What is the Fed?
U.S. President Woodrow Wilson created the Federal Reserve System (Fed), a central banking institution, in 1913 to stabilize the economy after multiple bank closures. The Fed is separate from the U.S. federal government and has unique powers over the nation's monetary policy. Notably, the Fed can increase or decrease loan interest rates and the reserves, which commercial banks hold.
The Fed's primary job is to promote healthy employment levels while maintaining a stable money supply. Its members constantly collect and monitor economic data to ensure inflation rates, consumer confidence, and GDP (gross domestic product) are within acceptable ranges. The Fed also regulates and supervises U.S. banks to prevent bankruptcies and economic damage.
What does the Federal Reserve do?
The Fed's goal is to promote a stable and thriving U.S. economy. Members of the Fed's Board of Governors and regional banks constantly review economic data to get a read on critical metrics such as unemployment, GDP, consumer spending, and business investment. Since the Fed is responsible for setting the monetary policy, it pays careful attention to the circulating supply of USD.
The FOMC’s members meet eight times yearly to discuss the latest economic data and craft actionable monetary policies. The FOMC holds press conferences after these meetings to inform the citizens about any upcoming policy changes. The Chair of the Federal Board of Directors also testifies in Washington, D.C., twice per year.
Since the Fed is separate from the U.S. Federal Government, it doesn't have to send its proposed monetary changes to Congress for review. If the FOMC agrees on interest rate changes or new reserve requirements, it can ratify them immediately. Its members aren’t elected, and some of the most important ones appoint officials in the U.S. government.
In addition to monetary policy, the Fed’s functions involve the U.S. banking sector. As the "lender of last resort," the Fed can issue loans to distressed banks to avoid widespread economic damage. To prevent these dire scenarios, the Fed conducts annual "stress tests" on all banks within the Federal Reserve System. In these tests, Fed agents review each bank's reserves and compare them with their obligations to creditors and depositors. The Fed publishes these results for consumer protection and may issue recommendations to banks with weak reports.
The Fed helps financial institutions transfer digital funds on its Fedwire payment rail. Any bank in the Federal Reserve System can use Fedwire to send transactions electronically with near-instant finality. Recent estimates suggest Fedwire processed transactions worth more than $900 trillion in 2021.
What tools does the Fed have?
The Fed's operations primarily include conducting research and collecting data. However, it doesn't mean the Fed passively addresses the U.S. economy. If the Fed notices something alarming such as high unemployment or above-average inflation, it steps in to address these issues. While the Fed's powers are limited, it can profoundly impact consumer and business activity.
It’s important to note that all these tools have several externalities, making it challenging to know how much to push where. This is another reason why the Fed’s job is so difficult.
- Adjusting the federal funds rate: When the FOMC says it's changing the federal funds rate, it's increasing or decreasing the overnight interest rate commercial banks charge for loans to other banks. Typically, when the Fed wants to spur growth, it makes lending easier by lowering the average interest rate. Alternatively, if the Fed wants to reduce spending to curb inflation, it’ll likely increase the federal funds rate.
- Changing bank reserve requirements: Depending on the current economic conditions, the Fed's Board of Directors can raise or lower the minimum amount banks need to hold in their reserves. This reserve requirement is a percentage relative to each bank's total deposits. When the Fed increases reserve requirements, it's deliberately slowing economic growth by making loans less attractive. However, banks will have greater liquidity for loans if the Fed reduces its reserve requirements.
- Purchasing or selling treasury bills: The Fed often uses Open Market Operations (OMOs) to buy and sell short-term treasury bills (T-bills) from commercial banks. If the Fed is in an "expansionary" mode, it’ll buy T-bills to increase bank reserves. However, during "contractionary" periods, it sells T-bills back to banks, decreasing loan activity.
- Quantitative easing and tightening: Quantitative easing (QE) is similar to expansionary OMOs, except with QE, the Fed buys longer-term securities on the open market. Two common assets the Fed buys during QE include government bonds or mortgage-backed securities. During quantitative tightening (QT), the Fed sells these assets back to banks. QE encourages banks to loan their excess money, while QT reduces excess bank reserves.
- Press conferences and published reports: Fed meetings and media conferences have a powerful psychological effect on the financial system. Even if Fed officials announce they won't change their current interest rates, financial markets will react to this news. Interviews with Fed directors and presidents can help banks, firms, and markets adjust their expectations and plan for the future.
Why is the Fed important?
The Fed's policies directly impact the country’s money supply. If the Fed wants to spur economic activity, it can start purchasing securities from banks and increasing its reserves. In theory, adding cash to the U.S. banking system should increase loans and propel economic growth. On the flip side, the Fed could dampen demand by taking money out of circulation through QT and contractionary OMOs.
The Fed also ensures U.S. banks meet high standards for reserve requirements. These stress tests make banks’ holdings increasingly transparent, improving consumer confidence. Plus, if financial institutions run into trouble, the Fed can serve as the "lender of last resort" to prevent further damage to the economy.
Although the goals of the Federal Reserve are to maintain stable prices and encourage maximum employment, its decisions could have unintended consequences. For instance, aggressive QE spending can put inflationary pressure on the U.S. dollar. In contrast, raising the federal funds rate too quickly could decrease demand to an extent that the U.S. falls into a recession.
The Fed's actions also influence the prices of stocks, ETFs (exchange-traded funds), and crypto. When the Fed increases interest rates, investors aren't as willing to take risks with speculative assets such as Bitcoin (BTC), Ethereum (ETH), or high-growth tech stocks. It's also less likely that start-ups and prospective homebuyers will take out a loan when the rates are high.
Does the Fed regulate crypto?
No central bank controls cryptocurrencies such as Bitcoin and Ethereum. Digital coins and tokens use decentralized networks of "nodes" to verify transactions on a public ledger. The Fed often issues warnings about using cryptocurrencies, but it has no authority over this asset class. Legally, the U.S. government defines Bitcoin as a "commodity," which means BTC falls under the Commodity Futures Trading Commission's jurisdiction.
Although the Fed doesn't regulate the crypto industry, it has expressed interest in blockchain technology. Recent reports suggest the Fed is working on CBDCs (Central Bank Digital Currencies) that may one day compete with privately issued stablecoins such as USDC.
It's difficult to overstate the Fed's significance in the current financial system. Although the Fed focuses on U.S. monetary policy, its actions have ripple effects on the global economy. From adjusting bank reserves to changing interest rates, the Fed has many powerful tools that affect how consumers, investors, and businesses spend their money.
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