What Is the Federal Reserve and Why Does It Matter to You?

According to the St. Louis Federal Reserve Bank, Congress wrote and passed the Federal Reserve Act (FRA) in 1913 after a series of crises and bank runs (when a large group of depositors at a bank withdraw their money all at once) in the Panic of 1907 that threatened to collapse the fragile financial system. The FRA created the Federal Reserve System (the Fed), which is composed of 12 regional banks, including the St. Louis Bank which oversees a large portion of the Midwest. Though the exact responsibilities and actions of the Federal Reserve have shifted over the past century, its congressional mandate statutorily has been to create policy “"so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

The primary tool the Fed has in its toolbox to achieve its goals of employment and price stability is raising or lowering the target federal funds rate. This is the headline number covered extensively in the past 18+ months as inflation has run at historically high rates in the post-pandemic economy. The federal fund rate governs how expensive it is for private banks to loan money to each other and sometimes from the Fed itself. This in turn impacts the interest rates that banks and other lending institutions charge consumers and businesses for everything from mortgages, auto loans, and credit cards to large construction loans and business venture funding.

So what has changed in the last two years? As the unpredictable consequences of the COVID pandemic set in during March of 2020, the Fed lowered its target rate to near-zero in an effort to provide liquidity to the economy. Once the economy began to recover from the pandemic, economic activity surged. Add in the impact of global supply chains finally recovering from pandemic snarls to economy-juicing low interest rates, and you get historic levels of inflation. Though inflation rates have declined over the last 6 months, the US economy is still seeing price increases at a rate not seen in decades.

What does this mean for the average consumer? As a result of high inflation, the Fed has been aggressively implementing its primary tool to influence monetary policy: raising interest rates. High inflation is counter to the Fed’s mandate of stable prices. Raising interest rates generally causes private-sector investment in capital projects and hiring to decline, because it’s more expensive to borrow the cash necessary to make these investments. This causes economic activity to decrease, which means less hiring and a reduction in borrowing. In short, higher interest rates make doing business more expensive, particularly for financial institutions. This means your bank or credit union will charge you a higher interest rate to buy your next car or home in order to remain profitable.

It can seem like the actions of a technocratic government institution does not affect the day to day lives of average Americans. The past year has shown that policy makers at the Fed can have long-lasting impacts on the personal financial situation of every American. For more financial and lending information visit https://www.southwestcapital.com/