In recent years, the news has been filled with stories about the impending collapses of the banking system. The Federal Reserve (the Fed) influences U.S. interest rates. Since the U.S. dollar is the global reserve currency, this means that the Fed also influences the level of interest rates around the world. As a result, Fed policy affects inflation, unemployment rates, and economic growth worldwide. Consequently, business professionals need to comprehend the nature of the Fed and its monetary policy intentions.
In this article, we will explore a brief history of central banking in America, the Fed’s dual mandate, and the internal structures that determine its functioning.
History of U.S. Central Banking
During the period from the late 1700s, economic turmoil and the challenge of repaying revolutionary war debt led the U.S. to charter its first central bank. However, due to political opposition to the centralization of financial power, this initial experiment in central banking was short lived.
Over a century later, the Panic of 1907 required J. P. Morgan, a prominent banker, to play a crucial role in bailing out the U.S. banking system. This event highlighted the extent to which financial stability in the U.S. banking system depended on the ad hoc decisions of private individuals. Resulting distrust of laissez faire policies led policymakers to push for the creation of a lender of last resort that could prevent future economic downturns.
In response, Congress passed the Federal Reserve Act of 1913.
The Fed has gained experience over the decades through dealing with stagflation, recessions, and other periods of economic downturn: the Great Depression, the great inflation of the 1970s, the great recession of 2008, and the great lockdown of COVID-19 pandemic. Through these trials the Fed has expanded its box of monetary policy tools, gained more independence from Congress, and today operates with almost unchecked power.
The Fed’s dual mandate
While the Federal Reserve is constantly evolving as an institution, it holds fast to its goal of maintaining the health of the overall economy. Even when the Chair of the Fed and the President of the United States share differing political views, the Fed holds fast to its Dual Mandate, that is its two-fold goal of achieving (1) price stability and (2) maximum employment.
Achieving these two goals simultaneously is a balancing act. If inflation is above the Fed’s 2% target rate based on the PCE Price Index, then the goal of maximizing employment is often swept under the rug while the Fed attempts to lower inflation. However, during ‘normal times’ the Fed aims to address both goals.
Functions of the Fed
One of the Fed’s primary functions is to implement monetary policy, which involves influencing interest rates in the overall economy to achieve its dual mandate of stable prices and full employment. During the last 20 years, the Fed has added a suite of policy tools that it can use to do this. The main one being to target the federal funds rate, which is the cost of unsecured borrowing by depository institutions (i.e. banks) in the overnight loan market.
In addition to implementing monetary policy, regulating banks, operating the payments system, and carrying out economic research, the Fed also provides emergency services to ensure financial stability. During economic crises, such as the Great Recession of 2008, the Fed increasingly acted as lender of last resort to banks to prevent bank runs and financial contagion.
Organization of the Fed
Currently, three entities make up the Federal Reserve System:
- Board of Governors: The Federal Reserve System is overseen by a seven-member Board of Governors located in Washington D. C. The board reports directly to Congress and oversees the 12 regional banks. The U.S. President nominates each board member, who then get confirmed by the Senate and serve a 14-year term. Jay Powell is the current chair of the board.
- Federal Reserve Banks: The Federal Reserve System is made up of 12 regional banks, each serving a particular district by implementing monetary policy, supervising banks, operating the payments system, and conducting economic research.
- Federal Open Markets Committee: The FOMC makes key decisions about monetary policy. Chaired by Jay Powell, the FOMC includes the seven members of the Board of Governors as well as five of the twelve regional bank presidents. At regular meetings, the FOMC reviews reports from the 12 regional banks as well as data on economic indicators like inflation and unemployment. The FOMC aims to influence interest rates in the overall economy by targeting the federal funds rate. They do this by employing various monetary policy tools such as open market operations, reserve requirements, quantitative easing, and forward guidance.
Final thoughts
The U.S. Federal Reserve, formed in 1913, wields substantial economic power as it aims to achieve its dual mandate of stabilizing prices and promoting full employment.
Its evolving authority and tools have raised questions about its independence and the concentration of economic control, prompting a vital debate about its role in shaping the U.S. and global economies.
Some economists and policymakers point to the Fed’s growing power as a cause for concern. Should a handful of men and women, independent from Congress and free from democratic process, have such a powerful hold on the trajectory of the U.S. economy?
In the next article, we will dive further into this question.
Wes Brooks is an incoming Summer Business Analyst at Cicero Group and an undergraduate studying economics, management, and strategy. He is a serial entrepreneur, works in venture capital, and enjoys singing a capella and piano improvisation.
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