What is the Federal Reserve?

If you’re like most people, you probably have some questions about the Federal Reserve. For starters, what is the Federal Reserve? And what in the world does it do? More importantly, when does the Fed take action (for instance, the Fed raising interest rates)? And what, if any, effect does it have on your personal finances?

It’s easy to get overwhelmed when you come across words like “monetary policy” and “systemic risk.” But hang in there. Once you have a better understanding of the Fed, you’ll realize that its job is actually pretty straightforward, and things don’t change as quickly as you may think. Whatever changes happen, they’re usually not drastic, which means you’ll have time to prepare. Let’s break it down.

Think of the Federal Reserve as the coolest chaperone at prom. She’s there to make sure that everyone is safe and nobody gets hurt, but she also wants everybody to have a great time. She’ll make sure the DJ plays all the right music to keep the party going, and she’ll make sure everyone gets home safely.

Before the Federal Reserve was created in 1913, the banking system was like the Wild West. Banks were decentralized. And there were problems with safety, stability and flexibility with the nation’s financial system. The Fed was created to fix those problems.¹

The Fed is an independent organization, not a political one, but it is overseen by Congress, and the president appoints its leader, the chair of the Federal Reserve Board.² Ultimately, the Fed’s stated goal is to “promote the health of the U.S. economy and the stability of the U.S. financial system.”

The Fed is the central bank of the United States. At the most basic level, the Fed is really just a big bank that serves other banks and the U.S. government. Like any bank, it has several jobs.² Whereas your bank handles your deposits and can cash checks, the Fed helps other banks manage their cash flow. It also serves as the U.S. government’s bank, handling withdrawals and deposits. It even monitors cash for wear and tear, taking damaged bills out of circulation.

The Fed also manages the growth and flow of the country’s money, which basically just means it is in charge of setting the country’s long-term interest rates. For example, when growth and inflation are low, the Fed might keep the interest rate really low in order to boost the economy.² The idea is that more people might be interested in applying for loans to buy things when interest rates are low. On the flip side, when the economy starts to grow, the Fed may bump up interest rates.

When interest rates change, people may notice small changes in their personal finances. As rates go up or down, banks may respond by changing the rate they offer on credit cards and other loans. Existing loans could also be affected.²

For people with savings accounts, a hike in the interest rate could be good news. It means the money in the bank could earn more each month. When you see news of a federal interest rate hike, it can be a good time to deposit more money into your savings.

And when the Fed keeps interest rates low, it encourages the economy by giving banks the opportunity to lend more.² That means more money in borrowers’ pockets, because they’re paying less money on interest.

Ultimately, the Fed’s main job is to keep things running smoothly and steadily. Interest rates usually change slowly and at incremental levels. This means you have time to prepare, and that you shouldn’t be affected in a dramatic way all at once.

The Fed was designed to keep your finances, and the country’s, from experiencing big, jarring ups and downs. When you understand how the Fed acts as an economic chaperone, and how changes in interest rates might affect you, you could have more peace of mind when those changes happen.