Who is the Federal Reserve and Why Are They Messing with Interest Rates?

August 8, 2015

If you’re someone who enjoys reading the news and keeping up with what’s going on in the world, you may have come across more than a few articles mentioning the Federal Reserve, raising interest rates, and what it could do to the stock market.  While the media may make it sound like the end of the world, we’re actually due for a slight rise in rates, and, as we’ll shortly learn, it is the job of the Federal Reserve to help instigate that.

 

The Federal Reserve System was created in 1913 in response to the Banking Panic of 1907, which pitted private banks against more “progressive” consumers.  To resolve this issue, President Woodrow Wilson signed the Federal Reserve Act, which created a decentralized bank that could help moderate the relationship between the private banks and the people who used them.  Today, the Federal Reserve exists as a series of branches across the U.S. (12 in total), which all fall under the Federal Reserve Board of Governors located in Washington D.C.

 

The Federal Reserve is uniquely structured as a hybrid of private and public elements.  The individuals who serve on the board are not elected, but appointed and are called to testify before Congress throughout the year.  The system serves a variety of purposes including tracking economic trends, providing economic research, supervising the financial industry, and guiding monetary policy.  Broadly speaking, the Federal Reserve has what is known as a dual mandate, which is to target a specific level of inflation (which the board sets based on economic conditions) and maintain interest rates at a certain level (also set as the board sees fit based on their research).

 

When journalists talk about the Federal Reserve raising rates, it’s important to understand that the Federal Reserve is not in charge of all interest rates, though they do influence them in a roundabout way.  The Federal Reserve is in charge of deciding what the Nominal Federal Funds Rate should be.  The term nominal refers to what the Federal Reserve wants the rate to be, not necessarily what it is.  The actual Federal Funds Rate is the average rate of all the rates that banks are lending to each other at.  The Federal Reserve influences these rates by requiring banks to hold a certain amount of money in reserve, thereby requiring them to lend or borrow to meet that requirement, which in turn affects the rates the banks charge each other.  What results is a trickle-down effect.  The rate that the big banks lend to each other affects the rates that the big banks lend to smaller banks, which eventually affects the rates that smaller banks lend to businesses and individuals like you and me.  While the decision to move rates has to do with the strength of the economy, it’s likely that the only way it will have a significant effect on financial markets is if the timing or the size of the raise is different than what everyone is expecting.

 

If you’d like to learn more about how the Federal Reserve works, check out this helpful video that we previously posted on how the economy works.

 

"History of the Federal Reserve." federalreserveeducation.org. Retrieved from: https://www.federalreserveeducation.org/about-the-fed/history.

 

"Federal Reserve Districts." federalreserveeducation.org. Retrieved from: https://www.federalreserveeducation.org/about-the-fed/structure-and-functions/districts.

 

"The Structure of the Federal Reserve System." federalreserveeducation.org. Retrieved from: https://www.federalreserveeducation.org/about-the-fed/structure-and-functions

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