Why the Federal Reserve matters

Now that President Trump has named Jerome Powell as the next Federal Reserve chairman, to succeed Janet Yellen in February, you may be wondering whether you should care.

Perhaps more than any other institution, the Federal Reserve has direct impacts our lives, from how much interest our savings accounts earn to the cost of borrowing money to finance a car, a home or a new business. It even affects the cost of our groceries.

Let’s start with a little bit of history. Congress established the Federal Reserve more than a century ago to build a more stable and secure financial system. Prior to the creation of the central bank, the U.S. economy was plagued by frequent panics, bank runs and failures, which often led to a drying up of credit availability. One of the more severe episodes occurred in 1907 and nearly took down the whole economy, until one banker, J.P. Morgan, personally intervened and wrangled his rich friends to arrange emergency loans for financial institutions. This episode fueled a reform movement, which prompted Congress to establish the Federal Reserve System in 1913.

However, it was not until after the Great Depression that the policy making arm of the Fed was created. Through the Banking Act of 1935, the Federal Open Market Committee (FOMC) was tasked with creating policies that influence the availability and cost of money and credit with a basic objective: to promote a healthy economy. In the late 1970s, Congress laid out two explicit policy goals that the Fed should pursue: price stability (meaning low and stable inflation) and adequate economic growth to foster maximum sustainable employment. Together, these goals are referred to as the Fed’s “dual mandate.”

The Fed has a number of tools that allow it to fulfill its dual mandate, though the one you hear about most frequently is the FOMC meeting, where voting members gather to determine the target for a key interest rate, called the federal funds rate. This is the interest rate that financial institutions charge each other for loans in the overnight borrowing market, which in turn becomes the rate on which many consumer loans and savings rates are determined. For investors, those interest rates can have a big impact on every asset class, depending on the speed and magnitude of rate movements, in either direction.

During the 2007-2008 financial crisis, and the Great Recession and tepid recovery that followed, the Fed dropped rates to zero and also used another tool to rescue a faltering economy: it purchased government and mortgage-backed bonds. The program, known as quantitative easing (QE), helped restore the functionality of markets, which had essentially locked up, and boosted the economy by lowering interest rates. Some economists worried that the Fed’s policies would lead to inflation, but if anything, prices have remained low, something for which consumers have been grateful!

Powell has always voted with Yellen on interest rates and has never offered a dissenting opinion in speeches in the way that some other Fed officials have, leading investors to believe that he will maintain the current slow and steady approach to rates.

There’s one more way the Fed impacts everyone: Following the financial crisis, Congress passed the Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), which expands the Fed’s regulatory responsibilities over the nation’s systemically important financial institutions (SIFIs). Because President Trump has made rolling back regulation a priority in his administration, some believe that Powell might ease up on the banks, though that remains to be seen.