What Is the Federal Reserve?

It can be easy to take for granted the money you have going in and coming out of your bank account each month. But the United States government actually has a tightly regulated financial system, thanks to an institution set up by the government called the Federal Reserve System. This system helps keep the United States economy moving by preventing panics, influencing interest rates and monitoring economic activity to keep unemployment rates low and spending high.

The Federal Reserve System, also known as “the Fed,” is the country's central bank. As such, it has certain general obligations to the general public.

The Fed:

• Conducts the country’s monetary policy with the goal of keeping unemployment rates low, prices stable and interest rates low
• Monitors the impact of the U.S. financial system with the goal of keeping risk at a minimum
• Keeps an eye on the international impact of all financial activities
• Strives to keep the country’s financial system safe and sound
• Sets up systems that make payments easier
• Promotes consumer protection

It’s hard to imagine today, but at one time, the U.S. banking system was a bit on the shaky side. Any time there was a crisis, consumers rushed to the bank en masse to take all their money out. This created a problem for banks as well as the U.S. government, which suddenly found itself on shaky ground due to money being under mattresses rather than in bank accounts.

On ​December 23, 1913​, President Woodrow Wilson signed into law the Federal Reserve Act. This move created a central bank, along with ​12​ regional Federal Reserve banks scattered around the country. The system operated independently and the agency, located in Washington D.C., was directed to have a board of governors

The Federal Reserve is run by ​seven​ ​governors​, each appointed by the U.S. President. This board makes decisions that affect the U.S. economy as a whole, including overseeing the operations of the ​12 regional banks​. The general members of the board are appointed for ​14-year​ terms, but the chair and vice chair only serve ​four years​. They can be reappointed for a second ​four-year​ term.

The Board of Governors serves on the Federal Open Market Committee, which holds ​eight​ ​meetings​ per year. The FOMC sets the discount rate, which is the interest rate regional Federal Reserve facilities charge commercial banks and other depository institutions on any loans they get from the Fed.

The FOMC includes the Board of Governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York and ​four​ of the remaining ​11​ Reserve Bank presidents. Those ​four​ remaining presidents serve ​one-year terms​ each, rotating between them. Reserve Banks are located in Boston, Philadelphia, Richmond, Cleveland, Chicago, Atlanta, St. Louis, Dallas, Minneapolis, Kansas City and San Francisco.

​Read More:​ The Relationship Between Inflation & Bank Interest Rates

One of the duties of the FOMC is to set the federal funds rate, which is charged by commercial banks to other banks that borrow money from them. This rate is set ​eight​ ​times​ a year at the public meetings held by the monetary policymaking arm of the Fed. This rate is based on what’s going on with the economy at the time the meeting is held.

To fully understand how this works, it helps to know how banks operate. Here are the basics:

• Lenders are required by law to maintain a percentage of their total deposits with the Federal Reserve. This helps ensure that no matter what happens, they’ll have the money to cover any withdrawals and transfers initiated by their members.
• Once that deposit, known as the reserve requirement, has been made with the Fed, banks can loan out the remainder of their assets.
• Banks loan the remainder of their assets to other banks that are having trouble meeting the reserve requirement. Once the bank is caught up on its Federal Reserve payments, it can begin paying the lending bank back with interest.

The federal funds rate is a baseline, not a requirement. It is merely a guideline that financial institutions can use to set their own rates. You can view the most recently available federal funds rate, as well as historical data, on the Federal Reserve website.

Although the Federal Reserve doesn’t directly set interest rates, the Board of Governors does indirectly impact them. The federal funds rate is used by commercial banks to determine how much to charge other banks that borrow funds from them. When it comes to loaning money to consumers, though, banks make that decision.

But banks don’t just pick a random number for that interest rate. They want to remain competitive, so they try to remain in line with what other lenders are charging when they issue you a mortgage on your house or a personal loan for a car purchase. But if the federal funds rate increases, the amount they pay to borrow money from other banks increases, and they may pass that increase on to you, the customer.

​Read More:​ How Federal Rate Cuts Affect CD Rates

Another function of the Federal Reserve System is the discount window. If banks can’t meet their reserve requirement and fail to get a loan from any other member banks, they can go straight to the Fed for those loans. The interest rate on these loans is based on the bank’s financial soundness and is ​one of three​ rate types:

• Primary credit rate: This rate is offered to the most financially sound institutions and is the lowest of the ​three​.
• Secondary credit rate: If a bank doesn’t meet the requirements for primary credit, this slightly higher rate will be offered.
• Seasonal discount rate: This rate is an average of various market rates. These loans are usually issued to smaller banks and credit unions that need a little help meeting the reserve requirements.

Unlike loans from member banks, though, loans using the discount window require collateral. Since banks can get a loan without collateral at a lower rate through member banks, the discount window is typically a last resort.

The Federal Reserve doesn’t operate in a vacuum. In fact, its findings are used by a variety of sources to make decisions about the health of the economy. A large part of this information comes from a report called the ​Summary of Commentary on Current Economic Conditions​, which is available on the Federal Reserve website. This document is most commonly referred to as “the Beige Book.”

To create the Beige Book, each of the Fed’s ​12 branches​ interviews local experts from the business and financial communities. Each branch uses this information to contribute one chapter to the document. The Beige Book is published ​two weeks​ before each FOMC meeting, which takes place ​eight times​ a year.

When you see information about how the economy is performing, often the information comes from the most recent edition of the Beige Book. Big players like the U.S. Treasury and Wall Street may look to the report to predict what the coming months will bring in terms of the economy. It could then inform policy decisions or activities, which can influence the overall health of the economy, as well.

​Read More:​ Do Interest Rates Go Down as the Stock Market Goes Down?

The Beige Book is only ​one report​ issued by the Federal Reserve. But unlike the Beige Book, these other ​two reports​ aren’t immediately provided to the general public. Known as the Green Book and Blue Book, these reports were created to be distributed to FOMC members, with covers matching their names.

The Green Book, which is also known as the ​Current Economic and Financial Conditions​, summarizes both the U.S. and international economies in order to create forecasts. The blue book, also known as Monetary Policy Alternatives, offers some suggestions for alternatives to the policies the FOMC may discuss at its meeting.

In ​2010​, both documents were combined into ​one book​, called “the Teal Book,” or “Tealbook.” This book is distributed to the FOMC to be discussed at the meeting when gauging the health of the economy and setting the discount rate. The public is not allowed to see each Tealbook for ​five years​, when it’s released to the public, but monitoring how the FOMC increases and reduces the discount rate can tell you quite a bit about what’s in that report.

There’s a reason the activities of the Federal Reserve get so much attention. The Fed has a direct impact on the economy through controlling inflation. It does this by raising and lowering the discount rate.

When the discount rate increases, banks have to pay more to borrow money, which in turn reduces the availability of money. If there’s a need for more money to be circulating, the Fed lowers the discount rate to encourage banks to borrow from each other. As banks enjoy a lower discount rate and have more faith in being able to borrow money if they need it, they’ll be more likely to keep interest rates low to encourage consumers to borrow money for a mortgage or personal loan.

In addition to supporting financial institutions and the customers that rely on them, the Federal Reserve System also exists to support the federal government. Reserve Banks serve as the liaison between the U.S. Treasury Department and lenders.

That includes:

• Collecting unemployment, as well as income and excise tax, and submitting the funds to the U.S. Treasury
• Issuing and redeeming bonds and T-bills to keep bank reserves in check
• Holding collateral for the U.S. government to protect funds being held in accounts at financial institutions across the country
• Making interest payments on government debts

There are times when the Federal Reserve takes action to keep the economy moving during a crisis. This was seen after the attacks of ​September 11, 2001​, as well as during the financial crisis of ​2008-2009​. Most recently, the Fed made changes to address the financial issues brought about by the ​2020​ COVID-19 pandemic.

In the case of the pandemic, the Board of Governors took the following actions:

• Lowered the federal funds rate to between ​0 and ¼ percent​
• Increased purchases of Treasury securities and mortgage-backed securities
• Issued regulatory relief to financial institutions to encourage lending
• Encouraged banks to help account holders in need
• Created ​three​ ​programs​ geared toward providing relief for wholesale markets: the Primary Dealer Credit Facility, the Commercial Paper Funding Facility and the Money Market Liquidity Facility
• Created another facility to provide relief to businesses through the Small Business Administration
• Created a facility to offer liquidity to lenders making Paycheck Protection Program loans

The Federal Reserve System is an integral part of the U.S. economy. In addition to monitoring the health of the economy and making forecasts about the short-term future, the Fed also supports both banks and government agencies. By monitoring the federal funds rate, experts and consumers can learn more about how the market is currently performing to help them make more informed decisions.