The Federal Reserve in plain English and the levers it really holds

Try a quiz on the next ten people you meet. Ask them who decides the interest rate on a car loan, who sets the price of money in this country, and whether that person ever faced a voter. You will get answers ranging from "the banks" to "the President" to a long silence. The truth is that the most powerful economic institution in America is also the one least understood by the people it affects.

That matters for a conservative argument. We believe power should be near the people, on the record, with someone to answer for it. The Federal Reserve is the biggest exception to that rule in our whole economy, and you cannot hold an institution accountable if you cannot describe it. So let me describe it: where it came from, how it is built, what it can really do, what it cannot, and what Congress still holds in its hand.

Why it exists: the Panic of 1907

America has had a central bank before. Alexander Hamilton's First Bank of the United States was chartered in 1791. The Second Bank was chartered in 1816, and President Andrew Jackson vetoed its recharter in 1832 on the grounds that it concentrated too much power in too few hands. After that came decades of a system with no central bank at all, run by a patchwork of state and national banks, with a recurring habit of panics.

The worst of the early twentieth-century panics came in 1907. Banks and trust companies failed, depositors ran, and the rescue was organized not by the government but by the financier J. P. Morgan, who locked bankers in his library until they agreed to pool money. The country concluded that it should never again depend on the personal credit of one private citizen. Congress created the National Monetary Commission, led by Senator Nelson Aldrich of Rhode Island, which studied foreign systems. Aldrich and a small group of bankers and officials drew up a plan at a secluded meeting on Jekyll Island, Georgia, in 1910.

The plan that became law was different from Aldrich's. It was written largely by Representative Carter Glass of Virginia and Senator Robert Owen of Oklahoma, and President Woodrow Wilson signed the Federal Reserve Act on December 23, 1913. The compromise was uniquely American: not one central bank in New York, but a system, with twelve regional banks and a board in Washington, so power would be spread out.

How it is built

Here is the layout, in plain terms.

1. The Board of Governors sits in Washington. It has seven members, appointed by the President and confirmed by the Senate, each serving a staggered fourteen-year term. The long terms are meant to keep any single President from reshaping the board in one go. The Chair and Vice Chair are named from among the governors for four-year terms, also subject to Senate confirmation.
2. Twelve regional Reserve Banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco. Their presidents are chosen by their own boards of directors, with the Board of Governors' approval, not by the President of the United States.
3. The Federal Open Market Committee, the FOMC, is the body that sets monetary policy. It has twelve voting members: the seven governors, the president of the New York Reserve Bank, and four of the other eleven regional presidents who vote on a rotating basis. It holds eight scheduled meetings a year.

That structure looks odd, because it is. A body with seven presidential appointees and five bankers chosen by regional boards sets the price of money for an entire continent of workers and borrowers. Whether that is a wise balance or a strange one is a legitimate debate, and the point is that it was a deliberate compromise between centralised and local control.

The lesson of 1951

Independence was not written into the 1913 law in any strong form, and for years the Fed was a junior partner to the Treasury. During and after the Second World War, the Fed kept interest rates on government bonds pegged low so that the Treasury could borrow cheaply. That meant the central bank was, in effect, buying whatever bonds were needed to hold the price, which is another way of saying it was printing money to finance the government. When the Korean War brought a burst of price increases in 1950, the arrangement became a public fight between the Treasury and the Fed. It ended with the Treasury-Federal Reserve Accord of March 1951, which freed the Fed from the duty to hold bond yields down. Most historians treat that accord as the real birth of the modern, independent Fed. It is worth remembering whenever you hear a politician say that the central bank should help pay for his plans.

The job description: the 1977 dual mandate

The original 1913 Act did not tell the Fed to pursue any particular goal for prices or jobs. That came later. Congress amended the Federal Reserve Act in 1977 to direct the Fed to promote maximum employment, stable prices and moderate long-term interest rates. Since long-term rates tend to be moderate when prices are stable, the three goals are usually summarized as two: the dual mandate of maximum employment and stable prices. The Full Employment and Balanced Growth Act of 1978, known as Humphrey-Hawkins, added a requirement that the Fed report to Congress twice a year on its plans, which is why the Chair testifies before the House and Senate banking committees on a regular schedule.

Notice what that sets up. Two goals, with no formula for trading one off against the other. When they point the same way, nobody complains. When they conflict, the Fed has to choose, and a choice among competing public goods is a political decision made by officials who never faced a ballot. I am not accusing anyone of bad faith. I am describing the structure, and the structure is the problem you should keep in mind.

The levers it holds

This is the heart of the matter. The Fed has several tools, and people mix them up.

The policy rate. The Fed targets the federal funds rate, the rate at which banks lend reserve balances to each other overnight. It is not a rate you pay. It is the foundation that other short-term rates are built on. When the FOMC announces it is raising or cutting "the rate," this is what it means.

Open market operations. To hit its target, the Fed has traditionally bought and sold Treasury securities. Buying securities puts money into the banking system, which pushes short-term rates down. Selling does the reverse. The name comes from doing it in the open market, with dealers, rather than by dictating a price.

Interest on reserves. Since October 2008, the Fed has paid interest on the balances banks keep with it, under authority Congress granted in 2006 and moved up in the 2008 rescue legislation. The rate it pays acts as a floor for what banks will accept when they lend, and it has become a main control for the policy rate. It also means taxpayers' central bank is paying banks, a point that fiscal conservatives rightly question when the amounts are large.

The discount rate. This is the rate at which the Fed itself lends to banks that need cash. It is the original tool, and now mostly a backstop.

The balance sheet. In and after the 2008 crisis, the Fed bought huge amounts of Treasury and mortgage securities, a policy known as quantitative easing, to push down longer-term rates when short-term rates were already near zero. The securities it holds are its balance sheet. Shrinking that balance sheet later is called quantitative tightening. These purchases are the reason the Fed became a very large player in the markets for government debt and mortgage bonds, and they are where I think the debate about mission creep belongs.

Reserve requirements. For most of its history the Fed required banks to hold a fraction of deposits in reserve. In March 2020 it reduced that requirement to zero.

Emergency lending. Under Section 13(3) of the Federal Reserve Act, the Fed can lend to non-bank firms in unusual and exigent circumstances. After the 2008 bailouts, the 2010 Dodd-Frank law added limits, including a requirement for the approval of the Treasury Secretary. Whether those limits are strong enough is something conservatives of good faith argue about.

A worked example: how the lever reaches your wallet

Say the FOMC raises its target for the federal funds rate by one percentage point. Banks pay more to borrow from each other, so they raise what they charge on short-term business loans and credit cards. Because longer-term rates, such as car loans and mortgages, depend on what investors expect short rates to do over the coming years, they move too, but by amounts that depend on expectations. If investors believe the Fed will hold the line on inflation, long rates may barely budge. If they think it will back down, long rates may even rise.

That last point surprises people. The Fed does not set your mortgage rate. The yield on the ten-year Treasury note is a much better guide, and the Fed influences it indirectly. A full example, with the arithmetic, is in a mortgage worksheet that shows what two points of interest really cost.

What the Fed cannot do

The Fed cannot spend money Congress has not appropriated. It cannot cut your taxes or raise them. It cannot order a company to hire, or conjure a harvest, or reopen a shut factory. It cannot fix a supply problem with a printing press; it can only change how much money is chasing the goods that exist. It cannot repair a regulatory burden, a zoning rule or a broken immigration system. And it cannot, despite its popular image, create lasting prosperity by cutting rates, because borrowing from the future does not make the future bigger.

Many of Washington's disappointments come from asking the Fed to do work that belongs to Congress and the President. When the budget is out of balance, the central bank is asked to make the debt cheaper. When growth is slow, it is asked to make up for tax and regulatory policy. The more we load onto it, the less accountable the people who should be doing those jobs have to be. For the fiscal side of the story, see twelve questions about the national debt, answered straight.

Who watches the watchers

The Fed is independent within the government, not independent of it. Congress created it by statute and can rewrite that statute: change the mandate, change the structure, change the oversight. Several things already exist.

1. The Chair testifies before the Senate Banking Committee and the House Financial Services Committee on a regular schedule, and the Fed publishes minutes of its meetings after a delay.
2. The Fed pays for itself out of the interest it earns on its portfolio, and sends its profits to the Treasury, so it does not depend on annual appropriations. That is the source of much of its independence, and also a reason some members of Congress want more say.
3. The Government Accountability Office can audit parts of the Fed's operations, but by law it is kept out of monetary policy deliberations and decisions. Dodd-Frank allowed one-time reviews of the emergency lending after 2008. The idea of a full audit has been pushed for years by Republican members, and it is a fair question what the public has a right to see.
4. Governors are chosen by the President and confirmed by the Senate. That is real accountability, though it works slowly given the fourteen-year terms.

The deeper defence of independence is that money printing is too tempting a tool for politicians who face elections. It is a serious argument, and the Volcker story is its best exhibit: a central banker could do something painful and unpopular because no one could fire him. You can read it in How Paul Volcker broke inflation and why it hurt so much. The deeper objection is the one I have been circling: power without accountability is a bad bet whether it wears a good suit or a bad one. And what monetary policy does to your savings is the subject of Inflation is the one tax that never needs a vote in Congress.

Reading the Fed like an adult

Do not try to predict the Fed. Learn to read what it says. The FOMC issues a statement after each meeting, and minutes follow. Compare what it says about prices, which you can check against How the CPI is built and why it never matches your grocery receipt, with what it says about jobs, which you can check against how the jobs numbers work, answered in eleven questions. Both pages exist so you can judge the judges.

The bottom line

• The Fed was created by the Federal Reserve Act of December 1913 after the Panic of 1907, as a system of a Washington board and twelve regional banks, not one central bank.
• It holds real, specific levers: a policy rate, open market operations, interest on reserves, the discount rate, a very large balance sheet, and emergency lending. It does not set your mortgage rate directly.
• Its dual mandate came from Congress in 1977, and Congress can change it. Treat any official who says "only the Fed can fix this" with suspicion.
• Ask your representative three questions: what should the Fed's goal be, what should it be forbidden to buy, and how much of its work should the public see?
• Read the Fed's statements for yourself. A person who can describe the institution is a person who can hold it to account.