Finance

What is the Federal Reserve?

Washington DC – A small district home to the Federal Reserve (Fed), the central bank of the United States.

I am here to give you an introduction to the most important bank in the U.S.! It’s important for you to understand how the Fed can affect economic growth and how much interest you pay on your credit cards.


The Federal Reserve was established in 1913. Prior to 1913, the U.S. encountered a series of financial crises which led consumers to withdraw money at unprecedented rates 0 driving banks banks out of business. In order to protect banks and their customers, the Fed was created.

As seen in this picture, the Fed has five key functions1:


What is an interest rate and how does the Fed control interest rates?

Interest is the cost to borrow money.

The Fed has control over the “Federal Funds Rate”, an interest rate that banks charge each other for overnight cash that is held at the Fed.

The Fed meets throughout the year where they decide to increase, decrease, or make no changes to the Federal Funds rate. The Fed will make their interest rate decisions based on the health of the U.S. economy.


Why does the Fed change interest rates?

Do you remember when we began the financial crisis in 2008? At that point in time, unemployment was high and economic growth was slow, and the U.S. was in a recession.

In order to boost economic growth, the Fed decreased the Federal Funds rate to rate to 0%. Lowering the Federal Funds rate allowed banks to borrow money at a cheaper rate to help stimulate economic growth. The Fed steps in to influence interest rates to ensure that economic growth can attain its full potential.


How does the Federal Funds Rate impact me?

Let’s say the Fed decided to increase the Federal Funds rate at their latest meeting – what happens to my wallet?

The interest rate on your credit cards uses the Federal Funds rate as a benchmark to determine the interest rate on your outstanding debt. In fact, credit card companies set their interest rates about 3% higher in comparison to the Federal Funds rate2. As a consumer, you will see an increase in the interest rate for your credit card. Changes in the Federal Funds rate can also impact interest rates on savings accounts, mortgages, and car loans.

So next time you’re watching the news, pay attention to the decisions that the Fed makes – you might be paying more on your credit card or perhaps get a few extra cents in interest on your savings account.


References:

  1. https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm
  2. https://www.nytimes.com/2017/12/13/business/fed-rate-mortgages-loans-credit.html?ref=oembed&_r=0