Learn Something Today: How the Federal Reserve Works and Why You Should Care

November 16th 2014

ATTN: Staff

David Wessel is director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution and a contributing correspondent for The Wall Street Journal. He also is the author of the 2009 best-seller, In Fed We Trust: Ben Bernanke’s War on the Great Panic. 

Q: What is the Federal Reserve and why is it so important?
The Federal Reserve, known to admirers and detractors as “the Fed,” is an extremely powerful arm of the federal government. It controls or influences the interest rates that are paid on Americans’ savings and that they pay on car loans, mortgages and the like.  You can think of it as a gigantic plumber with its hands on a spigot that controls the flow of credit in the economy.  The economy – everything from the price of gasoline to how hard it is to find a job – is influenced by lots of factors outside the control of the government, of course: the winds blowing from financial markets, the appetite of other countries for American goods and services, the confidence of businesses, the disruptions of technological change, etc.  But along with the power of Congress to tax and spend, the Fed is the major government force in the economy.  And it is designed to operate independently of the elected politicians who set its goals (stable prices and maximum sustainable employment) but largely let the Fed decide how to achieve them. 

Q: How does it affect me?
What the Fed does affects every consumer, worker and investor in the U.S.  It directly influences the interest rates you get on your checking or savings account and the interest rate you pay on a car loan or a mortgage, if you can get one.  And it plays a big role in the rate at which prices rise in the economy and on how many people have jobs.  And, especially after the wrenching financial crisis of the past few years, it has been playing an increasingly important role in making rules for banks and other financial institutions that are intended to reduce the risks of going through another crisis like the recent one. 

Q: Who controls the Federal Reserve?
Ultimately, Congress, which created the Fed in 1913 in response to some severe financial crises.  But it is an unusual government institution.  There are several governors of the Federal Reserve Board in Washington, appointed by the President and confirmed by the Senate. And then there are twelve Federal Reserve Banks scattered throughout the country, the presidents of which are chosen by private-sector boards of directors, subject to the approval of those Fed governors in Washington.  At any one time, decisions on interest rates and other aspects of monetary policy are made by a committee that consists of the seven Fed governors and five of the regional Fed bank presidents, who serve in rotation.  In a very technical legal sense, those regional Fed banks are actually owned by the banks in their districts, but there are limits on how much control those banks have. 

Q: Who holds the federal reserve accountable for corruption?
All of us.  The Fed’s books are audited, and it has an inspector general like other government agencies.  Congress holds frequent oversight hearings of varying quality. And the press scrutinizes the Fed with growing sophistication and, in some cases, skepticism.  The big issue really isn’t corruption (in the sense of someone at the Fed stealing money), but competence and conviction.  There’s a clear tension between having an independent Fed that can help steer the economy without worrying about the next election and making sure that this independent Fed is neither too timid nor too aggressive in pursuing its statutory mandate of price stability and maximum sustainable employment.  Holding the Fed accountable is essential in a democracy; doing that without having the politicians set interest rates is a constant challenge.  

Q: What is the daily role the Federal Reserve plays in our economy?
The Fed has substantial control over the short-term interest rates, and those, in term, influence the stock, bond and currency markets.  So daily moves into those markets are influenced by what investors and traders expect the Fed – and its counterparts in other countries – to do.  But for the rest of us,  the Fed hasn’t much influence on our daily lives; its impact is felt over longer periods of time.

Q: Why do only Wall Street people seem to care about the Fed, and not working class Americans?
Because many of their livelihoods depend on tracking the Fed closely and making decisions – trading stocks, pricing loans, betting on currencies – that correctly anticipate what the Fed’s next move is going to be.  And because monetary policy, that’s what the Fed does, is complicated.  But the Great Recession called attention to the Fed’s importance and power, and the Fed is far more prominent in the public mind than it once was – and for many people it is a lightning rod for the sense that Wall Street got bailed out and Main Street didn’t. 

Q: Anything else I should know about the Fed?
Yes. And for that, you should read my book (In Fed We Trust: Ben Bernanke’s War on the Great Panic) and check out the website of the Hutchins Center on Fiscal and Monetary Policy at Brookings.