Understanding the Federal Reserve
Last week, President Trump threatened to fire a member of the Federal Reserve’s governing board. But what is the Federal Reserve? (Often referred to as The Fed.) And what does it mean to cut short-term interest rates, and why is it controversial if the president tries to fire a member of the board? This week, Election Central unpacks some of these questions and explains this important influence on the U.S. economy.
What is the Fed?
The “Fed” is short for the Federal Reserve, and it is the central bank of the United States. Its job is to keep the U.S. financial systems stable. The Federal Reserve Act of 1913 created this agency. Before that time, the U.S. banking system was less predictable. Every bank across the country was, at that time, its own independent entity. Banks frequently “failed,” meaning that during times of economic depression people would rapidly withdraw their savings from the bank and the bank would run out of money. This often had a domino effect: if one bank ran out of money it would cause a panic for customers of other banks, who would then withdraw their money as well.
In 1907 there was a particularly serious economic panic. It was so bad that billionaire J.P. Morgan and other wealthy entrepreneurs used their own personal money to bail out the banks. That was when Congress decided it needed to create a central bank that could deal with these crises. Congress’s goal was to create a way to allow a bank facing a panic to access emergency funds. This would prevent one bank’s problems spreading to other banks as well. Congress also wanted to make it easier to make payments from one part of the country to another.
What Does the Fed Do Today?
Today, the Fed is also responsible for keeping a healthy economy and a sound banking system. It has a “dual mandate,” meaning two roles: price stability, and maximum employment. It is made up of three parts: the Board of Governors, the 12 reserve banks, and the Federal Open Market Committee. The Federal Open Market Committee sets monetary policy, which affects interest rates.
Interest is the extra money you must pay back on a loan. A lower interest rate means that it costs less to borrow money. In the short term, lower interest rates help grow the economy by encouraging people to start businesses, take out mortgages on new houses, and so on. This is because lower interest rates reduce the overall amount of money that must be paid back when people take out loans. So, lower interest rates encourage entrepreneurs to start businesses or encourage people to purchase home mortgages. These actions help the overall national economy and the many businesses that make the economy grow. But over time, in can also lead to inflation.
Explaining Monetary Policy
The Fed attempts to control the operation of the U.S. economy with a few different strategies. As mentioned above, the Federal Reserve can adjust the interest rate that banks change for loans. When the economy is growing too slowly, the Fed usually lowers this interest rate to stimulate economic growth. If the economy is growing too rapidly and price inflation is rising the Fed may raise the interest rate to make lending money less attractive. This can slow economic growth. In recent years, these types of rate adjustments have been done cautiously—one-quarter or maybe one-half of a percentage point at a time.
Another tool that the Federal Reserve may use is buying government bonds. This adds more circulating money in the economy and that may result in lower interest rates and increase consumer spending. The Fed can stop buying bonds or even sell some of those same bonds to decrease the money supply and slow down the economy.
Finally, the Fed can raise or lower the reserve requirement for its member banks. This is the minimum amount of currency that member banks must keep secure in their vaults in case withdrawals are needed. This puts a hard limit on the amount of money that a bank may lend out to entrepreneurs and businesses and can therefore affect economic growth.
The Board of Governors
The Fed’s board of governors is a seven-member body that votes on interest rate decisions and other financial regulation matters. The governors are appointed by the president and must be confirmed by a majority vote in the Senate. However, unlike cabinet secretaries, Federal Reserve governors don’t leave office when the president does, and the president doesn’t have control over them. Instead, they serve 14-year terms. This helps to keep the body free from political influence.
President Trump has publicly stated his desire for the Federal Reserve to sharply lower interest rates. This could make borrowing money cheaper and encourage economic growth. But Trump wants the Fed to cut rates by several percentage points all at once, which is much faster than the Fed has historically adjusted interest rates.
President Trump is frustrated that the member of the Federal Reserve are not acting quickly to lower interest rates, as he wants. But this demonstrates the role of the Federal Reserve—to act in the interest of the national economy and not to be driven by momentary political requests. The Fed is supposed to stay politically independent because it often must make unpopular decisions. Economic research shows that nations with independent central banks have lower inflation over time.
What might happen if the Fed deviates from a cautious approach and sharply cuts interest rates? Some economists say that this would likely cause higher inflation of prices. It woudl also make borrowing costs higher over time. When Democrat Lyndon Johnson and Republican Richard Nixon heavily pressured the Fed to keep rates low during their presidencies, it resulted in inflation that lasted into in the late 1960s and 1970s.
Show What You Know Based on what you’ve learned in this article, draw a picture showing how the Fed works. Remember to include all three of its parts.
