Updated on 02.08.07

What Is “The Fed,” What Do They Have To Do With My Money, And Why Should I Care?

Trent Hamm

Whenever my wife hears mention of the Federal Reserve on television or the radio, her eyes glaze over and she quickly looks for another station to listen to or watch. Sadly, she’s not alone in not having any interest at all in what the Federal Reserve does or what power it has directly over their wallets. The truth is every American who has ever borrowed money, ever might borrow money, or ever might invest money should at least be aware of what the Federal Reserve does and the basics of how it works, especially anyone with any outstanding debt.

What is it? The Federal Reserve, often referred to in the media as “the fed,” is a system of banks associated with (but not a direct part of) the federal government. Their job, at least in terms of the everyday consumer, is to use these banks to influence the financial and credit conditions in the United States with the general goals of maximizing employment and stabilizing prices. They do this in various different ways, some of which are important to everyday consumers and some of which are not. Basically, the Federal Reserve is the group that makes your money worth more than the paper it’s printed on.

Great, so what can they do to affect me? The biggest thing the Federal Reserve can do is, by their various actions, directly affect whether interest rates on all sorts of loans go up or whether they go down. They do this by altering the “discount interest rate,” which is the interest rate that any bank must pay the Federal Reserve to borrow money from it.

You might be wondering, “So what?” Think of it like this: imagine you’re on a street with ten gas stations. One of the gas stations is a BP station and the other ones are all local ones that are small and sometimes don’t have any gas to sell, so if that happens, they have to go borrow some gas from the big BP station. What happens on that street if the BP changes their price per gallon of gas? Almost every other station eventually goes along with it.

In other words, whenever the Federal Reserve changes their “discount interest rate,” most other interest rates soon follow along with it. That’s why news sources cover the Fed so much: as soon as they announce a change in their rates, all other banks and lenders will soon be changing their rates, too. And when those rates change, the actions of people like you and me change – we want to borrow money when the interest rates are low and aren’t nearly as interested when the interest rates are high.

Here are a few examples of how the Fed directly affects your wallet.

If you have a variable-rate student loan, it’s usually adjusted once a year. If you notice the Fed raising rates throughout the year, your student loan bill will go up. If you notice the Fed lowering rates throughout the year, your student loan bill will go down.

If you have an adjustable rate mortgage, the same is true. When it comes time to adjust, your rate will (generally) go up if the Fed has been raising rates, or stay steady or go down if the Fed has been lowering rates.

If you want to apply for almost any loan, you’re going to get a better rate if the Fed is lowering rates than if it’s raising rates.

Basically, it’s generally better for the average consumer if the rates are low rather than high. So why would the Federal Reserve ever raise rates? This often happens if the economy is doing well and most people are employed because if they left it low, the economy could start steamrolling out of control like it did in the 1920s. After nine years of incredible job growth and lots of people making money, the United States economy collapsed between 1929 and 1931 and it directly led to the Great Depression.

In short, it’s always useful to keep an eye on what the Federal Reserve is doing, because it directly affects your pocketbook.

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  1. Heidi says:

    Thanks Trent. I’ve been wondering for the longest time why those people on the news talk about ‘the Fed rates’ all the time. Now i understand and please dont ask me why I never tried to find the answer….i’m one of the ‘quickly looks for another station to listen to or watch’ people :)

  2. I preach to my co-workers all the time about how important the fed are to the economy their wallets! Good post.

  3. Jim Lippard says:

    The October 2004 issue of Liberty magazine had an article that went into more detail about how the Fed is structured and what it does (and commenting briefly on some of the crazy conspiracy theories that some people hold about it). This article, “Who Owns the Fed?”, by Citadel economics professor Bill Woolsey, is available online here.

  4. Ethan says:

    This is a good post and I think it is important for people to understand some simple economics like what the fed does, but you got some of the details wrong. The fed does have a discount interest rate, but this rate has a very small effect on interest rates. Borrowing from the fed is like admitting you have a liquidity problem. Banks would much rather borrow from other banks then the fed even if it is cheaper.

    When you hear the news talk about cutting interest rates they are probably talking about the rates banks charge each other. Banks have to keep a certain percentage of the money in their customers accounts in cash. Since banks make money by turning that cash into loans they try to keep it as close to the minimum as possible. Loans are constantly being repaid and accounts are constantly being putting more or less money in to so sometimes they are a little over or a little under. If a bank goes under the limit they will borrow from another bank for a few days. It is this interest rate that banks charge each other that the fed tries to control since it is a good indication of how much money is in the economy and generally what interest rates are.

    The federal reserve controls these interest rates indirectly. The board of governors meet every six weeks to decide what the target rate for banks to charge interests should be. If the fed wants interest rates to go down they will buy bonds from banks. The more cash within the banking system and economy in general the more extra cash banks have to loan each other. If the fed wants to raise interest rates it sells bonds to banks.

    The fed lowers interest rates when the economy is doing poorly and raises them when it is doing relatively well. Lower interest rates means more loans which means more new businesses and investments in capital(factories,tools etc.) which means more jobs and economic growth. Why not have low interest all the time? Inflation. If the fed tried to keep rates low all the time it would have to constantly be putting more money into the economy which would cause large inflation. The fed has a trade off between low inflation and a temporary economic boost.

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