What is the Federal Reserve?
And how does it affect you?
If you’re like most people, you probably have some questions about the Federal Reserve.1 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.
Why do we have a Federal Reserve?
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—lawless and a little dangerous. Some people saved their money in unique ways, like hiding it under the mattress at home, and the markets were really unstable. The Fed was created to fix those problems by making a few rules, like requiring that banks keep a certain amount of cash on hand and making sure that money is transferred from bank to bank safely.2
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. Ultimately, the Fed’s goal is to keep Americans employed and help the economy boom at a healthy rate, while also steering clear of big busts.
What does the Federal Reserve do?
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.3 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.4 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. This is done to avoid overinflation, which is what happens when prices rise too high too fast, making your money worth less.
How does the Fed affect my money?
When interest rates go up, people may notice small changes in their personal finances.5 For instance, credit card loan rates are tied to these rates, which means when the federal interest rate is raised half a quarter point (0.25%), you may pay 0.25% more on your credit card interest rate.6
For people with savings, a hike in the interest rate is good news. It means the money you have in the bank will 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. That means more money in your pocket because you’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’ll have more peace of mind when those changes happen.
This site is for educational purposes. The material provided on this site is not intended to provide legal, investment, or financial advice or to indicate the availability or suitability of any Capital One product or service to your unique circumstances. For specific advice about your unique circumstances, you may wish to consult a qualified professional.
Federalreserve.com. Retrieved November 15, 2017, from: https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm
Federalreserve.com. Retrieved November 17, 2017, from: https://www.federalreserve.gov/faqs/about_12594.htm
Investopedia.com. Retrieved November 15, 2017, from: https://www.investopedia.com/university/thefed/fed2.asp
Investopedia.com Retrieved November 17, 2017, from: https://www.investopedia.com/terms/m/monetarypolicy.asp
Baldwin, J. G. (2017, October 16). Retrieved June 13, 2018, from: https://www.investopedia.com/articles/investing/010616/impact-fed-interest-rate-hike.asp
Marks Jarvis, G. (2017, March 15). Retrieved November 17, 2017, from: http://www.chicagotribune.com/business/ct-fed-interest-rate-impact-0316-biz-20170315-story.html
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