Wednesday’s Word: The Fed

mary-annBy Mary Ann Hanke, Fall 2016 Student Intern

A July 2016 headline from the Wall Street Journal read, “Fed Officials Gain Confidence They Can Raise Rates This Year.” A few follow-up questions spring to mind:

  • Who is “The Fed?”
  • How do they have the authority to raise my interest rates?
  • Why does it seem like raising interest rates is a good thing?

This Wednesday Word post will, hopefully, answer these very important questions in turn.

The common term “the Fed” is short for the Federal Reserve System (FRS). The FRS is a government agency created by Congress that exists and acts independently of either the executive or judicial branch of the U.S. government. Any and all powers it has come from the Federal Reserve Act of 1913, which established the structure, organization, and duties of the FRS.

Prior to 1913, there was no permanent centralized banking system in the U.S. However, the idea of a central bank was conceptualized by the first Secretary of State, Alexander Hamilton, way back in 1780. After the expiration of two chartered central banks (aptly named the First and Second Banks of the United States), the U.S. went without a central bank for forty years.

Towards the end of this forty-year span, a financial crisis called the Panic of 1907 took hold of the country and called into question the soundness of a financial system without such a centralized bank. The “Panic” was triggered when a large number of people began to withdraw money from many different banks, fearing that the banks may go insolvent as a result of the recent market crash. This triggered a succession of banks and businesses filing for bankruptcy, jeopardizing the reliability and stability of the entire financial infrastructure. As a result, Congress passed the Federal Reserve Act, and here we are.

If we imagine an org-chart, the seven members of the Board of Governors sit at the top. Underneath their control are the twelve regional banks, with Atlanta being one of these locations. The Fed’s primary responsibilities are to maintain stability in the U.S. financial system and provide the U.S. government with financial services. And the functions that help them accomplish these policies are:

  1. Controlling monetary policy to ensure the country’s money supply doesn’t grow to quickly or too slowly
  2. Regulating banks, and
  3. Protecting the credit rights of consumers.

Let’s unpack the first duty, and tie it back to our WSJ headline. In order to ensure the county’s steady money supply, the Fed has to use several tools at its disposal. First, it can change interest rates, or discount rates, which are paid by member banks when they borrow money from the Fed and from other banks. Second, it can change bank reserve requirements, which are the percentage of deposits banks must retain in cash. Finally, it can buy or sell treasury securities to increase or decrease money supply. This last one amounts to the Fed’s ability to print money.

You might be thinking of another follow-up question: it seems as if these duties directly affect only banks, so how does all this affect the average American?

Essentially, when the economy is in a downturn, the Fed should lower interest rates that banks pay to borrow from each other. This in turn lowers the rates charged to consumers and businesses seeking bank loans or other financing. Lower interest rates for consumers and businesses incentivizes more people to enter the market, invest, buy homes, buy cars, start businesses, etc.

Alternatively, when the economy stabilizes, the Fed normally raises the interest rates that banks pay to borrow money, which trickles down and raises the rates charged to consumers and businesses. Although a higher interest rate is undesirable for the average consumer, the takeaways from a headline such as, “Fed Officials Gain Confidence They Can Raise Rates This Year” are:

  1. The economy is gaining momentum, and
  2. The Fed is exercising its duty to create a stabilizing effect on the economy.