What is the Federal Reserve?

I’m still not convinced money is real (or any of this really). Who makes it? Who decided what size a dollar should be? Why do we even have pennies anymore? Why is my fridge so loud? Okay that’s off topic.

The short answer: the Federal Reserve System (the Fed) is three different entities that determine and control the interest rate for loans. 

As I try to understand how, I feel dumber and dumber the more I read. 

The Fed is the Central Bank of the United States. The 1913 Federal Reserve Act created the Fed; however, it operates independently from the government. Unlike bills that are passed by Congress and the Senate then approved by the President, the Fed’s decisions are made and implemented entirely by the Fed. 

The Fed’s primary goal is to promote maximum employment and stable prices in the US economy. The Fed also monitors and regulates banks to ensure security for consumers, fosters a payment and settlement system for US dollar transactions, and promotes stability of the US and global financial system. 

We all know the Fed though for its ability to raise (and lower, but that hasn’t happened in a while) interest rates. So how does it do this?

The Structure:

The Fed is composed of three separate entities: the Federal Reserve Board of Governors, 12 Federal Reserve Banks, and the Federal Open Market Committee. 

The Federal Reserve Board of Governors has seven members each serving a 14-year term. A seat opens every two years, is appointed by the President, and approved by the Senate. This ensures stability across different political parties and prevents one President from nominating more than four members.

The Board of Governors is responsible for overseeing all actions of the Fed.

The 12 Federal Reserve Banks are responsible for implementing the decisions of the Fed. The Reserve Banks are the action arm of the Fed. They represent their geographic districts.

Each bank has its own board and elects a President. 

The Federal Open Market Committee has 12 voting members: the seven Board of Governors, the President of the Federal Reserve Bank of New York, and 4 Presidents from the other Banks (they serve a one year term and rotate through the regions). 

The Open Market Committee determines the monetary policy and how to effectively translate that to the markets. 

“So, the Board of Governors that oversees all actions also makes up the Committee that determines the policy?” Yes. It basically oversees itself. 

The only difference is the Committee has input from the Regional Bank Presidents not nominated by the President of the US. 

The How:

The Fed has many tools to implement its monetary policy, but the key tools are administered interest rates and the open market purchases and sales of securities. 

The primary tool is the Interest Rate On Reserve Balances (IORB). Consumer banks, like Bank of America, Chase, or Wells Fargo, keep their reserve balances at one (or several) of the Federal Reserve Banks. The Fed requires that banks maintain at least 10% percent of their deposits in reserves to ensure they don’t lose all their customers’ money. 

So if you have $10,000 deposited at Chase Bank right now, Chase is only required to keep $1,000 in reserve. They can loan out the remaining $9,000 to other people and earn interest on your money.

The Fed sets the interest rate for the Reserve Balances. Right now, the rate on Reserve Balances is 5.4%. Meaning, the Fed pays banks 5.4% on their reserve balances. So why would a bank loan that money for anything less than what the Fed is giving them?? They don’t! That is why mortgage rates are skyrocketing! Any lending between banks, to people, or other business has to exceed what the Fed is paying the banks to sit on the cash with miniscule risk. 

Another popular tool is the open market purchase and sale of securities. This is when the Fed buys or sells assets issued by or backed by the US Government, primarily Treasury Bonds. If the Fed is buying bonds, that decreases supply of bonds and lowers the yield of the security because the government can find a buyer at a low interest rate. This represents a loosening of monetary policy and increases the supply of money. 

If the Fed is selling bonds, that increases supply of bonds and increases the yield of the security because the government has to increase the interest rate to find a buyer of the bond. This represents a tightening of monetary policy to decrease supply of money and lower inflation. 

What does this mean for us right now?

Well right now, you are seeing and feeling the effects of the Fed’s policy. The increased interest rate on reserve balances, means banks are only lending out their money for a mortgage if the interest rate is far above 5.4%. 

The Fed selling bonds means the government has to increase the interest rates offered with bonds to make them more attractive to a supply-heavy market. This is what has increased the yield of any low-risk bond or money market funds you hold. It has also indirectly increased the return of all the high-yield savings accounts that are so hot right now. 

That is just the surface of the Fed. That is a quick rundown of the structure and the tools the Fed uses to lower inflation and maintain high employment, at least in theory. 

So next time someone says “the Fed is raising the rate of mortgages,” you can say, “actually, the Fed is raising the interest rate it offers to banks on their reserve cash. The banks then only offer their reserve cash for loans if the rates beat the rate that the Fed is offering them. It makes perfect sense. You’d do the same thing if you were a bank.” If you say that, I am sure you’ll be the star of the party. 

Call to Action

Look up the inflation numbers. How do you think the Fed is doing at lowering inflation?

What We’re Reading/Listening To:

Shoe Dog: A Memoir by the Creator of Nike. I finished listening to this book a few weeks ago and really enjoyed the story. It is an easy listen/read.

Debrief on Deck

Next week is Thanksgiving! Mike and I will take a break from our finance writing and respect the day.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

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