The Federal Reserve is the central bank of the United States, and its main function is to create the conditions for maximum employment, stable prices, and long-term economic stability through monetary policy. Financial regulation is among its other functions, but those are secondary to controlling the money supply.
The Fed’s primary tool of monetary policy is controlling the federal funds rate, which is the rate at which banks can borrow money overnight from the Fed. This rate affects other interest rates that private banks set. So, when the federal funds rate decreases, real interest rates decrease as well. Lower interest rates means that businesses and individuals take out more loans because it is cheaper to borrow. However, lower interest rates also mean there is increased risk of inflation because the demand for the dollar increases.
Structure
The Federal Reserve is split into 12 districts based on economic activity. Each district is independent of the others but governed by a board of governors, which reports to Congress. The federal government further centralized American central banking in 1933, 1935, and 1980 to make federal monetary policy more effective and cohesive. Several councils within the Fed represent the interests of banking and savings institutions as well as low-income communities, and a council of statisticians oversees forecasting models. Technically, the Federal Reserve is owned by private banks. According to one district, “while the Board of Governors is an independent government agency, the Federal Reserve Banks are set up like private corporations. Member banks hold stock in the Federal Reserve Banks and earn dividends. Holding this stock does not carry with it the control and financial interest given to holders of common stock in for-profit organizations. The stock may not be sold or pledged as collateral for loans. Member banks also appoint six of the nine members of each Bank’s board of directors.”
Combating Inflation and Historical Context
Inflation in fiscal year 2021 has thus far exceeded expectations. However, according to the chairman of the Federal Reserve Board, it is not clear yet that there is inflation across the board, which would be indicative of a more worrying, long-term trend (link to my context brief on inflation). In order for the Fed to raise interest rates before late 2022, which is when they currently plan their initial hike, there needs to be more evidence that the economy is overheating. The amount of fiscal support coming out of the COVID-19 recession is unprecedented, which complicates forecasting.
Inflation was chronically high during the 1970s due to energy crises and structural changes to international trade. To combat chronic inflation, the chairman of the Fed (1979-1987), raised interest rates to 19% in the early 1980s, causing two recessions. Such high interest rates would be ridiculous today (our current effective federal funds rate is 0.08%), but he set such high rates to combat inflation. With higher interest rates, businesses and consumers were incentivized to save, decreasing the demand for cash and goods alike. With decreased demand for immediate spending, inflation receded. After that recession, interest rates have remained relatively low compared to before the two recessions, while inflation has also remained simultaneously low. This is a textbook example of the Fed using interest rate hikes to combat inflation. Moreover, the post-recession years have demonstrated how full employment and stable prices are not necessarily in conflict. We can visualize the relationship between inflation and unemployment over time:
Source: The Federal Reserve Bank of St. Louis
As we can see, inflation has remained low since the 1980s, even during periods of full employment. In general, the business cycle has moderated so that unemployment during a recession remained lower than the unemployment rate during recessions before 1980. The pandemic recession is a notable outlier.
However, interest rate hikes come with their own set of issues. Part of the problem with predicting how the Fed will react to rising inflation is the lack of data points. Ever since the early 1980s—the first instance of the Fed raising interest rates high enough to combat inflation—there has not been significant inflation in the United States. This stability is one the defining characteristics of the Great Moderation, which describes the last forty or so years of American macroeconomic history during which inflation remained low, expansions were longer and more stable, and GDP grew slower relative to pre-1980 rates (link to business cycle brief)
Controversies around the Fed: Purview and Modern Monetary Theory
Some critics—particularly those who want to see more regulation of big businesses and financial institutions—want the Fed to shift its priorities. Proponents of this position —who tend to be progressive Democrats—want to see the Fed tackle issues beyond central banking like climate change. Perhaps the most prominent example of the expansion is the Consumer Financial Protection Bureau, which is an independent organization within the Fed whose mission is to ensure transparency for consumer financial products. The CFPB is primarily concerned with financial products like mortgages, credit cards, and other common financial products in which individuals take on risk. The expansion of the Fed’s authority has not come without obstacles. In October of 2019, the Supreme Court found in the case Seila Law LLC v. Consumer Financial Protection Bureau that the governing structure of the CFPB, which initially stipulated that its director could only be fired for cause, violated separation of powers. Some progressives also want to wrest control of the Fed away from financial institutions and toward a more centralized governance structure.Finally, some progressive economists within this sector ascribe to Modern Monetary Theory, in which fiscal policy is the primary driver of full employment and interest rates remain low. These economists favor an even more expansionary monetary policy; a policy in which the government may spend an unlimited amount of money because it issues the currency it spends. Inflation, the biggest downside risk MMT’s critics cite, would be handled via increased taxation.
