What is the Federal Reserve?

The Federal Reserve System (Fed) was founded by Congress in 1913, and has since been a key component in US economic policy. Initially created to address banking panics nationwide, the Fed is now tasked with cultivating a sound financial system and ensuring a healthy economy. From controlling interest rates to working with member banks to maintain liquidity, the Fed can influence many parts of the economic system.

Hold up, didn't Andrew Jackson get rid of that?

You are so close!! Actually, Andrew Jackson, the guy on the $20 note vetoed the recharter of the Second National Bank and subsequently used his presidential powers to remove federal funds from the bank. However, the First and Second National Banks differ from the Federal Reserve we see today. For starters, The First National Bank never had the power to buy government bonds and neither of the Banks had the ability to regulate the banking system. So, why was the Federal Reserve created and what does it even do?

The Fed was created to solve problems related to "inelastic currency", which occurred when the supply of money did not adjust with demand.  This led to multiple bank runs, which happens as a result of people trying to withdraw more money than the bank had available. You have probably heard of The Great Depression in a US History class, which lasted between 1929-1938, but did you know that a similar panic in 1873 led people to call the period in the 1870s the "Great Depression"? Finally, the Panic of 1907 finally persuaded the members of Congress to make some amendments to the country's financial system. The 1913 Federal Reserve Act, signed into law by President Wilson, created 12 regional banks across the country and a headquarters in Washington, D.C

So what exactly can the Fed do?

The primary responsibilities of the Fed include determining interest rates, managing the money supply, and regulating financial markets. The Federal Open Market Committee (FOMC) is a group of seven individuals who meet and carry out these tasks by conducting meetings eight times per year. Appointed by the president, each member serves a fourteen-year term. The current chairman of the Federal Reserve is Jerome Powell, who was appointed by President Trump and reinstated by President Biden.

Together, the FOMC determines the state of the economy and discusses the necessary tone they must set to best steer the ship. For example, the advent of the pandemic led to a shock that saw markets fall substantially and put many people out of business. While the President and Congress worked to issue stimulus checks, the Federal Reserve eased monetary policy by reducing interest rates to near-zero levels, and increasing the money supply almost 4-fold just between April and May 2020.

All in all, the Federal Reserve can do the following actions.

  • Monetary Policy
  • Quantitative tightening and easing
  • Interest Rate changes
  • Balance sheet changes, affects liquidity
  • Regulation T (Margin limits)

What's going on with them right now!

Recent Fed meetings have primarily had one tone: raising interest rates. After its last meeting of 2022, Powell and his posse voted to raise rates to an effective federal funds rate of 4.33%. Essentially, this means more expensive borrowing rates for things like car loans, student loans, or mortgages. Companies even rely on these rates as it determines their borrowing rates for operations or investments. Greater rates could mean a freeze on hiring employees or ceasing further investments.

But fret not! Bond investors tend to love high rate environments because the interest rates on bonds are higher. Say you bought a bond from the government back in March 2020, you would be making a market yield of around 0.23%. Fast forward to today, the same bond is trading at 4.233%. Crazy right! Well, that is the power of the Fed. Unfortunately, this high rate environment does not bode well for stocks, with the S&P 500 being down around 20% over 2022.

We hope you found this primer on bonds to be useful and informational. If you would like to dive deeper in your educational journey feel free to start with the topics below.