Hey, you — the average citizen of America. You know what the federal reserve is, right? And you know what it does, and why it’s so critically important not only to America but the global financial network, don’t you?
Surely you learned all you needed to know about the Fed in your freshman-year economics class, or over the course of your internet browsing, didn’t you?
Actually, this probably isn’t the case. You may know everything there is to know about the Fed, but odds are many of your buddies and girlfriends won’t be able to give you a coherent explanation of the federal reserve if you really press them on the issue.
I say this because we recently conducted a study of 1,000 US consumers and asked the question, what does the federal reserve do?
50% accurately responded that the federal reserve is responsible for overseeing the US monetary policy, 6.6% said they collect taxes, 18% said they don’t know and 24% said they are responsible for securing the US gold reserves.
Those results certainly could have been worse, but they don’t exactly paint a picture of a public that is well-informed about a key cog in our financial system, either.
We should all know more about the Fed because it really does matter. I’ll tell you why…
Why the Federal Reserve Matters
For starters, we should establish what the federal reserve is, and what it is not. In the simplest terms, the federal reserve is the central bank of the United States of America.
Washington, D.C. is home to the federal reserve, which sits atop the banking food chain, serving as a depository for twelve regional federal reserve banks. Those regional federal reserve banks serve as depositories for thousands of (generally) smaller member banks belonging to the federal reserve network.
This matters because you may be a customer at a federal reserve member bank, whether you realize it or not. If there were to be a run on your specific bank or preferred branch, the federal reserve branch that serves your region would, at least in theory, supply the funds necessary to pay customers their money.
You can think of the federal reserve and its regional iterations as an insurer of your bank’s deposits and in turn an insurer of your deposits. Do I have your attention yet?
The Fed Sets Interest Rates, Which Also Impact You
The federal reserve network is not merely a bank — that is, not in the classic sense. Aside from storing vast amounts of financial capital, the Board of Governors of the federal reserve set the discount rate, which is similar to national interest rates, but not quite the same.
The discount rate — which, again, is set by the Fed Board of Governors — is how much the federal reserve charges in interest when it issues loans to its member banks. This is not directly proportional to national interest rates but often falls in line with them.
The national interest rate is set by the Federal Open Market Committee (FOMC), a board that is also part of the federal reserve.
Raising Interest Rates Typically Spurs an Economic Slowdown
Interest rates directly impact anybody who wants to obtain a loan, whether to purchase a home, start a business, or send their kid to college. If the FOMC decides to increase interest rates, banks become stingier when it comes time to consider loan applications.
This chilling effect is compounded by the fact that fewer borrowers want a loan that is more expensive to pay down. So, the Fed typically raises interest rates to counter excessive inflation and bring a potentially overheating economy down to earth.
The idea that anybody would want to slow economic growth may seem nonsensical, but it’s not. Setting interest rates too low for too long incentivizes issuing loans to those who are probably not qualified to pay them back in the first place. In addition, the concept of lowering interest rates falls in line with limiting the ebbs and flows of the economic cycle. That is, if you limit the highs of the boom times, you hope to limit the depth of the lows, represented in the extreme by recessions and depressions.
Lowering Interest Rates May Spark Economic Activity
About those boom times…
Here’s an example to illustrate the catalytic nature of lowering interest rates. Joe wants to open a plumbing business, but he cannot qualify for a loan that requires him to pay interest at 20% each year, nor would he accept such terms if he were eligible. That 20% figure is the result, at least in part, of the interest rates set by the Fed.
This relatively high interest rate was put in place during booming economic times to fight inflation and cool an overheating economy, and they had the intended effect. But now the economy can be characterized as sluggish, and the Fed decides that it will reduce interest rates to 10% to incentivize borrowing once again.
Joe now qualifies for a loan and can afford to pay the loan back at the Fed-set interest rate of 10% per year. So he signs on the dotted line and opens his plumbing business.
Now replace Joe with yourself, and the plumbing business with something you would need to borrow money for — a mortgage, student loan, whatever.
I hope this helps you better understand why the Fed matters to you, and how decisions made by its leaders impact your life, whether now or in the future.
Conclusion
The federal reserve network is a 101-level lesson if you hope to understand how money works, particularly in America. We know that the American economy is a lodestone for the global economy, so there is no way around the reality: the Fed is a linchpin for the global economy, both in good times and bad.