The Federal Reserve is mighty powerful!
It may seem that every time you open up a newspaper there’s an article about the Federal Reserve – also known as the Fed. News about the Fed often makes waves across the financial markets, affecting everything from stock prices to the level of interest rates you earn on your savings accounts (even the amount of interest you pay on loan products).
Needless to say, the Fed is a powerful force in the US economy and thus the world. It’s powerful enough to help save the economy from a recession like the one experienced in 2008, control inflation, and even move the markets. And much like a superhero, who uses her superpowers to save humanity, the Fed has a few tricks up its sleeve to help protect us from economic distress.
What is the Federal Reserve?
The Fed is the central bank of the United States. A central bank isn’t quite like the bank where you keep your checking and savings accounts. A central bank, like the Fed, controls the country’s money supply and interest rates, which has many implications for the economy and financial markets. It also plays an important role in supervising banks and creating regulations that control banking and lending practices.
The Fed's primary superpower: Toggling interest rates
From an investment perspective, the most important role played by the Fed is in setting interest rates. Interest rates help determine how fast an economy can (and should) grow and generally are intended to help control inflation. Very high interest rates suppress borrowing and lending, thus slowing the economy down. Very low interest rates make it easier to borrow, thus spurring the economy. By toggling the discount rate, which is the minimum interest rate set by the Fed for lending to banks, the Fed is able to influence the pace of economic growth. It’s important to understand that when the Fed raises the discount rate, banks also hike the federal funds rate as well as the rates they charge to consumers, so borrowing costs increase across the economy.
The Fed also played a critical role during the financial crisis in 2008, when the economy entered a recession, the federal funds rate was pushed all the way down to zero to try to jump-start growth. The actions taken by the Fed were just as exciting as a superhero saving the world from imminent destruction (ok, maybe that’s an overexaggeration).
A healthy economy often translates to increased rates
The accompanying chart shows interest rates falling to zero in 2008, after Lehman Brothers (the fourth-largest US investment bank at the time) filed for bankruptcy. You can see that interest rates stayed at all-time lows until after 2015 when the Fed slowly started to increase rates. Today, with the economy healthy, the Fed continues to raise rates at a measured pace.
The discount rate (which impacts the federal funds rate) is used by the Fed to speed up and slow down the economy.
Source: Clearnomics, Federal Reserve
The Fed’s dual mandate: Maximize jobs and maintain inflation
The Fed has what is known as a “dual mandate” from Congress: To maximize employment and maintain stable prices. The first mandate is simply to make sure the job market is running smoothly and that workers can find jobs. The second mandate means that the Fed seeks to maintain a stable rate of inflation. In other words, the Fed wants to make sure prices you pay for food, gasoline, rent, cell phones, TVs, and other goods and services, don’t rise too quickly or too slowly. It usually targets an inflation rate of approximately 2% (over the course of a year). The Federal Reserve monitors these numbers closely and reports on them monthly.
The Federal Reserve plays a vital role in our economy
It’s pretty clear that the Fed plays a significant role in the economy. As a result, investors never get fed up with hearing about the Fed (see what we did there?). It’s a bird … it’s a plane … it’s the mighty Federal Reserve coming to save the day!