how the federal reserve works

In short

A friend of mine once asked me why the price of a car loan changed while his paycheck stayed put. The answer starts at a place most of us never visit, the Federal Reserve. The Fed is the central bank of the United States, and its main tool is a short term interest rate that ripples out to nearly every loan and savings account you will ever hold. Congress set its goals: stable prices and maximum employment. If you are holding a mortgage, a credit card, or a savings account, its decisions touch your money. You cannot vote on its rate, but you can learn how it moves and plan around it. That is a good place to begin.

The whole of it

What it is

I once watched an old farmer check the rain gauge each morning before he decided anything about his crops. He did not control the weather. He simply paid attention to it, and that made him calmer than his neighbors. The Federal Reserve is a bit like that gauge for your household money, and it helps to know who runs it.

Congress created the Federal Reserve System in 1913 through the Federal Reserve Act. It has three main parts. The Board of Governors sits in Washington, D.C., and has seven members nominated by the President and confirmed by the Senate. Twelve regional Reserve Banks spread across the country do much of the daily work. And the Federal Open Market Committee, called the FOMC, votes on interest rate policy. The FOMC includes the seven governors and five Reserve Bank presidents.

The Fed has a job description written by Congress. It is told to pursue maximum employment and stable prices. People call this the dual mandate. The Fed also supervises banks and keeps the payment system running. It is not a government agency that spends your tax money. It earns its own income, mostly from interest on the securities it holds, and sends its extra earnings to the Treasury.

How it works

You have probably heard that the Fed sets interest rates. That is close, but not quite right. The Fed sets a target range for the federal funds rate, which is the rate banks charge each other for overnight loans. Banks keep money at the Fed, and sometimes one bank has extra while another runs short. They lend to each other for a night, and that price is the federal funds rate.

The Fed steers that rate using a few tools. It pays interest on the money banks hold at the Fed, and that rate acts like a floor. It also offers an overnight arrangement for money market funds and others. Both tools keep the market rate inside the target range the FOMC chose. Years ago the Fed did this mostly by buying and selling securities in small amounts. Today it leans on the rates it pays directly.

Why should a family care about a bank to bank loan? Because everything else is priced off it. When the target rate goes up, banks raise what they charge on credit cards, car loans, and variable rate mortgages. Savings accounts and certificates of deposit tend to pay more too, though banks adjust at their own speed. When the target falls, borrowing gets cheaper and savers earn less.

The Fed has another lever. It can buy or sell large amounts of Treasury bonds and mortgage backed securities. Buying pushes longer term rates down. Selling or letting holdings run off pushes them up. This is called quantitative easing when the Fed buys and quantitative tightening when it shrinks. It matters most when the short term rate is already near zero.

The FOMC meets eight times a year. After each meeting it posts a statement on federalreserve.gov, and the chair holds a press conference. Every few months it also publishes a summary of economic projections, including where each member expects rates to go. That is how the rest of us get a peek at the thinking.

The numbers, and where to find yours

A neighbor told me she felt shut out of all this because the news talks in strange code. It is easier than it sounds, because only a few figures matter, and each one is posted for free.

The first is the target range for the federal funds rate, which is the current figure, which the official source publishes each year. The Federal Reserve posts it on its monetary policy page at federalreserve.gov after every FOMC meeting. The second is the inflation goal. The Fed has said it aims for the current figure, which the official source publishes each year a year, measured by the price index for personal consumption expenditures, which the Bureau of Economic Analysis publishes. The third is the unemployment rate, which the Bureau of Labor Statistics posts monthly at bls.gov.

To find your own exposure, look at the loans and accounts you hold. Your credit card statement lists the annual percentage rate, and many cards tie it to the prime rate, which banks set a little above the federal funds rate. A variable rate mortgage or home equity line spells out its index in the loan papers. Your savings account lists its yield on the bank's website or monthly statement. Write each rate on one page and you will see how much a move in the target could shift your costs.

A worked example

Let me tell you about a woman named Dana Brooks. She carries a $6,000 balance on a credit card with a variable rate. Her card charges 20 percent a year, and she pays only the interest each month so she can see the effect clearly.

Interest for a year at 20 percent on $6,000 is $6,000 times 0.20, which is $1,200. Divided by 12 months, that is $100 a month.

Now suppose the Fed raises its target by 1 percentage point, and her card follows right along. The new rate is 21 percent. Interest for a year is $6,000 times 0.21, which is $1,260. Divided by 12, that is $105 a month. Her cost went up $5 a month, or $60 over the year.

Now look at her savings. Dana keeps $10,000 in a savings account that pays 4 percent. Interest for a year is $10,000 times 0.04, which is $400. If the bank passes the full 1 point increase along, the new rate is 5 percent, and the interest becomes $10,000 times 0.05, which is $500. She earns $100 more a year.

So the same rate move cost Dana $60 on her card and paid her $100 on her savings. The lesson is plain. Whether a rate hike helps or hurts depends on whether you owe more than you hold. Dana pays $60 more but earns $100 more, so she comes out $40 ahead for the year. A friend with $20,000 in debt and $1,000 in savings would see it the other way.

Where it goes wrong

I have made my share of mistakes by assuming a thing was simple. A few misunderstandings are worth clearing up, and none of them is a mark against you.

Many people think the Fed sets the rate on your mortgage. It does not. A 30 year fixed mortgage rate follows the market for longer term bonds, which responds to what investors expect the Fed to do, along with inflation and other forces. The Fed's target can move while a fixed mortgage rate barely budges, or the reverse.

Another slip is expecting banks to pass every change along at once. They do not. Credit card rates often follow quickly because the contract ties them to prime. Savings rates tend to lag, and some banks pay very little no matter what the Fed does. Shopping around matters.

A third trap is reading one meeting as a promise. The FOMC projections are guesses, not pledges. The members say so themselves, and they change course when the data changes. Treat the forecast as a weather report, not a contract.

Last, some people believe the Fed can fix prices and jobs on its own. It cannot. Its tools are blunt, and they work with delays. Prices and employment also move with energy costs, wages, trade, and decisions made far from Washington. The Fed nudges. It does not command.

Questions to answer before you leave this page

Do you know which of your loans carry a variable rate, and what index each one follows? Have you looked at what your savings account actually pays, and whether another bank offers more for the same safe deposit? If the target rate rose by 1 percentage point tomorrow, would you pay more than you earn, or earn more than you pay? Have you checked the Federal Reserve's own posted target range at federalreserve.gov so you are not relying on a headline? And when you hear that the Fed did something, can you now say which part of the system did it, the Board, the Reserve Banks, or the FOMC?