Headlines are always talking about the Fed. The Fed raised rates. The Fed cut rates. The Fed is fighting inflation. Most people don't interact directly with the Fed. That is the Federal Reserve Bank. You don't walk into a Fed branch to open a checking account or make a withdrawal. Bonnie and Clyde never stormed the Fed. But Fed decisions can make your car payments more expensive, your mortgage cheaper, or a job harder to find. So, let's take a closer look at the Federal Reserve, the Central Bank of the United States. What is it? Who runs it? And why was it created?
Excuse me, Steve. May I? Gosh, I created a national bank, but it's just not the same. I look forward to hearing more. Take it away, Steve. I'll be watching.
I'm Steve Ballmer and this is Just the Facts. Data-driven facts to help you make up your own mind. In this episode, the Federal Reserve. It was created after a series of financial panics, especially the panic of 1907, which led to runs on banks and one big mess. A run on a bank is when lots of customers all try to withdraw their money at the same time from their regular everyday banks, the ones you and I use. Even a healthy bank can run out of cash if that happens. So in 1913, Congress passed the Federal Reserve Act. It's the most important bank you'll never actually use. So why is it even called the bank? Because it's a bank for banks. It holds cash reserves for banks. It moves money between banks and it can lend to banks whenever needed. Today, the Fed has five core responsibilities. First, conduct the nation's monetary policy to keep inflation in check and employment high. Second, keep the financial system stable by preventing crises like bank runs, by lending money to banks so they can keep operating. Third, supervise certain financial institutions like banks and savings and loans. Fourth, foster payments and settlement systems like wiring money. And fifth, promote consumer protection. The last three make sure the financial system works and plays by the rules.
I started a national bank, but never a central bank. That's impressive.
I'm going to focus most on number one, monetary policy, because that's where the Fed most directly affects your wallet. Here's a big reason why the Fed can influence interest rates. I'll explain how in a minute, but here's what it means. The Fed can run the economy hot by working to lower interest rates. That can make buying a house, getting a car loan, or borrowing to open a business less expensive. Problem with hot is it may make money easier to borrow, which may fuel inflation. Or the Fed can run the economy cold by raising interest rates. All those things become more expensive. The problem with cold is it may make money harder to borrow, which can slow the economy down and could have a lot of secondary effects such as higher unemployment. So exactly how does all that happen? Federal Reserve doesn't raise your interest rates directly. It raises or lowers its target range for what is known as the federal funds rate. Whoa. Whoa. Jargon warning. Federal funds range. What's that mean? Banks move money between each other every day as customers withdraw or deposit money. By the end of the day, some banks have extra cash, while others don't have enough. Banks with extra money lend it overnight to other banks that need it at a rate within a range that the Fed sets. How does the Fed drive banks to lend within this range? In simple terms, the Fed changes the interest on loans it gives and on other banks' cash reserves it holds, effectively setting the floor and the ceiling at which other banks can charge interest. Banks generally won't lend for less than they can earn from the Fed and they usually won't borrow from other banks for more than what the Fed itself would lend to them. The average of overnight transactions between banks is called the federal funds rate. So, let's dig deeper on the federal funds rate and how it can affect you. When the Fed raises the federal funds range, your bank may raise interest rates on new loans because their costs are going up. Higher rates make mortgages, car loans, credit cards, and short-term business loans more expensive. There can then be a domino effect because mortgages are more expensive. People could be less likely to buy a home. Fewer home sales could mean less spending on things like moving, furniture, and home improvement. That slowdown in spending can ripple through the economy. When this happens across the whole economy, people might spend less money because things are more expensive and then inflation can decrease because demand falls. And as demand decreases, companies may need fewer workers and often unemployment rises. That's economics 101. Higher interest rates can mean lower demand for certain products and that can cut inflation, but it can also mean more unemployment. This is not an exact science. The economy is complex with many influences: tax policy, wars, oil prices, consumer sentiment, innovation, and more. At USA Facts, we do not forecast. Now, let's look at another possible outcome. When the Fed lowers the federal funds range, the interest rates you pay from your bank can sometimes go down. In this case, for example, new car loans are cheaper and more people can afford to buy cars. Auto producers make more cars. And with more demand for those products, prices can increase, which means more inflation. Congress tasks the Fed with what's called a dual mandate to try to keep stable prices and maximum employment. That's a balance. Think of the economy like something in the oven. And the Fed controls the temperature. If things start overheating, prices rise too fast. The Fed turns down the heat. If things cool off too much, growth slows, jobs disappear, and the Fed turns the heat up. The goal is to keep the economy baking just right. No, Katy Perry. When it's hot and it's cold, you're yes and you're no. None of that.
Over the last decade, the Fed has changed the federal funds rate target range about 30 times. Some years, like 2021, there were no changes at all. Other years move quickly. In 2022, the Fed raised rates seven times in a single year. Well, why? The Fed aims for about 2% inflation over time. In 2022, inflation climbed well above the Fed's 2% goal, reaching about 7%. In response, the Fed raised the federal funds target range multiple times in 2022 and 2023. Short-term interest rates rose, car loan and mortgage rates increased, economic growth slowed, and inflation eventually slowed. It's not a perfect cause and effect, but the Fed's actions can influence the direction of inflation. Now let's take a look at an example of lowering interest rates. In March 2020, as the COVID-19 pandemic disrupted economic activity and unemployment rose very sharply, the Fed lowered the target range for the federal funds rate to 0% to 0.25%. Very near zero. Now stay with me. I got one more big thing. Sometimes the Fed uses other monetary policy tools when changes in interest rates are not enough. One big one is called open market operations.
Wait a second, that makes no sense.
Sorry, it's the nerd in me. Open market operations are just how the Fed puts money into the economy and how it takes money out of the economy.
