Understanding the Fed

Understanding the Fed

If you’ve ever had to bluff your way through a conversation on the Federal Reserve System–at a cocktail party, perhaps–you’re not alone.
After all, no institution is as camouflaged in academic jargon. And news reports about the Fed’s doings, including its recent interest rate cuts, are often described in mystifying terms, from monetary policy to discount rate and federal funds rate.

Aside from the lingo, though, the nation’s central banking system is fairly simple. The Fed, made up of a central governing agency plus 12 regional banks, regulates the value of money. It does so through the law of supply and demand; by increasing or decreasing the supply of dollars in circulation, it makes them cheap or expensive.

And cheap money–like the kind available on your 4% credit card or the low-cost bond debt available to corporations–propels spending, which creates jobs and keeps the economy moving forward. “The U.S. economy is built on the availability of credit,” explains Silas Myers, CEO of Latigo Investment Partners L.L.C. in Santa Monica, California. “If it becomes difficult to obtain, you can have a situation where the economy slows down.”

That is precisely what the Fed feared late this summer. With job creation slowing and financing for nearly everything at a virtual halt, the Fed acted decisively. At its September meeting, one of eight annually, the 12-member Federal Open Market Committee, led by Chairman Ben Bernanke, used its power to lower a key interest rate by half a percentage point.

That rate, known as the fed funds rate, is what banks charge each other to borrow money. Lowering it causes a cascade of activity that works its way through the country’s sources of credit.

There is a risk to the Fed chopping interest rates too far and too fast, however: inflation. To avoid it, the Fed, according to a time-honored metaphor, must decide when to remove the punch bowl–low interest rates–from the party.

Thanks to the Fed’s attention, inflation has not been a serious problem in decades. But price inflation is a grave concern because it whittles away at the value of the dollar. At the time of the September interest rate cut, the Fed said its concern about inflation was lessening, though “some risks remain.”

Although the U.S. president selects the members of the Fed’s Board of Governors, the Fed has become a more powerful shaper of the nation’s economy than Congress and the president, according to Michael Carew, assistant professor of economics and finance at the Zicklin School of Business at Baruch College in New York City.

Yes, the federal government controls a major lever on the economy through its ability to set fiscal policy–i.e., to tax and spend. But legislative gridlock too often means “it takes 10 years to get anything done,” says Carew. So it’s not surprising that the Fed gets scrutinized: its decisions, its economic data, and even the minutes of its meetings. “Congress has basically defaulted when it comes to making economic policy,” says Carew. “The Fed makes economic policy.”


  • Beige Book: The Fed’s report