On December 23, 1913, after a series of financial panics, the central bank of the United States was created by the passage of the Federal Reserve Act into law. The Fed is not a business or a government agency. Its stockholders do not get to vote on its actions. It is not funded by Congress, and its Chairman and Governors are not elected officials.
The Fed’s legal purpose is to moderate interest rates, stabilize prices, and reduce unemployment. To do these things, it purchases Treasury Notes – federal bonds also known as “Treasuries” – through “open market operations.” This just means buying and selling Treasuries in large quantities, which indirectly lowers or raises interest rates at the national level.
To understand how Treasury purchases change interest rates, you have to first understand the economic law of supply and demand. When demand for bonds rises because the Fed is buying, bond sellers can offer lower interest rates. Low rates are unattractive to buyers, but the Fed’s purchases overwhelm this problem. When the Fed is selling bonds, other sellers have to offer higher rates to attract customers.
How does the Fed buy enough bonds to influence national interest rates? The answer is simple: the Fed is legally empowered to “create” money out of thin air.
I’ll say that again.
The Fed creates money. It doesn’t print it. Instead, it electronically issues credit to banks in exchange for their Treasuries. The Fed funds itself using a small portion of the interest it collects on these notes, then returns the surplus to the US Government.
That’s the first effect of the Federal Reserve: its activities in effect grant the US government a large but variable, perpetual interest-free loan.
The Fed can also lend money to troubled banks. This effectively insures them against bankruptcy… even if the problems are caused by bad behavior of executives at those banks. These banks in turn keep lending money to other businesses because they don’t have to worry about risk even in shaky economic times. This keeps credit flowing and avoids shutdowns at businesses that use credit to fund daily operations.
At first, all of this this sounds great. Free loans to the government, recessions averted, bankruptcies avoided. Depending on who you ask, the Fed may have staved off a worse global financial disaster than the Great Depression of the 1920’s and 30’s.
But there are costs.
After the Fed’s moves during the Great Recession, banks paid far less interest to their customers, often offering nearly zero percent on savings accounts and CD’s. Government and corporate bonds offered less interest, and more risk, than before. Savers at banks and new bond-holders suddenly couldn’t earn decent returns.
With bank accounts and bonds paying so little interest, people sought alternative investments. New demand caused stock prices to rise dramatically. Those fortunate enough to own stocks before the crisis – think banks, investment companies, hedge funds, and wealthy individuals – earned excellent returns. But new stock buyers – for example, workers trying to save for retirement in 401(k) accounts – faced far higher prices, so their dollars bought fewer shares.
Maybe worst of all was the effect on existing retirees. Many who depended on interest to help pay for their retirement took a huge hit to their earning power. In many cases, pensions did too. Investment earnings were far below expectations, and this lasted for years. Many elderly folks who had diligently planned their retirements were forced back into the workforce because their investments no longer earned enough interest to sustain them.
Whether you think all of this pain is worth the gain or not, the Federal Reserve is an interesting creature. Lightly regulated, unelected, and autonomous, the Fed exercises far more control over our daily lives than many of us realize. Their symbols and seals even adorn our currency.
Perhaps it is no surprise that people have questions about this mysterious, powerful institution.