What it means
The system was created after a series of banking panics showed that the country needed a lender of last resort, an institution that can supply cash to solvent banks when nobody else will. The Federal Reserve Act of 1913 set it up as a blend of public and private elements, with a central board and regional banks, so that power would not sit in one place.
The structure has been adjusted by later laws. There are three main parts.
The Board of Governors has seven members appointed by the president and confirmed by the Senate, the twelve regional Reserve Banks serve the districts, and the Federal Open Market Committee sets the course for short-term interest rates. The committee has twelve voting members, made up of the seven governors, the president of the New York bank and four other regional presidents who rotate.
Congress has given the Federal Reserve a dual mandate: maximum employment and stable prices. In practice, the central bank aims for inflation of 2% over time, and it tries to move interest rates up or down to cool or support the economy.
Its other tools include buying and selling securities, setting the rate it pays on bank reserves and lending to banks. For businesses, the system influences almost every financial decision.
Loan rates, mortgage rates, exchange rates and share prices all react to its actions and statements. Finance teams follow the policy meetings, the statements and the economic projections to plan borrowing, investment and pricing.
The central bank is independent in the sense that its policy decisions do not need approval from the president or Congress, but it is accountable to Congress and reports to it regularly. Governors serve long, staggered terms to insulate them from short-term politics.
Critics argue about whether it has too much power or too little, and the debate is a regular feature of economic policy.
In practice
Real-world examples.
Example
A retail chain with a $30,000,000 floating-rate loan hears that the committee has raised its target rate by 0.50 percentage points. The finance director estimates the extra interest at 30,000,000 x 0.005 = $150,000 a year. She asks the bank about fixing part of the loan.
Example
A small bank has a sudden run of withdrawals and needs cash for a few days. It borrows from its regional Reserve Bank against high-quality collateral. The loan gives it time to raise funds without selling its loans at a loss.
Example
A technology company with large cash balances watches the committee's projections for future rates. When the projections show cuts ahead, the treasurer extends the average maturity of the company's investments from 6 months to 12 months to lock in higher yields.
Formula
Calculation
Taylor rule rate = neutral real rate + inflation + 0.5 x (inflation - target inflation) + 0.5 x output gap
The Taylor rule is a rule of thumb for judging where policy rates might sit; it is not an official Federal Reserve formula. Suppose the neutral real rate is 1.0%, inflation is 3.0%, the inflation target is 2.0% and the output gap (how far the economy is above its normal capacity) is 1.0%. Rate = 1.0 + 3.0 + 0.5 x (3.0 - 2.0) + 0.5 x 1.0 = 1.0 + 3.0 + 0.5 + 0.5 = 5.0%. If the actual policy rate were 4.0%, the rule would suggest that policy is 1.0 percentage point looser than this simple guide.Case study
Seen in the real world.
Redwood Appliances is an illustrative, fictional manufacturer that sells on instalment plans to retailers. Its chief financial officer wants to understand how a change in policy rates would affect both its borrowing cost and its customers.
She builds a simple scenario. A 1.0 percentage point rise in rates adds $400,000 a year to the interest on the company's $40,000,000 of floating debt. She also notes that retailers with weaker credit will struggle with higher interest and may delay orders.
The company fixes half of its debt, cutting the exposure to $200,000 per percentage point, and tightens credit limits on the weakest customers. In this illustrative case, the combined steps keep earnings within the budget range, and the lesson is that central bank policy shows up in both the cost of funds and the strength of demand.
Watch out
Common mistakes.
- Thinking the Federal Reserve is a single bank, when it is a system made up of a Board of Governors, twelve regional banks and a policy committee.
- Believing the Federal Reserve is part of the government budget, when it funds itself from its own income and pays most surplus to the Treasury.
- Assuming it directly sets the interest rate on mortgages and credit cards, when it targets a short-term rate that influences the others.
Questions
People also ask.
What is the dual mandate?
It is the instruction from Congress to pursue maximum employment and stable prices.
Who votes on interest rates?
The seven governors, the New York bank president and four other regional presidents on a rotating basis.
When was it founded?
It was created by the Federal Reserve Act, signed in 1913.
From the founder's library
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