What is the Federal Reserve?
Simply put, the Federal Reserve is the central bank of the United States. It was founded in 1913to provide an emergency supply of money to banks in times of panic and crisis, stabilizing the nation’s economy. Since then, its responsibilities have expanded to include controlling the nation’s supply of money, overseeing the nation’s banking system and providing banking services to the government. While it has leaders appointed by the president and is under Congressional oversight, the Federal Reserve is intended to operate independently from Congress, giving it a degree of separation from political pressures.
Image via The Federal Reserve (federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm), accessed 25 January 2021
The Federal Reserve has a three-part structure: a Board of Governors, appointed by the president, which oversees the system; the Federal Open Market Committee, which makes the Federal Reserve’s monetary policy decisions; and a network of 12 regional reserve banks, which carry out the day-to-day operations of the Federal Reserve.
Jerome Powell, chair of the Federal Reserve (via Samuel Corum | Getty Images)
What is monetary policy?
The ultimate goal of a central bank is to help a nation achieve sustainable economic growth. The steps a central bank takes to control the nation’s money supply to reach this goal are referred to as monetary policy. Monetary policy involves using various tools (primarily the ones listed in the next section) to manage both the supply and demand of money in an economy. In other words, how much money is in circulation at a given time and how willing firms and individuals are to borrow money. The policy decisions made by a central bank influence important economic factors such as consumption, inflation, employment, and growth.
What is the Federal Reserve’s role in monetary policy?
The Federal Reserve uses four main tools to shape the nation’s monetary policy and money supply:
The Federal Funds Rate and Discount Rate – The federal funds rate is the interest rate banks pay each other to borrow funds in the short term. The discount rate is the interest rate they pay to borrow from the Federal Reserve. If the Federal Reserve increases these rates, it becomes more expensive to borrow money, meaning economic growth will slow. If these rates are decreased, it becomes cheaper to borrow money, causing more money to circulate and economic growth to quicken.
Reserve Requirements – When money is deposited in a bank, the bank can lend or invest part of the deposit, but must keep a certain percentage in reserve for withdrawals for bank customers. The Federal Reserve sets this percentage. If this percentage is decreased, a bank’s funds become more liquid, as they have more cash available to lend to consumers and businesses. This increases the nation’s overall money supply and leads to economic growth. If the Federal Reserve increases this percentage, a bank’s funds become less liquid, because they have less available to lend. This decreases the supply of money and increases the cost of borrowing money.
Open Market Operations – The Federal Reserve both buys and sells U.S Treasury securities (debt issued by the government to finance government spending). By purchasing securities, the Federal Reserve releases money into the economy, stimulating growth. By selling securities, the Federal Reserve removes money from the economy, slowing growth and preventing the economy from overheating.
Interest on Reserves – The Federal Reserve pays banks interest on the money they keep in reserve above the amount which is required. By decreasing the percentage they pay, banks are encouraged to lend more money out to individuals and firms, stimulating the economy. If the Federal Reserve increases the interest percentage, banks will keep more money in reserve, slowing economic growth.
Why would the Federal Reserve ever try to slow down economic growth? Isn’t economic growth a good thing?
Inflation is a general increase in the prices of goods and a decrease in the purchasing power of money. Some inflation is normal in a healthy economy; this is because if consumers expect prices to rise, they will buy more goods in the short term, which spurs production and growth. A high level of inflation, however, can cause uncertainty and a dramatic increase in costs of living. If the economy is growing faster than an ideal rate (this is about two percent per year), the Federal Reserve uses its monetary policy tools to slow growth by increasing the cost of credit and removing money from the economy. Steps the Federal Reserve could take in this situation include increasing interest rates and reserve requirements, and selling Treasury securities.
How does the Federal Reserve help the government respond to crises such as the COVID-19 pandemic?
During an economic downturn, such as the one caused by the COVID-19 pandemic or during the Great Recession of 2009, the priority of the Federal Reserve is to use its monetary policy tools to keep unemployment to a minimum and halt the shrinking of the economy. Lowering interest rates makes it cheaper to borrow and increases money flow, and buying Treasury securities injects more money into the economy. In the case of the COVID-19 pandemic, the Federal Reserve dropped the federal funds rate to virtually zero and bought about $3 trillion in Treasury securities to ensure the smooth operation of the American economy.
How does the Federal Reserve affect the average American?
While the Federal Reserve may seem far removed from the everyday life of the average American, the policy decisions they make help to ensure a more stable economy. Some of the things the Federal Reserve attempts to ensure are:
- A low level of unemployment – Lowering interest rates when necessary allows businesses to borrow more money, and in turn increase production and hire more workers.
- A slow amount of inflation in the prices of consumer goods – Ensuring the prices of consumer goods do not rise too quickly helps consumers maintain their standard of living.
- Stability even in times of crisis – The Federal Reserve’s monetary policy tools allow the government to respond to both cyclical recessions and unforeseen economic crises.
How do the opposing political parties in America view the role of the Federal Reserve?
While the Federal Reserve is intended to operate independently of political pressures, it has received its fair share of criticisms and pressures from both sides of the aisle. Some Tea Party Republicans, such as Ron Paul, have criticized the role of the Federal Reserve in setting interest rates, saying that the free market should determine these policies and that the Federal Reserve’s policies have weakened the dollar and caused unnecessary inflation. He proposed legislation known colloquially as “Audit the Fed” which would give Congress more power to oversee and override the Federal Reserve’s monetary policy decisions, making them more susceptible to political pressure. During his administration, President Donald Trump exerted immense pressure on the Federal Reserve to institute policies that would help his trade agenda. He repeatedly urged the Federal Reserve to lower interest rates, which he said would drive growth and keep America competitive in terms of international trade, especially in respect to competition from China.
On the left, politicians such as Senator Bernie Sanders have criticized the undemocratic way in which leaders at the Federal Reserve are chosen, namely, that they are selected by big banks and do not reflect the overall diversity of America. They have called for more diversity in leaders (currently, 75 percent of directors at the Federal Reserve are men and 80% are white) and public input in the process. Joe Biden’s administration is expected to work closely with the Federal Reserve during the economic recovery from the COVID-19 pandemic and appoint leaders who are likely to further his economic agenda. This agenda includes restoring employment to pre-pandemic levels and increasing the amount of unemployment benefits and direct payments offered to individuals, as well as extensive investment in infrastructure, health care, and climate change preparedness.
About half of Americans believe the Federal Reserve is influenced by politics, with only a quarter believing it is a fully independent institution. Additionally, Americans are split almost evenly on whether they trust the Federal Reserve to act in their best interest, and this divide holds regardless of political beliefs.