Many of us watch for the next Fed meeting to see what happens to interest rates. But the Fed — officially the Federal Reserve Bank — does much more than lower or raise rates. And its actions can have wide implications for consumers. To understand those impacts, let’s look at what the Federal Reserve is, how it influences interest rates and other parts of the economy, and how its actions impact our everyday lives.
What is the Federal Reserve?
The Federal Reserve Bank is the U.S. central banking system, in charge of managing the country’s monetary system and policies. That includes controlling the money supply and availability of credit, and setting requirements for the banking industry. It’s also a lender of last resort for financial institutions. The Federal Reserve’s actions are guided by a dual mandate which includes working toward achieving high employment levels and stable prices, in modern times, 2% annual inflation.
The Fed is a government agency. While it’s politically independent, it is accountable to the U.S. Congress.
Components of the Federal Reserve
The Fed is comprised of three main entities:
- 12 District Reserve Banks – Representing different regions of the country, these banks are the operating arms of the Fed. They’re responsible for producing and circulating currency, and for acting as the national bankers bank.
- Board of Governors – This group of seven individuals oversees the Federal Reserve system. They are nominated by the U.S. President and confirmed by the Senate. Each governor serves a 14-year term. The chair of the board reports to Congress about the U.S. economy.
- Federal Open Market Committee (FOMC) – The FOMC members include the Fed Board of Governors, the president of the Reserve Bank of New York, and presidents from four of the other district Reserve Banks on a rotating basis. The group monitors the economy, adjusts interest rates, and buys and sells U.S. Treasuries and other securities. The FOMC meets eight times each year.
Federal Reserve Functions
The Federal Reserve’s role in the economy is based on five primary functions.
- Sets U.S. monetary policy. Raising or lowering the federal funds overnight rate is perhaps the most powerful tool the federal reserve uses to influence the economy. This action impacts other interest rates and many other financial factors, as we’ll discuss below. In making policy and rate decisions, the Fed considers numerous economic indicators, including inflation, employment, retail sales and real wages, and other tools, like quantitative easing.
- Assists in stabilizing the financial system. The Fed regularly assesses risks and vulnerabilities in the financial system to help ensure that individuals and businesses have the resources they need to thrive.
- Supervises and regulates financial institutions. The Fed monitors certain financial institutions to ensure they are operating in a safe and prudent manner. This includes establishing rules and guidelines for financial institutions to follow. For instance, the Fed requires that banks and credit unions maintain cash reserves. If the Fed lowers reserve requirements, it allows more money to flow back into the economy. Banks can then loan out more money, which in turn helps stimulate the economy.
- Fosters payment and settlement systems. The Fed helps ensure that financial transactions and the movement of money within the U.S. and between the U.S. and other countries are conducted in a safe, efficient manner. The Fed also provides various payment and settlement services to financial institutions and the federal government.
- Promotes consumer protection and community development. This function includes writing regulations, conducting research and working with stakeholders to identify, assess and address consumer and community issues and opportunities.
What does the Federal Reserve influence?
The Federal Reserve’s effect on the economy can be far-reaching. But much of its influence starts with decisions around the Federal funds overnight rate. Changes to this rate affect borrowing rates for financial institutions, who in turn pass the rate changes along to their customers. In this way, the Fed rate trickles down to other interest rates, from business loans and mortgages to savings accounts and CDs.
How does this affect the overall economy? When the cost to borrow money is relatively low, businesses and consumers may be more willing to take out loans. Businesses may expand and hire, while consumers may spend more. Money flows into the economy. In this way, the federal reserve can stimulate the economy by keeping interest rates low.
When the cost to borrow is relatively high, it has the opposite effect. Businesses may downsize and lay off employees. (This is one reason that the Fed considers the unemployment rate when making rate and policy decisions.) With higher interest rates, consumers may save more instead of spending. Money is pulled out of the economy. In this way, the Federal Reserve can contract the economy by increasing interest rates.
Why would the Fed want to contract the economy? It’s a way to battle inflation. Inflation is a measurement of how costs change over time. It’s based on the price for a group of commonly purchased goods — such as gas, bread and apples. Economists consider the Consumer Price Index and Personal Consumer Expenditures (different measures of what consumers pay for the goods) and Producer Price Index (what it costs to produce the goods). When the price for that group of goods goes up over time, that’s inflation, typically shown as a percentage.
High inflation can create financial difficulties for consumers and businesses. So, if it climbs, the Fed often raises interest rates to contract the economy and bring inflation down — aiming for that 2% rate. This doesn’t always work, and it’s possible to have a period of “sticky” inflation, where the rate stays stubbornly high — or drops slowly — even as rates climb.
How else does the Federal Reserve affect the economy?
Besides interest rates, the Fed may buy and sell U.S. Treasuries and other securities as a way to influence the economy.
When the Fed buys Treasuries, Treasury prices go up and yields go down. This is known as quantitative easing. It leads to lower interest rates, making it cheaper to borrow money and stimulating the economy. The Fed can use this tactic as another way to stabilize and uplift a down economy.
When the Fed slows down their Treasury purchases, with the eventual goal of stopping, this has the opposite effect. Treasury prices come down, yields and interest rates go up. This encourages contraction in the economy, which can help curb inflation, slowing price increases.
Fed actions also tend to impact the markets. When the Fed rate rises, markets generally (but not always) slow and performance drops. But the market pays attention to two types of information related to rates. First, rate information is announced during each Fed meeting. Then the Fed chair hosts a commentary session — and those comments may give the market a different sense of what impact to expect. Markets can react to both events.
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What is the 2023 Fed meeting schedule?
This is the Fed meeting schedule for the remainder of 2023:
- June 13-14
- July 25-26
- September 19-20
- October 31-November 1
- December 12-13
For a comprehensive explanation of the Fed, download this free PDF.
For more news and information about the Federal Reserve, including minutes from the FOMC meeting, visit the agency’s website.
For insights on how Federal Reserve actions may impact your financial plan, contact the experts at Hancock Whitney Bank for a personal discussion.
The information, views, opinions, and positions expressed by the author(s), presenter(s), and/or presented in the article are those of the author or individual who made the statement and do not necessarily reflect the policies, views, opinions, and positions of Hancock Whitney Bank. Hancock Whitney makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information presented.
This information is general in nature and is provided for educational purposes only. Information provided and statements made should not be relied on or interpreted as accounting, financial planning, investment, legal, or tax advice. Hancock Whitney Bank encourages you to consult a professional for advice applicable to your specific situation.
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