What the Federal Reserve Actually Does

Foundations

The Federal Reserve is the central bank of the United States. It does not take deposits or make loans to people; it is the bank for banks and for the US government, and its decisions set the baseline price of money for the entire world. When headlines say “the Fed raised rates” or “the Fed turned hawkish”, they are describing the institution whose choices ripple into every mortgage, bond, share price and currency on earth.

What it actually does

The Fed has two jobs by law, known as the dual mandate: keep prices stable (inflation around 2 per cent) and keep employment as high as sustainably possible. Its main tool is the federal funds rate, the interest rate banks charge each other overnight. By raising or lowering it, the Fed makes borrowing dearer or cheaper across the whole economy. It also manages a vast portfolio of bonds (see quantitative tightening below) and supervises the banking system.

Who decides, and when

Interest rate decisions are made by the Federal Open Market Committee (FOMC), which meets eight times a year on a published schedule. Twelve members vote: the seven Fed governors in Washington, the head of the New York Fed, and four of the other regional Fed presidents on rotation. The Chair, currently the public face of every decision, holds one vote like everyone else but shapes the debate. Markets hang on every word because a change in the expected path of rates changes the value of nearly every financial asset.

Why markets care so much

The Fed’s rate is the anchor for the risk-free rate: the return you can earn without taking risk. Every other investment is priced against it. When the Fed raises rates, bonds pay more, so shares must offer more to compete, and their prices tend to adjust down; borrowing costs rise for companies and homebuyers; the dollar usually strengthens. Cut rates, and the reverse. That is why a single sentence in a Fed statement can move trillions of dollars of value within minutes, and why so much of financial journalism is, one way or another, Fed-watching.