By Sean Sparkman

Commonly known as The Fed, the Federal Reserve System is the United States’ central banking system. Established in 1913 by the Federal Reserve Act, the Fed’s creation was a response to financial panics and downturns in the late 19th and early 20th centuries.

Federal Reserve banks are technically not part of the Federal government, existing only because of an act of Congress. This fact has some critics contending that the Fed is a private institution. However, it’s more accurate to say that the Fed is a kind of hybrid institution and thus both private and public. For example, the Fed’s Board of Governors is a government agency. The Fed’s banks are set up like private corporations with members holding stock and earning dividends.

It’s crucial to note that holding stock in a Fed bank doesn’t come with the usual control and financial interest afforded to stockholders in for-profit organizations.

A short history of the Federal Reserve

Before the Fed came into existence, the US banking system was plagued by instability and inconsistency due to a lack of central control and regulation. Banks issued their own currencies, and the value of those currencies varied depending on the issuing bank’s stability. Such lack of uniformity hindered the economy by making trade and commerce more complicated and burdensome.

Several attempts at centralized banking had been made before the Fed’s creation. The first iteration, established in 1791 by Alexander Hamilton, was the First Bank of the United States. Many opposed the bank, however, because they believed the First Bank’s charter gave too much power to the government. The government did not renew First Bank’s charter when it expired in 1811.

The government established the Second Bank of the United States five years later. But, just as its predecessor had, the bank faced opposition. President Andrew Jackson ultimately ended it in the 1830s. After the demise of the Second Bank, the US banking system became decentralized primarily and unregulated.

Pushback against centralized banking softened somewhat in the 19th century when a series of recessions and financial panics caused politicians to re-think the idea of a central bank. The most acute financial panic occurred in 1907 when bank runs led to a widespread economic crisis. Numerous factors contributed to the economy’s volatility, including a lack of central control in the banking industry, an overproduction of goods, and speculative investing, particularly investment in the railroad industry.

Congress reacted to the Panic of 1907 by passing the Federal Reserve Act of 1913. This legislation created the Federal Reserve System, a central bank with authority to regulate the money supply, set interest rates, and act as the lender of last resort to banks in times of economic crisis.

How the Fed works

The Federal Reserve comprises a Board of Governors. This board is appointed by the President and confirmed by the Senate, along with 12 regional Federal Reserve Banks in the USA. The Board of Governors is charged with setting monetary policy, while the regional banks implement it in their regions.

An essential tool employed by the Fed in its monetary policy is manipulating the federal funds rate. The federal funds rate is the interest rate banks charge to lend to one another overnight. Setting the federal funds rate allows the Fed to influence the interest rates banks charge their customers for loans and mortgages. Controlling the interest rate affects how much consumers and businesses are willing to borrow and spend, stimulating or slowing down the economy.

In addition to controlling the money supply, the Fed is the lender of last resort to banks during a financial crisis. In 2008, for instance, the Fed loaned money and supported banks and other financial institutions to help stabilize the economy. The Federal Reserve is also responsible for the supervision and regulations of banks and other financial institutions. It is charged with making the system safer and sounder and helping shield consumers from deceptive practices.

Can the Fed help stave off recessions and depressions?

The Great Depression lasting from 1929 to the late 1930s, was a severe, prolonged downturn that tested the Fed’s effectiveness in mitigating panics and recessions. While it was a key player during the Depression, numerous factors hampered the Fed’s ability to avert this economic catastrophe.

One reason the Fed couldn’t stop the Great Depression was the weakness of monetary policy during this period. To cool off the economy, the Fed raised interest rates in 1928 and again in 1929m which caused a reduction in the money supply and related contraction in credit. This situation, in turn, had the unintended consequence of reducing economic activity and sparking the Depression.

Another thing handcuffing the Fed during the Depression was the international gold standard. US currency was linked to a finite, fixed amount of gold. The Fed had to have enough gold reserves to back that currency. The requirement to back currency with physical gold and silver severely constrained the Federal Reserve’s ability to expand the money supply. Printing money to stimulate the economy was not feasible because doing so put too much pressure on gold reserves. In other words, unlike today, the Fed could not print its way out of trouble.

Finally, the Great Depression was a complex global event involving many economic, social, and political factors. The Fed was not the only entity in charge of the economy then. Its actions were but one of several factors leading to the severity of the Depression.

So, while the Fed is a player in recessions and depressions, its ability to curtail economic downturns is somewhat limited. Although precious metals no longer back our currency, the Fed must contend with political and social issues that are generally beyond its control. The Fed isn’t a magic bullet to cure bad monetary policy or ineffective regulations. And it can only do so much to correct irresponsible, reckless spending by governments and individuals.

How does the Fed affect individuals?

The Fed’s decisions influence other interest rates. When the Federal Reserve hikes interest rates, it means that it becomes more expensive to borrow money. Everything from automobile financing to mortgages to credit cards is impacted. Financing nearly everything becomes challenging because crucial borrowing rate benchmarks influencing popular financial products (the prime rate and Secured Overnight Financing Rate (SOFR) tend to mirror whatever the Fed does. When interest rates go up, the money supply shrinks, making borrowing more expensive.

On a positive note, although loans might become more expensive after a rate increase, banks often wind up increasing yields to attract more depositors. You might see higher yields for “safe money” products such as CDs, savings accounts, or specific life or annuity products.

What the Fed does affects Wall Street. While cheap borrowing rates can incentivize investors to put more money at risk in the stock market, higher rates give Wall Street the heebie-jeebies. When it raises rates, the Fed siphons off market liquidity, creating volatility as investors revise their portfolios accordingly. Investors also worry that the Fed’s policies may become too aggressive and slow down the economy too quickly. This sudden slowdown could launch a recession.

The Fed’s actions affect the job market. The job market is one of the most significant sectors of the economy to experience the sting of higher interest rates. Companies contemplating increasing their workforce or adding new locations tend to postpone those plans when borrowing is no longer cheap. In 2023, for example, companies in Silicon Valley, including Meta, Zoom, and Salesforce, laid off thousands of workers and halted expansion plans.

The Federal Reserve influences your purchasing power. Rate decisions made by the Federal Reserve go beyond simply swaying the cost of borrowing money and how much you get paid to save. What the Fed does immediately influences the entire economy, especially the purchasing power of individuals’ money. Lowering interest rates to stimulate an economy’s performance can be like throwing gasoline on a campfire. Demand increases so much that supply can’t keep pace, leading to inflation. Raising interest rates is the Fed’s tool to tamp down price increases, although this tactic doesn’t always work, as we’re currently discovering.

Summing it up: The Federal Reserve is a part-private, part-public entity chartered initially to smooth out flaws in the banking system and ensure uniformity. As the Central Bank of the United States, the Fed’s decisions influence banking, the job market, and Wall Street and can negatively or positively impact individuals’ purchasing power and savings.