What Is the Federal Reserve and How Does It Work?

Investors are constantly surrounded by headlines about the Federal Reserve’s meetings, their decisions on interest rates, the rate of inflation, supply shocks, output gaps, and all kinds of other economic jargon. But what do these terms really mean—and which of them matter for investors?

In short: Yes, the Federal Reserve (Fed) does have a major bearing on the economy, interest rates, inflation, and other key variables—and these concepts are all important to investors.

The most important things to understand about the Fed are: what it’s trying to accomplish, the actions it will take to try to accomplish these goals, and the implications of these actions on the broader economy and specific investments.

Here, we break down frequently asked questions about the Fed and US monetary policy.

• What is the Federal Reserve?
• What is the structure of the Federal Reserve?
• What is monetary policy? How does the Fed influence monetary policy?
• How does the Fed control interest rates?
• What is a “good” inflation rate?
• What is the “right” employment rate?
• What is a supply shock and how does the Fed react to one?
• What is quantitative easing?
• Does quantitative easing cause inflation?
• What is quantitative tightening?
• What is debt monetization and does the Fed engage in it?
• What is the Fed dot plot?

What is the Federal Reserve?

The Federal Reserve (Fed) is the central bank of the United States. It has the power to influence interest rates, inflation, inflation expectations, economic growth, and more, which can influence the relative attractiveness of certain investments.

The Fed’s goals are to provide financial stability, ensure the stability of individual banks, and generally promote a healthy economy. Specifically, it aims to help the economy stay at its full capacity and to maintain stable prices, which it does by setting monetary policy.

• Staying at its full capacity means ensuring that employment in the US is at its maximum potential.
• Maintaining stable prices means managing inflation.

What is monetary policy? How does the Federal Reserve influence it?

US monetary policy is the actions of the Fed, that it takes to work toward its goal of a healthy economy. The Fed has several tools at its disposal to drive monetary policy. The most well-known one is the setting of interest rates, specifically the federal-funds rate.

The explicit definition of the fed-funds rate is the interest rate that banks will charge other financial institutions in exchange for lending them cash. But in turn, this rate influences the rates that banks charge consumers for things like credit cards and consumer loans.

A higher interest rate curbs demand and reins in inflation; a lower interest rate increases demand and can heighten inflation. In other words: If the economy is overactive, the Fed will curb it by raising interest rates. If the economy is weak, the Fed will raise the rate to encourage economic activity.

Other tools that the Fed may use to enact monetary policy include:

• Forward guidance. This includes communicating with the public to set expectations about the economy. Often, expectations become self-fulfilling—so the public will end up manifesting what the Fed has told them to expect.
• Asset purchases. This entails purchasing large quantities of longer-duration securities, to provide extra demand and consequently lower their overall yield. This is also called quantitative easing, described in more detail below.
• Reserve requirements. This tool means the Fed can increase the minimum sum that commercial banks must hold in reserves. Though this tool is still at the Fed’s disposal, it hasn’t been implemented often and is no longer considered significant.

What is the structure of the Federal Reserve? What is the Federal Open Market Committee?

The Fed is comprised of the Board of Governors, 12 Federal Reserve Banks (based in cities across the US), and the Federal Open Market Committee.

• The Board of Governors. This includes the chair, vice chair, and five members, each of whom is appointed by the president. Under President Joe Biden, the chair is Jerome Powell.
• 12 Federal Reserve Banks. These banks are based in different cities across the US and each oversees its own region. Each is run by a president.
• Federal Open Market Committee. Together, the members of the Board of Governors and four presidents of the Federal Reserve Banks make up the Federal Open Market Committee. Four of the 12 presidents of the banks serve on the FOMC at a time, and they rotate who serves on it so each president gets a chance to serve.

The FOMC is the entity that most investors care about, since this group sets the direction of US monetary policy.

The FOMC meets at least eight times a year to vote on monetary policy decisions such as interest rates. After each meeting, the FOMC releases their meeting’s statements, economic projections, and minutes.

The members of the Board of Governors are appointed by the president, but the presidents of the Federal Reserve Banks are appointed by local bank boards. So while the Fed is arguably partially influenced by politics, it also maintains a large degree of independence—which is important to its effectiveness.

How does the Fed control interest rates?

Technically, the Fed doesn’t directly change the federal-funds rate: Rather, it influences the federal-funds market to achieve its desired rate outcome.

As the central bank of the US, the Fed has the power to either pump cash into the banking system (by buying Treasury securities) or take cash out of the system (by selling them). This concept is known as “open market operations.”

When the Fed sells a security, it “absorbs” the money—that is, because someone paid cash to buy the security from the Fed, that cash that used to be in the economy has now moved to the Fed’s balance sheet, where it sits doing nothing. The reverse is also true when the Fed buys a security. The point is: The Fed can add or subtract money from the US money supply at will.

By altering the US money supply, the Fed alters the supply of reserves in the banking system.

What does that mean? Banks are required to keep a certain amount of excess reserves in their system, and an active federal funds market depends on financial institutions loaning each other money to increase these reserves or make money from any excess reserves.

Today, however, most US banks have plenty of excess reserves. So, the Fed pays banks interest on these reserves—and this is the rate that informs the rate at which banks will lend their reserves to other institutions. (After all, why would they bother lending reserves at a lower rate than what the Fed is offering?) Though this doesn’t drive consumer interest rates directly, it deeply influences how banks will translate these rates into short-term rates.

What is a ‘good’ inflation rate?

The Fed targets average inflation of 2% over time and wants long-run inflation expectations to remain anchored at 2%. The word “average” is important here. That is, if inflation has consistently been below 2%, the Fed may subsequently tolerate and even seek out inflation that is above 2% for a time.

While no inflation would be great from a consumer standpoint, there are two primary reasons the Fed doesn’t set the target inflation rate at 0%:

• To avoid the risk of deflation. Deflation, when the costs of goods and services decline, is uniquely destructive on the economy. Deflation often makes interest rates increase, which makes debt more of a burden for borrowers and leads to lower economic growth—a situation that can be hard to escape from. Because deflation is so destructive, economists generally favor a bit of a buffer zone above 0%.
• Wages tend to be resistant to declines. It’s difficult for wages to adjust downward. Some inflation gives space for wage cuts in real terms without having to decrease wages in nominal terms. (In other words, though workers may experience decreased purchasing power because their wages are not fully adjusted for inflation, they’re not experiencing an actual decline in their take-home dollar amount.) This improves the efficiency of the labor market.

Conversely, economists want to avoid inflation that is too high because inflation tends to become less stable the higher it goes, and unstable inflation expectations are destructive to the economy as well.

What is the ‘right’ employment rate?

The “right” employment rate is the highest rate that can be achieved. However, this does not mean zero unemployment: There will always be a certain number of people who are unemployed because they are new to the workforce or are between jobs (this is called frictional unemployment), not for reasons that can be attributed to the economy.

While a realistic measure for maximum employment is open to interpretation, it generally is meant to represent maximum potential GDP.

The Fed currently thinks the longer-run level of unemployment at full capacity is roughly 4%, though there is room for debate.

What is a supply shock and how does the Fed react to one?

A supply shock is an unexpected event that suddenly changes the supply of a product or commodity. A positive supply shock results in unexpectedly high supply; a negative supply shock results in an unexpected shortage.

For example, we experienced a negative supply shock when a lower supply of oil led to high oil prices; and when the pandemic caused a microchip shortage, which caused inflation to surge for these commodities. The reverse is also possible: Increased supply of a commodity can result in lower prices.

In the case of a supply shock, the Fed must choose between stabilizing prices and closing the output gap (that is, closing the gap between the economy’s current GDP and its potential GDP). High interest rates can stabilize prices but make the output gap worse; lower rates can improve the output gap but worsen inflation.

If the economy is thought to be operating below its potential GDP, that’s a good sign that it could use some monetary support. The Fed may prioritize lowering rates to improve the economy’s output (even at the cost of inflation). However, this can be a dangerous game to play as it may result in inflation spiraling too far out of control, which can lead to an even more severe correction once the Fed decides it needs to tame inflation once again.

What is quantitative easing?

Quantitative easing is one of the Fed’s tools for driving monetary policy. Its goal is to lower interest rates on longer-duration and riskier forms of credit, such as mortgages.

If the fed-funds rate is already at its lowest level and the economy needs more incentivizing, the Fed may use quantitative easing to stimulate aggregate demand.

This entails purchasing additional longer-duration securities such as government bonds or mortgage-backed securities—which increases the size of the Fed’s balance sheet and consequently encourages lower rates on the relevant assets.

Does quantitative easing cause inflation?

It can, but it doesn’t necessarily.

Quantitative easing mainly happens “behind the scenes” (between the Fed and bank reserves), so it doesn’t directly affect consumer spending. Once the Fed pumps cash into the economy as part of quantitative easing efforts, the extra cash mostly sits on bank’s balance sheets, and isn’t actively spent by consumers.

However, you could make an argument that quantitative easing contributes to an overblown sense of the economy’s efficiency—which could encourage poor investment decisions and increased risk-taking, and thus lead to inflation.

What is quantitative tightening?

Quantitative tightening, as it sounds, is the exact opposite of quantitative easing.

Whereas quantitative easing is purchasing longer-duration securities to provide additional stimulus to the economy, quantitative tightening occurs when the Fed sells these same securities back into the market.

These actions reduce the size of the Fed’s balance sheet and reverse the stimulative effect of the previous quantitative easing.

Think of this as just another tool the Fed has to manage the economy, in addition to changing the federal-funds rate.

What is debt monetization and does the Fed engage in it?

Debt monetization is when a government or central bank permanently takes on debt to fund the government.

So does the Fed do this? Yes and no.

The interest the Fed pays on reserve balances is essentially the same as interest it receives from 1- and 2-year Treasuries—so in these cases, the Fed isn’t really assuming any debt but rather passing along similar interest payments to the banks. Therefore the government is still paying the banks—it does not get this debt for free.

In cases where Treasuries’ interest rates are above the interest rate for reserve balances, there is something to the monetization argument: The Fed is buying up debt, earning more on this debt than it sends to the banks, and sending these profits back to the Treasury. In other words, the government is paying itself back on a portion of these interest payments.

What is the Fed dot plot?

The “Summary of Economic Projections”—more often known as the Fed dot plot—is a quarterly graph that shows the interest rate expectations of each Federal Reserve member (including the Fed Chair, Vice Chair, and regional Fed presidents).

This is important for investors because it gives greater detail into the rate expectations of individuals who influence rate-setting decisions, including where the majority of the members think rates should go and how far and wide the disagreement is about future rate levels.

While this doesn’t directly foretell the future of interest rates, it gives investors a sense of these key figures’ inclinations.

This article was compiled by Emelia Fredlick.