can help in achieving full employment.

Despite these goals, the Fed has heard its share of criticisms. Milton Friedman, an economist who generally opposed government intervention in the economy, blamed the Fed for converting what, in his view, would have been a standard recession into “a major catastrophe” - now known as the Great Depression (10). He also was opposed to the Fed’s existence, as so much power was put into the hands of a few men. He wanted the Fed abolished and replaced with a model that would just keep increasing the money supply at a steady rate. According to Business Insider, money used to actually gain or retain its value over time (11). Since the creation of the Fed, it’s mostly been one long decline in the value of money. Some have also criticized the Fed’s lack of transparency. It has even been proposed that we return to the old Gold Standard, which would lead to an actual limit on government spending. Without one, the government can just keep borrowing money. The gold standard was a system in which the value of the US dollar was pegged to gold at a fixed price (12). You used to be able to convert US dollars directly into gold, but President Nixon stopped that in 1971.

Hopefully this helped make a little sense of recent news about interest rates and inflation. It’s kind of shocking that money actually used to appreciate back in the 1800s. That would be nice to see. As I write this, I’m home for the Easter holiday in Hopkins, MN (my old stomping grounds). When I was in high school, I remember the price of a Chipotle chicken burrito being $6.25. As of April 16th, 2022, it was $7.60. If you do the math, that’s about a 2% price increase each year on average. But imagine if it dropped. That would be nice, too.

 

Curran Martin is a Minnetonka, Minnesota native and currently resides in Madison, Wisconsin. He graduated from the University of Wisconsin-Madison in May of 2019 with a degree in Economics, then spent two years working with a campus ministry, and now works in the insurance industry. Curran enjoys playing outdoor sports, learning about history and politics, and playing board games with friends in his spare time.