What is the Federal Reserve anyway?

Here’s a crash course on America’s central bank and interest rates.

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Key takeaways

  • The Federal Reserve, a.k.a the Fed, is the central bank of the United States.
  • The Fed’s primary job is to work on the monetary policy that helps keep the US economy running smoothly.
  • Staying up to date on the Fed’s policy changes can help you understand market moves and make smart money decisions.

One of the biggest influences on the US banking system, the financial sector, and even the economy as a whole is the Federal Reserve. Understanding how and why it functions can help you understand major market moves and make more-informed money decisions. Read on to learn more about what the Federal Reserve does and how it can affect the economy and your money.

What is the Federal Reserve?

The Federal Reserve, nicknamed the Fed, is the central bank of the United States. Congress created it in 1913 to help promote a more stable financial and monetary system.

Here’s an overview of how the Fed is structured: The Board of Governors heads up the Fed from DC. That group includes 7 members, all appointed by the president and confirmed by the Senate. A chair and vice chair serve as the board’s leaders for a renewable term of 4 years. The current Fed boss, Jerome Powell, has been in his role since 2018 and was preceded by now-Secretary of the Treasury Janet Yellen. Within the broader Fed system, there are 12 regional banks in major US cities, including Boston, Chicago, and San Francisco. They help gather economic information from around the country.

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And then there’s the Federal Open Market Committee (FOMC), a key group—including the board of governors and 5 regional bank presidents—who control the country’s monetary policy. The FOMC meets 8 times a year and is tasked with a dual mandate of maximizing employment and stabilizing prices (as in keeping inflation in check).

The Fed also acts in a regulatory role, ensuring that banks are following financial laws and protecting consumer rights.

How does the Fed influence the economy?

The Fed uses several tools, which work together to accomplish its goals.

1. Traditional tools: Controlling the money supply and adjusting the cost of borrowing (interest rates) via the federal funds rate

The Fed can create more dollars within the economy or take them away. One way is by changing the rules for how much money banks must keep in cash reserves versus lend out to consumers. The greater the money supply, the more people can borrow, spend, and invest. That can benefit the job market because the uptick in buying means companies can afford to hire more people. While this can stimulate economic growth, it can also lead to inflation. If the Fed needs to cool off a too-hot economy and curb inflation, it can restrict the money supply.

Then there’s the federal funds rate (FFR), a range set by the Fed that dictates how much it costs banks and other financial institutions to borrow money from each other overnight to meet on-hand cash requirements. That’s a technical definition with real-world consequences for regular consumers. When it costs more (or less) for banks to do business, it can influence what they charge their customers to do business.

2. Unconventional tools: Quantitative easing

In response to the extreme financial conditions during the 2008 global financial crisis and, more recently, the March 2020 pandemic outbreak, the Fed turned to extraordinary measures. This included buying large quantities of securities, such as government bonds, from the public market. This was intended to bolster the financial system in a way that lowers borrowing costs and stabilizes long-term interest rates.

When and why would the Fed influence interest rates?

In a time of slow economic growth or even a recession, the Fed can lower interest rates to make it cheaper for businesses and consumers to borrow money. Lower rates make it more likely that people borrow and spend. Lowering interest rates typically expands the economy and accelerates growth. But too much of a good thing can lead to inflation.

If inflation increases too much, or if the economy grows too quickly, the Fed may increase interest rates. When borrowing becomes more expensive, consumers and corporations may take out fewer new loans and spend less. Less demand for goods and services can cause companies to lower prices.

How could interest rates impact you?

A Fed policy change related to interest rates—or even rumors of it—can have a ripple effect on your personal finances, especially if you have variable-rate debt or plan to take out a new loan.

While the fed funds rate doesn’t directly change interest rates on forms of consumer debt, such as mortgages, car loans, and credit cards, it can influence them. Because large loans, such as mortgages, are typically paid back over many years, even a small difference in your interest rate can cost you a lot. If you have an existing fixed-rate mortgage, your interest rate won't change. But if you're planning to buy a home when interest rates are on the rise, you can expect higher monthly payments. And while your credit card balance probably isn’t as big as a mortgage, consider paying off any of that debt as quickly as possible when rates are rising. Many credit cards come with double-digit variable interest rates, and you could see your interest rate spike after a Fed rate hike.

Some good news for savers: The federal funds rate is also indirectly tied to what banks pay you to keep money in savings accounts. The higher the interest rate, the more you’re likely to earn at the bank.

Fed moves can affect your investments too. Investors tend to react to headlines about whether the FOMC is likely to increase or decrease interest rates at their next meeting—though this type of market volatility is usually short-lived. The utilities sector has generally done well during times of low interest rates because they borrow a lot to complete their infrastructure projects. Bank stocks, though, tend to benefit from high interest rates because they can make more money on loans. The past can’t guarantee future performance, but it’s worth considering as you look at your portfolio.

To learn more about interest rate moves, you can read the minutes of Federal Reserve meetings. Also, keep up to date with Fidelity's latest insights on where we are in the business cycle, which corresponds to how the Fed’s policy may change in the future.

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