What Is the U.S. Federal Reserve?

Over the past decade, the Fed kept interest rates low while it deployed trillions of dollars in stimulus and expanded its regulatory oversight. Now, the central bank is back in the spotlight for its battle against inflation.

The U.S. central banking system—the Federal Reserve, or the Fed—is the most powerful economic institution in the United States, and perhaps the world. Its core responsibilities include setting interest rates, managing the money supply, and regulating financial markets. It also acts as a lender of last resort during periods of economic crisis, as demonstrated during the 2008 financial meltdown and the COVID-19 pandemic. Since 2020, the central bank has struggled with how to slow rapid inflation without damaging economic growth.

Given the immensity of its powers, the Fed is no stranger to controversy. Some economists have argued that its aggressive policies risk inflation and asset bubbles, while others feel the Fed’s support for financial markets favors big business over workers. The central bank is also one of the most politically independent U.S. government bodies, which has long caused tension with lawmakers and presidents.

What does the Fed do?

For most of the nineteenth century, the United States had no central bank to serve as a lender of last resort, leaving the country vulnerable to a series of financial panics and banking runs. In response, Congress passed—and President Woodrow Wilson signed into law—the 1913 Federal Reserve Act, which created a Federal Reserve System of twelve public-private regional banks. The New York Fed, which is responsible for the heart of the nation’s financial life, has long been considered first among equals. It runs the Fed’s trading desks, helps regulate Wall Street, and oversees the largest pool of assets.

Today, the Fed is tasked with managing U.S. monetary policy, regulating bank holding companies and other member banks, and monitoring systemic risk in the financial system. The seven-member Board of Governors, the system’s seat of power, is based in Washington, DC, and currently led by Fed Chair Jerome Powell. Each member is appointed by the president to a fourteen-year term, subject to confirmation by the Senate. The Board of Governors forms part of a larger board, the Federal Open Market Committee (FOMC), which includes five of the twelve regional bank presidents on a rotating basis. The FOMC is responsible for setting interest rate targets and managing the money supply.

Historically, the Fed has been driven by a dual mandate: first, to maintain stable prices, and second, to achieve full employment. The Fed sets an annual inflation target of 2 percent in pursuit of price stability, and economists debate the definition of full employment but generally accept it to mean an unemployment rate of around 4 or 5 percent. (In August 2020, the bank announced that it would begin tolerating periods of higher inflation to make up for periods when it is lower, though it has not yet embraced this practice.)

To fulfill its mandate, the Fed’s most important lever is the buying or selling of U.S. Treasury bonds in the open market to influence banking reserves and interest rates. For instance, the Fed’s purchase of bonds puts more money into the financial system and thus reduces the cost of borrowing. At the same time, the Fed can also make loans to commercial banks, at an interest rate that it sets (known as the discount rate) to increase the money supply.

The Federal Reserve has five main responsibilities: conducting monetary policy to achieve maximum employment and stable prices, maintaining financial system stability, supervising and regulating banks to ensure safety and soundness, fostering payments system efficiency and safety, and promoting consumer protection and community development. It serves as a central bank for the U.S., managing the nation’s money supply and credit to foster economic stability and growth. 

Monetary Policy

• Dual Mandate:The Fed operates under a “dual mandate” from Congress to promote maximum employment and stable prices. 
• Tools:It uses tools like setting interest rates, reserve requirements, and open market operations to influence the money supply and credit conditions in the economy. 

Financial Stability

• Risk Management: The Fed monitors and works to contain risks within the financial system to prevent panics and ensure stability. 
• Bank Safety: It promotes the safety and soundness of individual financial institutions. 

Bank Supervision and Regulation

• Oversight:The Fed supervises and regulates banking institutions to ensure they operate safely and soundly. 
• Community Needs:It also ensures banks meet the credit needs of their communities by observing community reinvestment laws. 

Payments System

• Services: The Fed provides payment services to banks and the U.S. government. 
• Efficiency: It works to ensure the nation’s payments and settlement systems are efficient and safe. 

Consumer Protection and Community Development

• Consumer Protection: The Fed enforces laws to protect consumers of financial institutions and ensures fair access to credit. 
• Community Development: It also engages in community economic development activities. 

The Federal Reserve has four main functions:

• Manage inflation: This is the Fed’s most visible function. As part of this function, the Fed also promotes maximum employment and ensures interest rates remain moderate over time.
• Supervise the banking system: The Fed supervises and regulates the nation’s largest banks and enacts laws to protect consumers.
• Maintain the stability of the financial system: It maintains the stability of the financial markets and constrains potential crises.
• Provide banking services: The Fed provides services to other banks, the U.S. government, and foreign banks.

Here’s a look at each of these in turn.

Manage Inflation

The Fed manages inflation while promoting maximum employment and stable interest rates. The Fed sets a 2% inflation target for the core inflation rate. The core rate strips out volatile food and gasoline prices because they have a wider range of volatility. On Aug. 27, 2020, the Fed announced it would tolerate inflation above 2% in the short term if it maximized employment.⁶ The Fed uses the Personal Consumption Expenditures Price Index (PCE) to measure inflation.

The Fed has many powerful tools at its disposal for this purpose. Its most powerful tool is setting the target for the federal funds rate, which guides interest rates.

If a bank doesn’t have enough cash on hand at the end of the day, it borrows what it needs from other banks. The funds it borrows are known as federal funds. Banks charge each other the federal funds rate on these loans.

Note

Knowledge of the current fed funds rate is important because this rate is a benchmark in financial markets. Many interest rates are based upon the fed funds rate.

The Federal Reserve uses expansionary monetary policy when it lowers interest rates. This makes loans cheaper, spurs business growth, and reduces unemployment.

The opposite, when the Fed raises interest rates, is known as contractionary monetary policy. High interest rates make borrowing expensive, and increased loan costs slow growth and keep prices low.

The FOMC sets the target for the fed funds rate. Banks set their own effective fed funds rate. To keep it near its target, the Fed uses open market operations to buy or sell securities from its member banks. That adds to the reserves the banks can lend and results in the lowering of the fed funds rate.

Supervise the Banking System

The Federal Reserve Banking System is a network of 12 Federal Reserve banks under the supervision of the board of governors. These 12 banks supervise and serve as banks for commercial banks in their region.

Note

The 12 Federal Reserve regional banks are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis, and San Francisco.

The Reserve Banks serve the U.S. Treasury by handling its payments, selling government securities, and assisting with its cash management and investment activities. Reserve banks also conduct valuable research on economic issues.

Maintain the Stability of the Financial System

The 2008 financial crisis revealed regulations on individual banks weren’t enough. The financial system had become so interconnected that the Fed, and other regulators, needed to look at it as a whole.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 strengthened the Fed’s ability to maintain stability. Each bank with over $50 billion in assets had to submit a “living will” to the Fed outlining its financial health and ability to handle a crisis. This was to prevent another bankruptcy on the scale of Lehman Brothers.

Note

In 2018, Congress waived Dodd-Frank regulations on banks with less than $10 billion in assets.

The Fed’s Large Institution Supervision Coordinating Committee (LISCC) regulates the largest and most systematically important banks. It conducts stress tests to determine whether the banks have enough capital to make loans even in a financial crisis.

Provide Banking Services

The Fed is called the “banks’ bank” because each Reserve Bank stores currency, processes checks, and makes loans for its members to meet their reserve requirements when needed. These loans are made through the discount window.

Banks are charged the discount rate, which is a little higher than the fed funds rate. Most banks avoid using the discount window because there is a stigma attached. It is assumed the bank can’t get loans from other banks—that’s why the Federal Reserve is also known as the bank of last resort.

How has the Fed’s regulatory role evolved?

The Fed’s regulatory purview steadily expanded through the 1990s. The U.S. banking industry changed dramatically under a 1999 law that legalized the merger of securities, insurance, and banking institutions, and allowed banks to combine retail and investment operations. These two functions had previously been separated under the 1933 Glass-Steagall Act. The changes also made the Fed responsible for ensuring banks’ solvency by enforcing provisions such as minimum capital requirements, consumer protections, antitrust laws, and anti–money laundering policies.

The U.S. financial crisis, which expanded into a global economic crisis beginning in 2008, highlighted the systemic risk embedded in the financial system, and raised questions over the Fed’s oversight. Some economists point to the repeal of Glass-Steagall in particular as the starting gun for a “race to the bottom” among financial regulators, which allowed “too-big-to-fail” institutions to take on dangerous levels of risk. As many assets became “toxic,” especially new types of securities based on risky housing loans, the federal government was forced to step in with trillions of dollars in bailout money to avert the financial system’s collapse.

In the aftermath, debate has continued over how both regulatory changes and monetary policy created the conditions for the crisis. In addition to the Glass-Steagall repeal, regulators in the early 2000s also allowed banks to take on unprecedented levels of debt. Bernanke has blamed excessive debt, lax government regulation, and gaps in oversight of too-big-to-fail banks for the disaster.

In addition, some critics blame the Fed’s long-running policy of low interest rates for contributing to the crisis. Many economists judge Fed policy by the so-called Taylor rule, formulated by Stanford economist John Taylor, which says that interest rates should be raised when inflation or employment rates are high. Taylor and others have argued that then Fed Chair Greenspan’s decision to keep rates low during a period of economic growth helped create the housing bubble by making home loans extremely cheap and encouraging many borrowers to go into debt beyond their means. Greenspan attributed this policy to his belief that the U.S. economy faced the risk of deflation, or a decline in prices, due to a tightening supply of credit.

How did the Fed deal with the Great Recession?

Like other central banks around the world, the Fed immediately slashed interest rates to boost lending and other economic activity. By the end of 2008, it dropped rates to near zero, where they would stay until 2015. Unlike some other central banks, including the European Central Bank, the Fed decided against negative interest rates. It thought that such a move—essentially charging banks for holding their funds with the Fed in order to spur them to lend—was unlikely to have much effect.

However, the Fed did pursue another unorthodox policy, known as quantitative easing, or QE, which refers to the large-scale purchase of assets, including Treasury bonds, mortgage-backed securities, and other debt. Between 2008 and 2014, the Fed’s balance sheet ballooned from about $900 billion to over $4.5 trillion as the central bank launched several rounds of asset buying.

The goal of QE was to further spur lending when all other monetary policy tools had been maxed out. This was thought to work in multiple ways: by taking bad assets off of banks’ balance sheets, by dramatically increasing the supply of money to be lent, and by signaling to banks and investors that the Fed was committed to taking any steps necessary to restore growth.

The move was not without its critics, as some economists feared such an increase in the money supply would cause out-of-control inflation. Many also argued that additional monetary easing would do little at a time of low demand in the economy.

Economists still debate the results of QE in the wake of the recession. Fed officials and others say it helped stabilize the economy, increase lending, and boost employment. Other experts call the policy disappointing, noting the historically slow U.S. recovery and suggesting that it set the stage for postpandemic inflationary conditions. Fears also remain that winding down, or “tapering,” the Fed’s asset purchases has contributed to market instability—leading to several so-called “taper tantrums.”

After 2014, with U.S. growth rebounding and unemployment falling, the Fed sought to return to normalcy. QE purchases ended in 2014, though the Fed did not move to start gradually shrinking its balance sheet until 2017. The Fed also began slowly raising interest rates starting in December 2015, the first increase since 2006.

However, these efforts were interrupted in 2019, as the Fed became worried about slowing global growth and rising trade tensions. In July 2019, Powell announced he was cutting interest rates, which had reached 2.5 percent, and several more cuts followed that year. At the same time, the Fed again started buying assets, at a pace of $60 billion per month, in an attempt to calm volatile financial markets. The pandemic led to an acceleration in purchases as the Fed sought to contain an economic crisis; the bank’s balance sheet doubled between 2020 and 2022, reaching nearly $9 trillion.

What did Dodd-Frank do?

In the wake of the financial crisis, Congress passed a new set of regulations, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The legislation seeks to reduce systemic risk through a wide range of policies, including new limits on derivatives trading, stricter oversight of banks, and greater consumer protections. A major plank is the so-called Volcker Rule, named after the former Fed chair, which prohibits federally backed banks from proprietary trading, or making risky bets with their depositors’ funds.

Dodd-Frank introduced what is essentially a third official mandate for the Fed, alongside its inflation and employment targets, by expanding its oversight of the financial system. It does that in part via the Fed’s participation in the newly created Financial Stability Oversight Council, which identifies risks to the system and imposes new regulations as needed.

The Fed is also now in charge of keeping a closer eye on banks’ solvency, so it can ensure they have enough reserves to survive another major downturn. All financial firms big enough to pose a risk to the broader economy—known as “systemically important financial institutions”—are evaluated yearly with so-called “stress tests” that simulate the conditions of an economic crisis. These policies together represent a consolidation of oversight in Washington—previously, the regional reserve banks, and the New York Fed in particular, took the lead on regulating banks in their territory. In 2018, Trump signed legislation weakening the Volcker Rule, reducing the number of banks subject to stress tests, and rolling back other Dodd-Frank provisions. Some economists argue that these rollbacks helped create the conditions for the 2023 collapse of Silicon Valley Bank—the third largest bank failure in U.S. history.

How has the Fed responded to postpandemic inflation?

Beginning in early 2020, the pandemic emerged as a major global economic disruption. That March, the Fed responded with an immediate return to its emergency footing, cutting rates to zero and announcing a slew of measures to bolster markets and pump money into the financial system. With an aggressive Fed response and unprecedented fiscal stimulus, the economic recovery was much faster than that following the Great Recession. However, the stimulus, in combination with depressed demand from lockdowns, snarled supply chains, and high global energy prices following the Russian invasion of Ukraine, contributed to the highest inflation rate since the early 1980s. This inflationary environment has led the Fed to use interest rate hikes to try to cool off the economy while avoiding a recession—a goal known as a “soft landing.”

Fed officials initially took the view that higher inflation was temporary. But as higher prices persisted, they began raising interest rates in 2022 at their fastest clip in forty years, and they currently sit at a twenty-three-year high. After months of debate among economists over the appropriate time to begin lowering rates, Powell signaled in July 2024 that the bank could soon do so. Some experts contend that waiting unnecessarily heightened the risk of recession. Others, including CFR’s Roger W. Ferguson, a former Fed vice chairman, note that lowering interest rates while inflation remained high could have further entrenched it. 

At the same time, the Fed’s actions have reverberated beyond the U.S. economy. Its persistent tightening put pressure on other central banks to raise their interest rates to prevent their currencies from falling further against the surging U.S. dollar, writes CFR’s Brad W. Setser, a former U.S. Treasury official. When Japan—where interest rates were far lower than in the United States—raised rates in July 2024, a series of bets on the low value of the yen relative to the U.S. dollar unraveled, leading to a short-lived collapse in the largest Japanese stock index and an associated drop in major American indices.

CFR’s Sebastian Mallaby dubbed the past decades of low interest rates and low inflation the “age of magic money.” With the opposite now occurring—high rates and above-target inflation—he argues that the Fed could be better served with a higher inflation target than the historical 2 percent. Either way, Mallaby maintains, magic money is now “off the table.”

How the Fed Affects You

The Federal Reserve has a significant impact on the lives of all Americans. The press scrutinizes the Federal Reserve for clues on how the economy is performing and what the FOMC and board of governors plan to do about it. The Fed directly affects your stock and bond mutual funds, as well as your loan rates. By having such an influence on the economy, the Fed also indirectly affects your home’s value and even your chances of being laid off or rehired.

Frequently Asked Questions (FAQs)

How is the chair of the Federal Reserve chosen?

The president chooses the Fed chairman, and then the Senate must confirm the president’s choice.

Where is the Federal Reserve located?

The headquarters of the Federal Reserve are in Washington, D.C. The reserve bank locations are in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

Does the Federal Reserve print money?

The Fed does not print money. The U.S. Treasury is the institution that prints money.