The 20 Simple Questions That Explain The Entire Federal Reserve

A blog about business and economics.
Oct. 10 2013 7:50 AM

20 Simple Questions About The Federal Reserve

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WASHINGTON, DC - OCTOBER 09: I'm kind of a big deal.

Photo by Chip Somodevilla/Getty Images

Introducing Janet Yellen yesterday, President Obama observed that most Americans don't know what the Fed chair does. That's true, but it's unfortunate. The Fed chair is basically the second most important person in the government and one of the most important people in the whole world. People ought to understand what the job is and something about how the Fed works. But they don't. And I don't think we should be so complacent about that. So here's 20 basic questions and answers about the Fed that I whipped up that I think ought to help get you up to speed.

1. What's the Federal Reserve System? It's America's central bank.

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2. What's a central bank? A central bank is many things. But what makes it a "central bank" is this. When banks take deposits they lend most of that money back out. As a regulatory matter, however, they are not allowed to lend all of it out. They have to hold some of the money back as reserves. Those reserves are placed on deposit with the Fed. Hence "Federal Reserve." It's central in the sense that it stands at the center of the banking system; the bank where banks do their banking.

3. Why's that important? It's actually not that important.

4. Wait—isn't the Fed super-important? Absolutely. But its importance is only loosely related to this business about reserves. Over time for historical reasons the central bank was put in charge of other public functions beyond simply supervising reserves. In particular, central banks all around the world are important primarily because they make monetary policy. The Fed is also a very important bank regulator, but this varies from country to country.

5. So what's monetary policy? That's a bit of a metaphysical issue. In a sense, "monetary policy" is just a word for "stuff central banks do to try to keep growth on track and inflation in check" and doesn't refer to anything in particular. In practice, there are two main things the Fed does to try to do monetary policy—it manipulates interest rates and it tries to shape expectations about the future.

6. How does the Fed manipulate interest rates? Traditionally the overwhelming focus of monetary policy has been moving the "federal funds rate" up and down. That's the rate that's been at-or-near zero since the crisis began.

7. What's the federal funds rate? It's the interest rate at which banks can lend reserves to each other overnight to make up for short-term funding gaps.

8. Is that really so important? Sort of. In a sense this is the foundational interest rate upon which lots of other interest rates are based. A higher federal funds rate propagates through the economy resulting in higher mortgage rates, higher auto loan rates, higher small business rates, etc. reducing investment and durable goods purchases and slowing the economy down. In another sense, though, the federal funds rate is important because it's a symbol that shapes expectations.

9. Why do expectations matter? It makes more sense to invest if you think economic growth is going to be strong. And if lots of people invest, then economic growth will be strong. So if people expect faster growth they'll invest more, and you'll get faster growth. A self-fulfilling prophesy! Unless, that is, there's no excess capacity in the economy. Absent slack, if everyone tries to invest more you'll just end up with higher prices and more inflation. So if inflation's running too high, you might want to create the opposite self-fulfilling prophesy in which everyone invests less and prices moderate as there's less demand for stuff.

10. So what's the deal with quantitative easing? This is a somewhat unfortunate term that's come to stand for "the Fed trying to manipulate other kinds of interest rates by buying lots of stuff."

11. What would that possibly accomplish? It's really no different from the federal funds rate business. If you can't push the federal funds rate any lower because it's already near zero, you can try to push other long-term interest rates—like the rate on 10-year government debt—down as a way of forcing rates down throughout the economy. But, again, another way of looking at it is mostly that the QE is a symbol aimed at influencing expectations.

12. So who makes these decisions? The Fed's Open Market Committee (FOMC). But you want to know who that is specifically. Well the Federal Reserve System is made up of two parts. One is the Board of Governors in DC—a chairman, a vice chair, five other governors. The other is the twelve Federal Reserve Banks—San Francisco, Dallas, Minneapolis, Chicago, Kansas City, St Louis, Cleveland, Atlanta, Richmond, Philadelphia, New York, and Boston. The FOMC consists of the seven governors, the President of the New York Federal Reserve, and then four regional bank presidents. Cleveland and Chicago each serve every other year, while the other nine each serve one year out of three.

13. That rotation system doesn't make much sense, does it? Not really, no. But it's nothing compared to the Fed's nutty geography. It was set up this way 100 years ago and you know how congress is—there's just no way to change it.

14. If the chairman is just one vote out of twelve is he (or, soon, she) really so important? Yes. But this has a heavy dose of custom to it. The Supreme Court has a rich history of angry dissents and Chief Justices who find themselves in the minority. The FOMC isn't like that. The chairman exercises a lot of informal pressure over the rest of the board to get in line. The chairman also influences the process through the Fed's professional staff. The chair speaks for the Fed in a way that nobody else does. But it's always possible in principle that an inept chair could blunder and erode the office's power since a lot of that power is bound up with tradition and informal lines of influence rather than red letter legal authority.

15. So how about that bank regulation? There are a lot of different people regulating banks in America, but the Fed is very much in on the game and the fact that the Fed doesn't report to congress in some ways gives it the most leeway. Right now the most important thing the Fed is doing regulation-wise is looking at bank capital requirements, basically forcing banks to borrow less money which would make bank failures less likely. This big picture regulatory stuff is the province of the Board of Governors in DC.

16. What do the regional banks do when they're not sitting on the FOMC? There's a lot of more-or-less boring operational stuff. They deliver physical cash to the banks in their district. They play a role in clearing checks. The decline of both cash and checks relative to electronic payments has reduced the amount of day-to-day stuff happening. They also employ bank examiners who play a regulatory role. They do community development work. And they also sponsor a lot of research—both academic type big picture work and tons and tons of granual work on economic conditions in their district. Then each bank usually runs one or more publications about economics. Different banks also have some idiosyncratic local projects. The St Louis Fed runs the great FRED database, for example. 

17. Where does the Fed get the money to do this QE? They just make it up. Pull some cash out of your wallet and you'll see that the bill says it's a "Federal Reserve Note." That's a reminder that in the current monetary system, all money floweth from the Fed. If the Fed buys something from a bank, it simply increases the quantity of reserves the bank is credited with in the system. Boom.

18. What about all that gold they steal in Die Hard With a Vengeance? Great movie, but that huge pile of gold in the NY Fed is totally incidental to the operation of the monetary system. The gold standard of the pre-WWII era made the stashes of gold in the basement of the NY Fed and the Bank of England an important practical part of the world economy. Today it's mostly just hanging out because there's no point in shipping it back. Gold is heavy and if you try to move large quantities of it, someone might try to steal it.

19. Back to monetary policy! What's this business with "forward guidance"? Forward guidance is an initiative undertaken by the Bernanke Fed to try to influence rates and expectations by talking about future actions. If you say "short-term rates will stay low until such-and-such" then that should move medium-term rates. And depending on what you said instead of "such-and-such" it can shape expectations as well.

20. So what's the "Evans Rule"? That's the specific form of forward guidance the Fed is currently operating under. It says that short-term interest rates will stay at their near-zero level at least until either the unemployment rate falls below 6.5 percent or else the inflation rate rises above 2.5 percent. In other words "rates will stay low even if we get some good news about the economy." This is a very theoretically elegant idea. Unfortunately, since the real-world Fed is a bunch of different people serving overlapping terms it turns out to be harder in practice to make really firm proclamations about future policy.    

No more questions!

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.