If you read the news even occasionally, particularly since President Biden’s election, mentions of “the Fed” have crossed your path.

What is the Fed?

 In 1913, Congress created the Federal Reserve System to be the central banking system of the U.S.  That organization is often referred to as the Fed.  

Financial crises – often “panics” – have been regular occurrences throughout U.S. history.  To address the economic devastation created by those crises, Congress created the Fed.  

A bank does not simply hold the money people deposit in its vaults.  Profit is a required part of life, and banks are no exception.  To make a profit, they must loan out that money to businesses needing money to expand, to people needing a mortgage to buy a house, etc.  Those loans require payment of interest – the bank’s profit.

Not everyone is successful enough to repay those loans.  Business or personal failures are a fact of life.  That interest charged by the bank must also be enough to recover the money from such failures, so the banks themselves can continue to operate.

A key problem for banks is a “run on a bank” by its customers.  As noted, banks give out the money deposited by its customers as loans.  Banks keep only a relatively small amount of the deposited money on hand.  If too many of the bank’s customers decide to withdraw their money from the bank, those withdrawals can total up to more money than the bank keeps on hand.

A run on the bank is usually due to news of a financial scare.

Prior to the Fed’s creation, if a bank went bankrupt, the money deposited by all its customers was lost.  Farms, businesses, and peoples’ lives were severely disrupted, with no chance of recovering their wealth.  

Congress created the Fed, giving it three major objectives:  maximizing employment, stabilizing prices, and moderating long-term interest rates.  The Fed, through its Federal Deposit Insurance Corporation (FDIC) insures (most) deposits, assuring that depositors’ savings will survive, even if a bank fails.

Controlling interest rates is the Fed’s primary means of controlling inflation.  When inflation occurs, as it did as a result of President Biden’s $4 trillion spending package in 2021, the Fed raised interest rates to stop that inflation.  

Raising interest rates makes it more difficult for people to afford mortgages, or for businesses to afford loans.  With the borrowing of money reduced, spending is reduced. Budgets, personal or business, tend to stabilize.  As a result, inflation declines.

When inflation has been reduced, the Fed lowers interest rates.  Loans cost less, and a general economic improvement results.  The country’s productivity and job growth can resume, to everyone’s benefit.

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