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Banking 101: The Ultimate Guide to Understanding the Federal Reserve


Written by Dan Rafter | Published on 3/29/2019

Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.

Here's how important the Federal Reserve System is: Its actions could determine how much you pay in interest on your credit cards, how much interest the money you’ve stashed away in your savings accounts earns and how much you’ll pay when borrowing money to buy your next car.

Yet, for however much the Fed affects our daily lives, many Americans aren’t clear on how this important financial institution operates. To help you, here is a comprehensive guide to what the Federal Reserve is, who runs it, what it does and how it affects your daily financial life.

What does the Federal Reserve do?

The Federal Reserve System is the central bank of the United States. The Fed's job is to promote the most effective operation of the U.S. economy as possible.

The Fed sets monetary policy to boost employment across the country, which stabilizes the prices of goods and moderates long-term interest rates. The Fed also monitors financial institutions across the U.S. to make sure they are stable.

The Fed’s most important tool for doing of all this is its federal funds rate. This is a rate that the Fed alters (or not) to influence the economy.

How the federal funds rate affects your loans

The Banking Act of 1935 created the Federal Open Market Committee, which remains an important influence on the national economy today. The committee makes headlines today whenever it changes the federal funds rate, which is the interest rate banks across the country charge each other to lend Federal Reserve funds overnight.

The Federal Reserve requires that banks keep this amount of funds available each night. The reserve ensures that banks have enough money available to start each day.

This interest rate is an important one. When the members of the open market committee change this rate, it eventually affects both short-term and long-term interest rates across the country. For instance, credit card providers generally charge variable interest rates that are tied to the prime rate — the base lending rate that the providers of credit use when determining what interest rates they'll charge consumers. The prime rate is about 3 percentage points above the federal funds rate.

When the federal funds rate rises, so does the prime rate. Your credit card issuer might increase the variable interest rate on your credit card when the federal funds rate jumps, meaning that you'll pay more in interest if you don't pay off your credit card balance in full each month. Other loan products may also be impacted by the prime rate.

But what about student loans? If your loan has a fixed interest rate, a hike by the Fed won't change its terms. But if you took out a private loan with a variable interest rate, that might rise or fall as the prime rate changes.

Home equity lines of credit (HELOCs) are impacted by the federal funds rate, too. That's because HELOCs are also tied to the prime rate. When the Federal Reserve boosts its funds rate, lenders may also increase the interest rates tied to HELOCs.

You shouldn't worry as much about the interest that lenders charge on long-term mortgage loans, such as 15- or 30-year mortgages. An increase in the federal funds rate could cause mortgage interest rates to rise, but that’s not always the case.

How the federal funds rate affects your savings

Robert Schultz, senior partner with NWF Advisory Group in Los Angeles, said that the Fed can have a positive impact on the finances of consumers, too.

That’s because a boost in the federal funds rate is good news for savers, Schultz said. When the Fed raises the rate, it could encourage banks and credit unions to boost the interest rates they pay out on their savings accounts, CDs and money market accounts. This will benefit people who have a significant amount of money saved in these types of accounts.

"They are getting paid to have money in the bank instead of searching for yield in riskier assets," Schultz said.

Changes to the federal funds rate in recent years

The Fed has earned headlines lately for increasing its federal funds rate. But there are times, too, when it lowers this rate.

The Fed lowers its federal funds rate when it wants to encourage consumers to borrow, which can boost economic growth. When the Fed lowers its rate, it makes borrowing money less expensive for consumers because credit card interest rates, auto loan rates and the rates charged by student loan lenders could all fall.

After the Great Recession, the Fed kept its rate near zero as a way to inspire consumers to borrow even though the economy was struggling. The Fed decreased its federal funds rate seven times in 2008, and didn't raise it again until December 2015.

Today, the Fed is in a period of raising its federal funds rate. It raises the rate when it wants economic growth to cool down, a way of keeping inflation at modest levels.

The Fed increased its federal funds rate four times in 2018, in March, June, September, and most recently on December 19th. It also raised this rate three times in 2017.

Saving and investing your money over time

Michael Tanney, co-founder and managing director of New York City-based Wanderlust Wealth Management, said that one of the Federal Reserve's main goals is to control inflation. What the Fed wants, he said, is modest inflation, which helps keep the U.S. economy in growth mode.

Knowing this, consumers should seek out a mix of both safe and riskier investments, Tanney said. Safe investments, such as savings accounts, are good for growing an emergency fund that consumers can tap when unexpected financial situations hit.

But Tanney recommended that consumers also invest in stocks, real estate and other investment vehicles that could generate a return higher than inflation. Leaving that money in low-interest-bearing savings or money market accounts won't generate returns that keep up with inflation, he said, in part because the Fed seems intent on gradually raising its federal funds rate as a way to maintain at least a modest amount of inflation to keep the U.S. economy growing.

"The Federal Reserve forces you to invest your money and put it back into the economy to stimulate overall growth," Tanney said.

The history of the Federal Reserve System

The Federal Reserve System got its official start in 1914. But you can trace the reasons for its existence to far earlier times.

Consider the year 1863. That's when the National Banking Act, during the height of the Civil War, was passed. This legislation paved the way for nationally chartered banks. The notes these banks shared had to be backed by U.S. government securities. Just as important was an amendment added to the act. The amendment required taxation on state bank notes but not on national ones.

As the Federal Reserve says on its online history timeline, this effectively forced a uniform national currency for the United States.

The National Banking Act, though, wasn't able to stabilize the U.S. economy on its own. In 1893, a banking panic swept the country, spurring the most serious economic depression to have ever hit the nation. The Fed says it took the intervention of financial mogul J.P. Morgan to get the country through the crisis. This made it clear that the country's financial and banking systems were lacking.

It was 1912, though, that became the key year for the formation of the Federal Reserve. Woodrow Wilson was elected president, and he committed to establishing a central bank. Wilson called on Virginia Rep. Carter Glass and H. Parker Willis, a former professor of economics at Washington and Lee University, to draft a proposal for central U.S. bank. In December of this year, the two presented what would eventually become the Federal Reserve Act.

Wilson signed the Federal Reserve Act into law on Dec. 23, 1913, after about a year of debate in Congress. By late 1914, Congress selected and approved the 12 cities that would become home to regional Federal Reserve banks. This was the result of a compromise: As the Fed states on its timeline page, having the regional banks created a central bank that was decentralized. This helped appease those in Congress who opposed a single bank in the United States having so much power.

The Federal Reserve System, though, wasn't yet a cure-all for the country's economy. Banks needed to offer some type of insurance to their account holders that they wouldn’t lose the money they deposited if a bank should fail. That insurance wouldn’t come about until 1933.

The need for this type of insurance was highlighted in October 1929, when the stock market crashed, sending the United States into the Great Depression. According to the Fed, from 1930 to 1933, nearly 10,000 banks failed. What caused these failures? A series of bank runs across the United States.

A bank run happens when a large number of a bank's account holders withdraw all their money from that bank because they fear that it might fail. As more customers withdraw their funds, a bank could run out of money, facing the threat of bankruptcy.

On March 5, 1933, President Franklin Delano Roosevelt declared a four-day national bank holiday that shut down all banks in the country for four days to prevent further runs.

On March 9, Congress passed the Emergency Banking Relief Act, which allowed the 12 banks in the Federal Reserve System to issue additional currency to banks across the country. This meant that banks would now always be able to meet the withdrawal requests of its customers. This essentially created deposit insurance, which still exists today. When you deposit your money to a bank, your funds are insured up to $250,000 by the Federal Deposit Insurance Corporation. If you deposit your dollars in a credit union, the National Credit Union Administration insures your funds up to $250,000.

Who runs the Federal Reserve System?

The Federal Reserve System actually consists of 12 reserve banks spread across the country. These districts each operate independently but are all under the supervision of the Federal Reserve Board of Directors.

The 12 regional banks are located in Boston; New York City; Philadelphia; Cleveland; Richmond, Va.; Atlanta; Chicago; St. Louis; Minneapolis; Kansas City, Mo.; Dallas; and San Francisco.

The Board of Governors oversees this system. The seven members who sit on this board are nominated by the U.S. president and confirmed by the U.S. Senate for 14-year terms. One new board member is appointed every two years, with the term starting on Feb. 1 of even-numbered years.

The president also names the chairman and vice chairman of the board, while the U.S. Senate also confirms these positions. The chairman and vice chairman each serve four-year terms.

The Federal Open Market Committee is the other key agency that directs the Fed's monetary policy. This committee holds eight meetings a year where members review economic and financial conditions and then decide if the Fed needs to take any actions to promote economic growth or stabilize the economy.

This committee is made up of 12 members, the seven members of the Board of Governors; the president of the Federal Reserve Bank of New York; and four of the presidents of the remaining 11 reserve banks. These four each serve one-year terms on a rotating basis.

Federal Reserve FAQs

Who owns the Federal Reserve? The Federal Reserve System isn't owned by anyone. The Fed, though, is overseen by its Board of Governors based in Washington, D.C. The president of the United States appoints the members of that board, while the U.S. Senate votes to confirm these appointments. The board oversees the 12 regional banks that make up the Federal Reserve.

How does the Federal Reserve's board of governors determine how much currency to order each year? Each year, the Federal Reserve Board orders currency from the Treasury department's Bureau of Engraving and Printing. In this order, the Fed board tells the Treasury department how much new currency of every denomination it wants.

The Fed says it considers the demand for each type of currency it expects and how much currency the system's reserve banks will have to destroy because the bills are in such bad shape they can no longer be circulated. The Fed says that in 2015, as an example, 85% of new notes were printed to replace currency that was destroyed, while 15% were printed to meet increased demand from the public.

How much U.S. currency is currently out there? The Fed says that of Sept. 26, 2018, there was about $1.69 trillion worth of currency in circulation. Of that amount, $1.64 trillion was in Federal Reserve notes. A Federal Reserve note is paper currency, such as $1, $5 and $10 bills.

Where does the Fed get its money? Congress does not fund the Federal Reserve. Instead, its income comes mostly from the interest on government securities that it has acquired through its open market operations.

The Fed says that it also receives income from the interest generated on foreign currency investments; fees for services such as check clearing, funds transfers and automated clearinghouse operations; and interest on loans it makes to depository institutions such as banks or credit unions.

After the Fed pays its expenses, it sends the rest of its income to the U.S. Treasury.

Comments
Bank Dummy
Bank Dummy   |     |   Comment #1
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