Who is The Fed and What Do They Have To Do With Inflation and Interest Rates?

By Karen Stevenson, 17 November, 2023

There is lots in the news these days about the actions of the Federal Reserve (the Fed). It’s pretty clear that they have some important role in controlling inflation and interest rates. So what exactly is The Fed, what do they do, and why?

The Federal Reserve was created after a national emergency, the Panic of 1907, a crisis that endangered the entire banking system. Multiple runs on banks caused banks to go out of business. Nobody wanted to loan money to anyone, and the interest rate on overnight loans between banks jumped to 100%, making it impossible for banks to raise cash and pay off depositors. The entire banking system was locked up and commercial activity was impossible. Prior to this time there was skepticism about centralized federal control over banks, but the Panic of 1907 made it clear that something had to be done to calm the markets and keep the banking system working.

Congress created the Federal Reserve system in 1913. The country was divided into 12 Federal Reserve districts, each with its own Federal Reserve bank. Those 12 banks, collectively, make up the Federal Reserve. The Federal Reserve banks are “bankers’ banks”. The Fed acts as the central bank for the federal government, and as the banks’ bank for commercial banks. Commercial banks can deposit funds with the Federal Reserve to earn money on them, or borrow funds if they need more. The Fed processes checks, distributes currency, acts as a lender of last resort, and performs other services for the federal government and commercial banks. 

In addition to its banking functions, the Fed, together with the Federal Deposit Insurance Corporation (FDIC), has regulatory oversight over banks. The purpose of the oversight is to increase public trust in the banking system, ensuring everyone that banks are safe and reliable.

The Fed is overseen by a seven-member Board of Governors. The chairman of the board is appointed by the President and approved by Congress. The remaining governors are chosen from the presidents of the twelve Federal Reserve banks. The terms of the chairman and governors are staggered to try to eliminate the chance for one party to control the Federal Reserve by changing all the governors at once.

In addition to its banking activities, the Federal Reserve has a Federal Open Market Committee (FOMC).  The chairman of the FOMC is the chairman of the board of governors, and the FOMC members are the seven members of the board of governors and a rotating group of five of the twelve regional Federal Reserve Bank presidents. Each regional bank president is expected to contribute knowledge of things going on in their part of the country as a part of creating national monetary policy.

The FOMC is the arm that does most of the things that we hear about in the news related to the Fed’s efforts to fight inflation and set interest rates. At the highest level, the job of the Federal Reserve is to keep the monetary system working smoothly. The FOMC specifically has what is called a “dual mandate”, although the mandate actually has three parts:

  • maximum employment
  • stable prices (by influencing the inflation rate)
  • moderate long term interest rates

The “maximum employment” part of that mandate was added in 1977 when a long hard fight against inflation resulted in high unemployment. The FOMC is now supposed to manage inflation without letting unemployment get any higher than necessary.

The FOMC can’t directly do any of the things in their mandate, but they have “tools” that they use to try to influence what happens. For instance, they have no ability to directly set long term interest rates, nor do they have any direct control over employment, nor inflation. All they can do is use tools that they hope will impact those things.

The tools that the Fed uses have expanded and changed over time. Here are some of them:

The Fed sets the Fed Funds rates, which is the interest rate paid on excess reserves that banks park overnight at the Fed, and the rate paid for repurchase agreements (repos), which is another overnight transaction where money market funds and other financial institutions can loan money overnight to the Fed to earn a little safe interest on those funds. This puts a floor under interest rates so they don’t go too low. This was really important when interest rates were extremely low prior to 2020, it kept interest rates from going negative.

The Fed Funds rate is an ultra short term interest rate, an overnight rate, the shortest possible interest rate. Generally short term interest rates are lower than long term interest rates. A lender will want a higher interest rate if they are tying up the money for a longer term. And generally interest rates for very safe lenders will be lower than interest rates for lenders who might go out of business or not pay their bills. So the Fed Funds rate is literally the floor. It should be the lowest possible interest rate, because it is the shortest possible term and the safest possible lender.

The Fed’s mandate is not to control short term interest rates, though, it is to control long term interest rates. Long term interest rates are set by the market, and it’s often a matter of supply and demand. If lots of people are willing to loan you money, they will compete to give you a lower interest rate. But if nobody wants to loan money to you, interest rates from anyone who does will be much higher, because the lack of competition allows them to charge more.  So increased demand reduces interest rates and reduced demand increases interest rates.

Therefore the Fed can affect long term interest rates by buying or selling securities. Treasury bills, notes, and bonds are printed by the Treasury Department then sold to the public. If the Fed steps in and starts buying those securities instead of waiting for other buyers to do it, they expand the pool of buyers and that should help lower long term interest rates (this is called Quantitative Easing or QE). If they want interest rates to go up, they can do the reverse and start selling securities. In that case they are no longer a buyer and they are making the buyer shortage even worse by adding more securities for sale than what was already on the market (this is called Quantitative Tightening or QT). 

Another way they can influence long term rates is by adding money supply to the economy using their position as the nexus of the banking system. They can add reserves to the banks, which should then encourage banks to go loan their excess reserves out. That is “easy money”, which should push long term interest rates down. Or they can reduce bank reserves, creating “tight money” which would discourage banks from lending money, and that should push long term interest rates up.

During the pandemic the Fed took things even further. Not only did they purchase treasuries when they did QE, they also purchased lots of mortgage-backed securities, impacting mortgage interest rates. Early in the pandemic the concern was that the monetary system might lock up as the economy shut down, so the Fed was trying to make money extremely easy.

The ability of the Fed to impact inflation is controversial. The general idea is that if they can push interest rates up, that is going to reduce economic activity, and the reduced economic activity will reduce inflation as well. If they pull interest rates down, that should encourage economic activity, which will allow prices to go up. They can also impact inflation because they have control over the money supply. If more money is in circulation, inflation should go up, and the reverse should happen if money is taken out of circulation. 

The Fed’s impact on employment is just as controversial. If the economy is humming, there should be lots of jobs and low unemployment. If the economy is contracting, employment will probably contract as well. But what direct impact can the Fed have on the unemployment rate?

There are reams of material written about how much, if at all, the Fed can actually control any of the things in their mandate, and about exactly which Fed tools might actually work. Another fascinating discussion is about the potential lag effect of changes the Fed has already made. Let’s say they figured out the right thing to do to reduce inflation, how long will it take for their steps to take effect? And at what point will they have gone too far because they don’t realize they already achieved their aim and are now sending things into a downward spiral? All of this is complicated by questions about how we measure unemployment and inflation and whether we are getting an accurate picture from those measurements. And all of this is even further complicated by the fact that lots of other things affect inflation and unemployment. For instance, if the federal government is sending everyone stimulus checks, that might completely undo anything the Fed tries to do. The whole thing is a crazy complicated subject.