Backgrounder, 11/08/2022, Written by: James McBride, Anshu Siripurapu, and Noah Berman

https://www.cfr.org/backgrounder/what-us-federal-reserve

Over the past decade, the Fed kept interest rates low while it deployed trillions of dollars in stimulus and expanded its regulatory oversight. Now, the central bank is back in the spotlight for its battle against inflation.

• The Federal Reserve is the most powerful economic institution in the United States. It is responsible for managing monetary policy and regulating the financial system.
• It does this by setting interest rates, influencing the supply of money in the economy, and, in recent years, making trillions of dollars in asset purchases to boost financial markets.
• The COVID-19 pandemic and repercussions from the Russian invasion of Ukraine have spurred alarming inflation, pushing the Fed to sharply raise rates in 2022.

The U.S. central banking system—the Federal Reserve, or the Fed—is the most powerful economic institution in the United States, perhaps the world. Its core responsibilities include setting interest rates, managing the money supply, and regulating financial markets. It also acts as a lender of last resort during periods of economic crisis, as demonstrated during the 2008 financial meltdown and the COVID-19 pandemic. In the wake of Russia’s invasion of Ukraine in 2022 and the ensuing spike in energy prices, the central bank has struggled with how to slow rapid inflation without damaging economic growth.

Given the immensity of its powers, the Fed is no stranger to controversy. Some economists have argued that its aggressive policies risk inflation and asset bubbles, while others feel the Fed’s support for financial markets favors big business over workers. The central bank is also one of the most politically independent U.S. government bodies, which has long caused tension with lawmakers and presidents.

What does the Fed do?

For most of the nineteenth century, the United States had no central bank to serve as a lender of last resort, leaving the country vulnerable to a series of financial panics and banking runs. In response, Congress passed—and President Woodrow Wilson signed into law—the 1913 Federal Reserve Act, which created a Federal Reserve System of twelve public-private regional banks. The New York Fed, which is responsible for the heart of the nation’s financial life, has long been considered first among equals. It runs the Fed’s trading desks, helps regulate Wall Street, and oversees the largest pool of assets.

Today, the Fed is tasked with managing U.S. monetary policy, regulating bank holding companies and other member banks, and monitoring systemic risk in the financial system. The seven-member Board of Governors, the system’s seat of power, is based in Washington, DC, and currently led by Fed Chair Jerome Powell. Each member is appointed by the president to a fourteen-year term, subject to confirmation by the Senate. The Board of Governors forms part of a larger board, the Federal Open Market Committee (FOMC), which includes five of the twelve regional bank presidents on a rotating basis. The FOMC is responsible for setting interest rate targets and managing the money supply.

Historically, the Fed has been driven by a dual mandate: first, to maintain stable prices, and second, to achieve full employment. Stable prices were long characterized by an annual inflation target of 2 percent, until the bank announced in August 2020 that it would begin tolerating periods of higher inflation to make up for periods when it is lower. The definition of full employment is debated by economists but is often considered to mean an unemployment rate of around 4 or 5 percent.

To fulfill its mandate, the Fed’s most important lever is the buying or selling of U.S. Treasury bonds in the open market to influence banking reserves and interest rates. For instance, the Fed’s purchase of bonds puts more money into the financial system and thus reduces the cost of borrowing. At the same time, the Fed can also make loans to commercial banks, at an interest rate that it sets (known as the discount rate) to increase the money supply.

Recent Fed chairs include:

Paul Volcker, 1979–1987. Appointed by President Jimmy Carter, Volcker, previously head of the New York Fed, took over at a time of double-digit inflation and slow growth, known as “stagflation.” To fight inflation he restricted the supply of money in the economy, pushing interest rates to their highest level in history, topping 20 percent. While the immediate result was a recession and high unemployment, many economists say this “shock therapy” set the stage for the country’s 1980s economic boom. President Ronald Reagan replaced Volcker in 1987 after disagreements over rising U.S. debt, high interest rates, and financial regulation.

Alan Greenspan, 1987–2006. Reagan appointed Greenspan, an economist and former White House advisor, who would go on to serve five terms as Fed chair under four different presidents. A noted inflation hawk and skeptic of government regulation, he was often credited with leading the U.S. economy through its long 1990s expansion. In the wake of the 2008 financial crisis, however, many experts also criticized him for doing little to regulate risky new financial products and allowing a housing bubble to build.

Ben Bernanke, 2006–2014. Appointed by President George W. Bush, Bernanke’s two terms spanned the worst years of the 2008 crisis and its aftermath, known as the Great Recession. His aggressive response included slashing interest rates to zero, supporting financial institutions on the brink of collapse, and pumping trillions of dollars into financial markets to support liquidity and lending. President Barack Obama reappointed Bernanke to a second term, crediting him with avoiding a total economic collapse.

Janet Yellen, 2014–2018. After Bernanke announced his retirement in 2013, Obama chose Yellen, a Yale-trained economist and the first woman to head the U.S. central bank. Before becoming chair, Yellen had issued early warnings about the housing crash and pushed for more aggressive monetary policy to bring down unemployment. During her term, as the United States saw a recovery in the labor market, Yellen oversaw the first rise in interest rates in nearly a decade.

Jerome Powell, 2018–Present. New presidents have almost always reappointed the sitting Fed chair to a second term, regardless of party. But after Yellen’s first term expired in February 2018, Trump replaced her with Powell, a businessman, financier, and sitting Fed governor. Though Trump criticized Yellen’s “easy money” policies during his 2016 campaign, Powell initially followed her blueprint for slowly increasing interest rates. But, like Trump, Powell has been more skeptical about some of the Fed’s regulations, particularly on smaller banks that have faced more scrutiny in the wake of the financial crisis. Still, Trump repeatedly threatened to sack Powell, alleging that he did not do enough to support the economy. President Joe Biden reappointed Powell in 2022, who confronted surging inflation by raising rates to their highest levels in fifteen years.

How has the Fed’s regulatory role evolved?

The Fed’s regulatory purview steadily expanded through the 1990s. The U.S. banking industry changed dramatically under a 1999 law that legalized the merger of securities, insurance, and banking institutions, and allowed banks to combine retail and investment operations. These two functions had previously been separated under the 1933 Glass-Steagall Act. The changes also made the Fed responsible for ensuring banks’ solvency by enforcing provisions such as minimum capital requirements, consumer protections, antitrust laws, and anti–money laundering policies.

The U.S. financial crisis, which expanded into a global economic crisis beginning in 2008, highlighted the systemic risk embedded in the financial system, and raised questions over the Fed’s oversight. Some economists point to the repeal of Glass-Steagall in particular as the starting gun for a “race to the bottom” among financial regulators, which allowed “too-big-to-fail” institutions to take on dangerous levels of risk. As many assets became “toxic,” especially new types of securities based on risky housing loans, the federal government was forced to step in with trillions of dollars in bailout money to avert the financial system’s collapse.

In the aftermath, debate has continued over how both regulatory changes and monetary policy created the conditions for the crisis. In addition to the Glass-Steagall repeal, regulators in the early 2000s also allowed banks to take on unprecedented levels of debt. Bernanke has blamed excessive debt, lax government regulation, and gaps in oversight of too-big-to-fail banks for the disaster.

In addition, some critics blame the Fed’s long-running policy of low interest rates for contributing to the crisis. Many economists judge Fed policy by the so-called Taylor rule, formulated by Stanford economist John Taylor, which says that interest rates should be raised when inflation or employment rates are high. Taylor and others have argued that then Fed Chair Greenspan’s decision to keep rates low during a period of economic growth helped create the housing bubble by making home loans extremely cheap and encouraging many borrowers to go into debt beyond their means. Greenspan attributed this policy to his belief that the U.S. economy faced the risk of deflation, or a decline in prices, due to a tightening supply of credit.

How did the Fed deal with the Great Recession?

Like other central banks around the world, the Fed immediately slashed interest rates to boost lending and other economic activity. By the end of 2008, it dropped rates to near zero, where they would stay until 2015. Unlike some other central banks, including the European Central Bank, the Fed decided against negative interest rates. It thought that such a move—essentially charging banks for holding their funds with the Fed in order to spur them to lend—was unlikely to have much effect.

However, the Fed did pursue another unorthodox policy, known as quantitative easing, or QE, which refers to the large-scale purchase of assets, including Treasury bonds, mortgage-backed securities, and other debt. Between 2008 and 2014, the Fed’s balance sheet ballooned from about $900 billion to over $4.5 trillion as the central bank launched several rounds of asset buying.

The goal of QE was to further spur lending when all other monetary policy tools had been maxed out. This was thought to work in multiple ways: by taking bad assets off of banks’ balance sheets, by dramatically increasing the supply of money to be lent, and by signaling to banks and investors that the Fed was committed to taking any steps necessary to restore growth.

The move was not without its critics, as some economists feared such an increase in the money supply would cause out-of-control inflation. Many also argued that additional monetary easing would do little at a time of low demand in the economy.

Economists still debate the results of QE in the wake of the recession. Fed officials and others say it helped stabilize the economy, increase lending, and boost employment. Other experts call the policy disappointing, noting the historically slow U.S. recovery and suggesting that it set the stage for postpandemic inflationary conditions. Fears also remain that winding down, or “tapering,” the Fed’s asset purchases has contributed to market instability—leading to several so-called “taper tantrums.”

After 2014, with U.S. growth rebounding and unemployment falling, the Fed sought to return to normalcy. QE purchases ended in 2014, though the Fed did not move to start gradually shrinking its balance sheet until 2017. The Fed also began slowly raising interest rates starting in December 2015, the first increase since 2006.

However, these efforts were interrupted in 2019, as the Fed became worried about slowing global growth and rising trade tensions. In July 2019, Powell announced he was cutting interest rates, which had reached 2.5 percent, and several more cuts followed that year. At the same time, the Fed again started buying assets, at a pace of $60 billion per month, in an attempt to calm volatile financial markets.

What did Dodd-Frank do?

In the wake of the financial crisis, Congress passed a new set of regulations, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The legislation seeks to reduce systemic risk through a wide range of policies, including new limits on derivatives trading, stricter oversight of banks, and greater consumer protections. A major plank is the so-called Volcker Rule, named after the former Fed chair, which prohibits federally backed banks from proprietary trading, or making risky bets with their depositors’ funds.

Dodd-Frank introduced what is essentially a third official mandate for the Fed, alongside its inflation and employment targets, by expanding its oversight of the financial system. It does that in part via the Fed’s participation in the newly created Financial Stability Oversight Council, which identifies risks to the system and imposes new regulations as needed.

The Fed is also now in charge of keeping a closer eye on banks’ solvency, to ensure they have enough reserves to survive another major downturn. All financial firms big enough to pose a risk to the broader economy—known as “systemically important financial institutions”—are evaluated yearly with so-called “stress tests” that simulate the conditions of an economic crisis. These policies together represent a consolidation of oversight in Washington—previously, the regional reserve banks, and the New York Fed in particular, took the lead on regulating banks in their territory.

How has the Fed responded to postpandemic inflation?

Beginning in early 2020, the COVID-19 pandemic emerged as an economic disruption rivaling the 2008 crisis. That March, the Fed responded with an immediate return to its emergency footing—cutting rates to zero and announcing a slew of measures to bolster markets and pump money into the financial system—and by the summer of 2022, the Fed’s balance sheet had doubled to a record high of nearly $9 trillion. With an aggressive Fed response and unprecedented fiscal stimulus, the economic recovery was much faster than that following the Great Recession. However, with supply chains still snarled and global energy prices rattled following the Russian invasion of Ukraine, the postpandemic economic rebound has been accompanied by the highest inflation rates in decades. This inflationary environment has led the Fed to try to slow down the economy by hiking interest rates.

Fed officials initially took the view that higher inflation was temporary. But as higher prices persisted, they began raising interest rates in 2022 at their fastest clip since the 1980s. By November, the Fed had raised interest rates six times, and more increases appear to be on the horizon. With inflation showing no signs of slowing, economists have debated the Fed’s approach: Many say slowing the pace of interest rate increases raises the risk that consumers will accept permanently higher prices, while others worry that defeating inflation with rate hikes will come at the cost of a recession or a return to stagflation.

At the same time, the Fed’s actions have reverberated beyond the U.S. economy. Its persistent tightening has put pressure on other central banks to raise their interest rates to prevent their currencies from falling further against the surging U.S. dollar, writes CFR’s Brad W. Setser, a former U.S. Treasury official. The result has been what Setser calls a reverse currency war that has made imports of natural gas and other energy supplies—already high following Europe’s broad sanctions on Russian oil and gas—even more expensive.

CFR’s Sebastian Mallaby dubbed the past decades of low interest rates and low inflation the “age of magic money.” With the opposite now occurring—high rates and high inflation—the Fed could be better served with a higher inflation target than the historical 2 percent, he writes in the Washington Post. While the Fed attempts to tamp down inflation, Mallaby argues, magic money is “off the table.”