THE ROLE OF THE FEDERAL RESERVE

The Federal Reserve is making headlines for how it is handling short-term interest rates, but you may not be aware of the colorful history and wide range of financial responsibilities that fall to the central bank of the United States.

The Federal Reserve as we know it today was created in 1913. This was the third attempt by lawmakers to create a central bank. The first was created in 1791 at the urging of Treasury Secretary Alexander Hamilton but was broken up after its 20-year charter expired. The second was created several years later, but its charter was not renewed.¹

Four Key Jobs

Today’s Federal Reserve responsibilities fall into four areas.

Overseeing U.S. monetary policy: The Fed administers the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. Sometimes, the Fed’s responsibility for promoting employment and stable prices can conflict with each other. In the past year, the Fed has pushed short-term interest rates higher in an attempt to tame hot inflation. However, higher rates may lead to slower economic growth, which may result in higher unemployment.²

Stabilizing the financial system: The Fed looks to keep the financial system operating smoothly by avoiding disruptions. For example, during the onset of the Covid-19 pandemic, the Fed quickly moved to lower interest rates to near zero. It also purchased securities to keep the markets working when assets were hard to sell. Eligible borrowers were provided with a source of funding.³

Supervising and regulating: In addition to banks, the Fed examines a wide range of financial institutions to make sure they are operating safely and are sound. During the 2008 financial crisis, the Fed quickly stepped in to help insurance companies, investment banks, and other companies that provided consumer finances. Fed officials learned that nonbank financial companies threatened the stability of the entire financial system.⁴

Providing banking services: Many financial assets around the world are priced in U.S. dollars. Crude oil, for example, is priced in dollars because oil exporters believe that the greenback is the preeminent global currency for global investments. Closer to home, the Fed works with the nation’s 10,000 financial institutions that process about $5 trillion in payments each day.⁵

As 2023 progresses, investors will closely watch to see whether the Fed’s policies in 2022 will result in a recession or a “soft landing” for the economy.

A recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months,” according to the National Bureau of Economic Research, which determines business cycles. In contrast, a soft landing is an economic slowdown following a period of growth.⁶

One survey of business and academic economists estimated the probability of a recession in the next 12 months at 61%. Roughly 75% of economists stated the Fed wouldn’t be able to achieve a soft landing. However, the survey also found that most economists expect the recession to be shallow and short lived.⁷

So, the next time the Federal Reserve is in the headlines with an adjustment to interest rates, you’ll know that a wide range of short-term and long-term factors were taken into consideration before making the change.