Look up a definition of the Federal Reserve, and you'll see things like "central bank," "monetary policy," and "regulation and stabilization of the financial system." But what does it mean to have a national bank, and how does this government agency impact your ability to have a job, earn and borrow money, and afford things like groceries, rent, and pet food?
In this episode, we'll explain how the Federal Reserve came to be, how it works, and how the actions the Fed takes influence our economy. Our guest is Louise Sheiner, policy director at the Brookings Institution's Hutchins Center on Fiscal and Monetary Policy. She spoke with Civics 101 in 2017.
Want to learn more about the financial crisis of 2008? Here's some of our favorite resources:
PBS has a list of documentaries about the crisis. Christina loved "Inside the Meltdown" from Frontline.
"The Giant Pool of Money," from This American Life explores the housing crisis.
Marketplace has a series of reports on the Great Recession, including its continuing impacts on today's economy.
Federal Reserve
Christina Phillips: [00:00:00] You know how money works, but like, do you really know how money works? You know what I mean?
News Clip: [00:00:05] From the opening bell, investors were sounding the alarm. A massive stock
News Clip: [00:00:09] Sell that wild ride on Wall Street, the worst day in more than four years. Half of all
News Clip: [00:00:14] Grocery items rose six points to be
News Clip: [00:00:17] The most serious recession in decades. And that means life, as most Americans know it is about to change.
Christina Phillips: [00:00:23] You're listening to Civics 101, and today we're talking about the Federal Reserve.
Nick Capodice: [00:00:27] And listeners, this is Christina Phillips. She's our senior producer.
Christina Phillips: [00:00:31] Nick, have you ever listened to a speech by the chair of the Federal Reserve?
Nick Capodice: [00:00:34] No, absolutely. Absolutely not. Never in a thousand years would I do that on a night off.
Christina Phillips: [00:00:39] All right, so I did used to listen to the Federal Reserve's speeches, because in a former job when I was in news, I would cover the economy as part of my beat. And so I actually want to play you a quick clip of our current Federal Reserve Chair, Jerome Powell, back in 2019. So tell me what you think.
Jerome Powell: [00:00:55] Its 11th year, however, inflation has been running below the FOMC symmetric two percent objective, and crosscurrents such as trade tensions and concerns about global growth have been weighing on economic strength.
Nick Capodice: [00:01:08] Christina, I'm glad I have not spent any of my nights listening to Chair of the Fed Reserve talking.
Christina Phillips: [00:01:13] Yeah, I feel like, you know, I've listened to at least a dozen speeches by Jerome Powell over the years, and they're all like this. There's this language that is very difficult to understand.
Nick Capodice: [00:01:24] Yeah, and that ticks me off because at the end of the day, words like policies and growth indicators and inflation and market volatility, they're relevant to our lives. They flow down to you and me. So I'm very excited because a lot of this goes over my head most of the time to learn about the Fed. What is the Federal Reserve?
Christina Phillips: [00:01:42] Before we get into the big stuff, I want to spend a little time going over a few economic terms that we're going to hear over and over because they're super important to have. The Fed does its job. I'm calling this the Federal Reserve warm up, so I'm going to get a little warm up music going. The first word is interest. Interest is the cost of borrowing money, and it's how banks work as businesses. When you take out a loan, you're charged a percentage of the money that you owe. And that works in reverse. So if you have a savings account, for example, often if you put money into the savings account, if you're putting money into the bank, the bank will pay you interest.
Nick Capodice: [00:02:17] Ok, so if you open a savings account with a one percent annual interest rate and you put one hundred bucks in it at the end of 12 months, you have one hundred and one dollars.
Christina Phillips: [00:02:27] Yes, exactly. And the next word is inflation. Prices are going up. If you want to think of that another way, the value of money is going down. Things feel more expensive.
Nick Capodice: [00:02:40] It costs more money to get the same amount of groceries. Or you could sell the house you bought five years ago for $50000 more than you paid for it.
Christina Phillips: [00:02:48] Right. And I've got one more term before we get into the Federal Reserve, the unemployment rate. Now this is the percentage of the workforce or people who could be working, who aren't for any number of reasons.
Nick Capodice: [00:03:00] Ok, so it's not just all the people who don't have jobs compared against the whole population.
Christina Phillips: [00:03:05] Yeah, yeah. It's just how many people could be working who aren't. Another important thing is that unemployment rate and inflation are very closely linked, which we'll talk more about later. So that's the end of our warm up. It's time to get into the Federal Reserve.
Nick Capodice: [00:03:19] I know that the Federal Reserve is our central bank, but what is central bank mean?
Christina Phillips: [00:03:25] A central bank is set up by a government to oversee all other banking. It manages how much money is in circulation and regulates what banks can do with that money and how a central bank works in any given country is unique to that government.
Nick Capodice: [00:03:40] So we've done a lot of episodes on the founding documents, and one thing I know about our founders and the framers of the Constitution was a huge fear of giving the government too much power. No tyrants right. So how do we end up with the central bank that gives the government power over our economy?
Christina Phillips: [00:03:57] I've got some help breaking this down thanks to Louise Sheiner. She's the policy director at the Hutchins Center for Fiscal and Monetary Policy at the Brookings Institution, and before that, she worked as an economist with Federal Reserve.
Louise Sheiner: [00:04:09] So for a long time, there was no central bank in the United States. And you come to the early 1900s and the banking system was just extremely dysfunctional and it was wholly unsuited to the needs of the U.S. economy, which by then had been industrialized and quite sophisticated.
Nick Capodice: [00:04:24] Oh, so you haven't always had a central bank?
Christina Phillips: [00:04:26] Yeah. What you said earlier about the founding of the United States. Alexander Hamilton was the first to try to give the U.S. a central banking system an effort which got him a lot of opposition and ultimately failed. But a century or so later, industrialization transformed the economy
Louise Sheiner: [00:04:41] And without a national banking system, without a central bank, you had problems like there would be cash shortages in one part of the country and leading to bank runs and spikes in interest rates and recessions. And these happen quite frequently. Some type of central bank was needed to manage the peaks and valleys of the economy and to smooth out. Developments in different areas of the economy, and so the result was the Federal Reserve Act of 1913, which established the Federal Reserve System.
Nick Capodice: [00:05:08] How did they do that without giving too much power to the federal government?
Louise Sheiner: [00:05:12] Yes. So in order to get the political support for the central bank, there were a lot of compromises that were made and those compromises actually are still reflected in the organization of the Fed today. So in particular, the Federal Reserve is not this strong federal central bank. It is actually called the Federal Reserve System, and it consists of different parts. One is the board of Governors and that's located in Washington, and the members of the Board of Governors are appointed by the president. Members of the Board of Governors are appointed for staggered 14 year terms and the board chair is appointed for a four year term. Unlike other executive agencies, a new president or a new Congress cannot come in and just change the membership of the Fed.
Christina Phillips: [00:05:53] This board of Governors is made up of seven people who ideally have a diversity of experience in finance, industry and commerce and aren't all appointed by the same president. As far as the board chair, you can think of that person as the face of the Federal Reserve. This is who you'll see giving speeches and interviews.
Jerome Powell: [00:06:12] The current economic situation and outlook before turning to monetary policy.
Christina Phillips: [00:06:16] Jerome Powell is our current board chair. He was appointed first in 2018 and then again in 2022. But the Federal Reserve isn't just these board of governors. There's more.
Louise Sheiner: [00:06:26] It also has 12 regional Federal Reserve banks, which are scattered across the country and who have presidents that are appointed not by Washington, but by bankers and private citizens.
Nick Capodice: [00:06:37] And what are those regional banks do?
Christina Phillips: [00:06:39] These regional reserve banks are doing the everyday business of banking on behalf of the Federal Reserve. They're the ones making the sausage. Basically, they're the direct link to the private sector. So private banks that you and I use are overseen by a regional Reserve Bank, and they borrow and lend from it. For us in New Hampshire, that's the Reserve Bank in Boston. These reserve banks are also the Fed's experts on the economics of that region, so the Fed always has a sense of what's going on in different parts of the country.
Louise Sheiner: [00:07:07] So the system was created to balance all the competing worries and interests. Some Partisan the federal government in Washington, some part is controlled by government, some part is controlled by private citizens and bankers. And there's also regional coverage so that the interests of different people in different areas of the country are represented.
Nick Capodice: [00:07:25] So we've been talking a lot about banking and bankers so far. I would like to know when does the public start to come in? How does the Federal Reserve work in our interest?
Louise Sheiner: [00:07:34] The Fed is an independent agency, but it is accountable. It is part of government, so it is accountable to Congress and to the American people. So it is overseen by Congress, but it is independent in a way that many other agencies are not.
Christina Phillips: [00:07:50] The Federal Reserve is not funded by the budgeting process in Congress.
Louise Sheiner: [00:07:54] It's funded actually by the lending that it does. It lends money to banks and banks pay its interest, and from that interest, it funds itself. And then what they don't use to fund itself goes back to the Treasury. So although there is congressional oversight, they can't control the Fed by determining its budget. So the Fed has a lot more independence than other agencies.
Nick Capodice: [00:08:12] So politicians who might hate the idea of a central bank, they can't use their ability to just slash funding to reduce its power. Right. But earlier, Louise said that Congress did have oversight. So what does that mean?
Christina Phillips: [00:08:25] Congress gives the Federal Reserve a mandate to keep our economy healthy.
Louise Sheiner: [00:08:29] So formally, the mandate calls for maximum employment and stable prices. But it's interpreted as basically saying we shouldn't have inflation too high and we shouldn't have unemployment too high either. But then it's left to the technical experts at the Fed to figure out how best to do that. So it has both the technical expertise to figure out how to do that. You know, the Fed employs many, many PhD economists and also tries to insulate it from political pressure that would make it try to do things in the short run that might not be in the long run interest of the economy.
Nick Capodice: [00:09:05] Ok, so we've come back to inflation and unemployment.
Christina Phillips: [00:09:08] It's almost like I planned it that way.
Nick Capodice: [00:09:10] How does the Fed affect inflation and unemployment?
Christina Phillips: [00:09:14] Two ways. The first is monetary policy. The second is regulation and stabilization. And if you're wondering what I mean, when I say monetary policy and regulation and stabilization, rest assured we are going to define what those things mean and what they actually look like in practice right after the break.
Nick Capodice: [00:09:33] Before we continue as we are talking an awful lot about money today. I want to say that Civics 101 is always going to be free, but it can't be that way without your support. Head over to our website civics101podcast.org and help us out in any way you can. It means the world to us.
Nick Capodice: [00:09:57] Christina, you've told me about how the Federal Reserve is created and what it is now, can you tell me what it does?
Christina Phillips: [00:10:04] Yeah, and we're going to break that down into two parts. The monetary policy part and what I'm calling the responsible adult part.
Nick Capodice: [00:10:12] What is the responsible adult part?
Christina Phillips: [00:10:15] That's the regulation and stabilization part. Basically, the Federal Reserve is trying to keep financial institutions and people from playing too closely with fire. And then if things go wrong, how the Fed comes charging in with the fire extinguisher. Let's start with monetary policy,
Louise Sheiner: [00:10:31] Meaning that it uses its capacity to affect interest rates and the money supply to try to fulfill its mandate, which is to keep both inflation and unemployment low.
Christina Phillips: [00:10:42] That's Louise Sheiner, policy director at the Brookings Institution's Hutchins Center on Fiscal and Monetary Policy. She spoke with Civics 101 back in 2017. As I said earlier, inflation and unemployment are connected to each other and in a healthy economy, neither is changing too quickly. It's sort of like Goldilocks. The Fed wants to keep the economy not too hot, not too cold. Just right. Which, by the way, in the 1990s, there was a period of time called the Goldilocks economy.
Nick Capodice: [00:11:09] Wow. Really?
Christina Phillips: [00:11:11] Yeah, it was like everybody was like, OK, things are cool. Everything is good.
Nick Capodice: [00:11:16] Why don't we want the economy to change too quickly?
Christina Phillips: [00:11:20] So economists often use this metaphor of a playground swing, and it's the perfect metaphor. So I'm going to use it now. All right, I'm with you. You know how when you get on a swing, the further you swing forwards, the further you swing backwards?
Nick Capodice: [00:11:34] Oh yeah, yeah, yeah. Yeah, yeah, absolutely. Yeah. That's how they work. That's how swings work.
Christina Phillips: [00:11:43] So when a swing goes forwards, that momentum carries it backwards and an economy, if it's like a swing, if it swings really far in one direction, it's going to go really far in the other direction and it's really difficult to stop. The Federal Reserve doesn't want that. Small swings are easy to control. Those big swings are how we end up with economic crises, right?
Nick Capodice: [00:12:05] Like a recession?
Christina Phillips: [00:12:06] Yeah, exactly. If you've ever heard an economist say the economy is contracting, that's basically a slowdown of growth. That's the swing going backwards. A recession is a significant contraction that lasts over months, and now a depression is a more severe contraction that lasts years. Both of these mean that it gets harder and harder for people to afford things. Businesses can't make the money they need. People get laid off. Companies may fail and people are just struggling to afford their everyday expenses.
Nick Capodice: [00:12:37] So what is that just right perfect bowl of economy porridge?
Christina Phillips: [00:12:42] I'm sure that many people would argue that there's no like, perfect just right. But we do have some, some markers that we can go by. And if we start with inflation, which is the rate that the value of money is decreasing over time, some inflation is actually healthy.
Louise Sheiner: [00:12:55] The Fed has to be constantly monitoring the state of the economy to decide whether it's getting too strong, meaning that inflation is going to be right around the corner or too weak, meaning that employment is going to increase.
Nick Capodice: [00:13:06] So let's say the Fed starts to notice that inflation is going up pretty quickly. What can it do?
Christina Phillips: [00:13:12] Nick, we've arrived at interest rates. Remember how we talked about banks making money by charging interest when they lend money? Yes. Well, one thing the Federal Reserve does that other banks can't do is that it sets a federal interest rate. It has the power to say this is the interest rate that banks charge one another for lending interbank loans, so it serves as a baseline. If the federal interest rate goes up or down, it's likely that the interest rates that banks charge you or me will also follow suit.
Nick Capodice: [00:13:41] All right. So if I went out and got a loan for a car tomorrow, that interest rate a bank charges me is going to be affected by the interest rate the Federal Reserve has set.
Christina Phillips: [00:13:50] Exactly. The Federal Reserve meets eight times a year to decide if the rate should go up or down or if it's just right.
Louise Sheiner: [00:13:58] So when the Fed changes interest rates, it can change how fast the economy is growing
News Clip: [00:14:04] To hike? Or not to hike. That is the question.
Christina Phillips: [00:14:11] So you asked what the Fed can do if inflation starts going up too quickly? If inflation is going up, the economy is getting too hot. The Fed might increase that federal interest rate.
Louise Sheiner: [00:14:20] So when it raises interest rates, borrowing becomes more expensive, so people will cut back on new home purchases, credit card borrowing or other types of spending. And that can keep the economy from getting out of whack, growing too fast and causing inflation. On the other hand, when the economy is weak or is in a recession, the Fed can lower interest rates to try to help spur investment and increase spending and get the economy out of its bad situation and lower unemployment.
Christina Phillips: [00:14:48] And that, my friend, is the very basic rundown of monetary policy.
Nick Capodice: [00:14:52] This is something I never thought I would understand, but I think I get it. For the first time in my life, I do I do get it.
Christina Phillips: [00:15:00] Phew.
Nick Capodice: [00:15:00] I want to go back to this responsible adult thing. You mentioned the regulation and stabilization side of the Federal Reserve. What's that about?
Louise Sheiner: [00:15:09] The Fed has a very important role in regulating banks and also just in promoting the stability of the financial system as a whole. So it kind of does this in two ways. One, it makes sure that the banks under its supervision, which are most large banks, are in good financial shape and aren't taking on too much risk. So that's kind of like trying to prevent a financial crisis from happening.
Nick Capodice: [00:15:31] These crises have happened or been very close to happening several times during my life.
Christina Phillips: [00:15:35] Yeah. And if they do, for whatever reason, the economy begins to slide into a recession. For example, the Federal Reserve does have tools to respond, and it just so happens that we have a recent example of this type of response that we can talk through. So you can see exactly what that looks like.
Nick Capodice: [00:15:54] Are you talking about the 2008 financial crisis?
Christina Phillips: [00:15:56] Oh, you know, I am.
News Clip: [00:15:57] Wall Street veterans call it the worst financial crisis of their lifetime. For traders here working, the phones say a lot of their customers are freaked out waiting.
News Clip: [00:16:06] The financial markets from Asia to Europe are doing their utmost to prevent Monday from turning from dark to black.
Christina Phillips: [00:16:15] Just a caveat here. This is a complicated crisis that I'm going to try to boil down in a way that helps us understand the role of the Federal Reserve. But there are lots of sources about this crisis and the Fed's response that you can look at if you want more information, and we'll link to those in our show notes and at civics101podcast.org. So in the years leading up to 2008, there was a lot of risky investing that was happening largely outside of these regulations set by the Fed, meaning investors were making lending decisions that were higher risk. They could make a lot of money or they could lose a lot of money, and that risk flowed down to borrowers like you and me. A lot of this played out in the housing market, where lenders made it really easy to get mortgages and people bet on the value of their homes going up right.
Nick Capodice: [00:16:59] Maybe your mortgage has a really high interest rate, but if your house is going to be worth a lot more than you paid for, you'll make that sum up when you sell it.
Christina Phillips: [00:17:06] And for a lot of reasons, that bubble eventually burst. The value of homes plummeted. People who borrowed money with that expectation that their home's value would go up couldn't afford payments on houses that were no longer even worth what they paid for them.
News Clip: [00:17:20] Who are watching us from the last home you'll ever own tonight. Consider yourself lucky. Same goes for anyone ready to buy a slice of the American dream. But if you're among the millions trying to sell, this was a very bad day.
Christina Phillips: [00:17:32] For financial institutions that had been engaging in risky investing, couldn't support themselves. They were overleveraged and they started to collapse.
News Clip: [00:17:40] Major American investment bank in trouble, running out of money, perhaps on the verge of going out of business.
Louise Sheiner: [00:17:46] There's some still do some dispute in the economics literature about whether the Fed should have eased earlier. It's clear that the Fed did not see what was coming. And you know what I'll say I was at the Fed at the time is, you know, neither did the rest of the economics profession. So I don't know if this is a knock on the Fed or a knock on the economics profession or in some sense, maybe neither. It may be just these things are very difficult to know. I think most economists agree that if the Fed hadn't acted the way it did in the recession, the recession would have lasted much longer and would have been even worse than it was.
Nick Capodice: [00:18:21] And what did the Federal Reserve do?
Christina Phillips: [00:18:22] As Louise said, there was a lot of debate about what could have been done, maybe to prevent this crisis. And there's also criticism of how the Federal Reserve did respond, but to help us understand what the Federal Reserve can do to stabilize an economy that's in crisis. I want to go through the actions that it did take.
Louise Sheiner: [00:18:39] So one of the things it did was do what it normally does, which is to adjust monetary policy to try to stimulate the economy. And the Fed lowered interest rates from five and a quarter percent in September 2007 to near zero and kept them there for about nine years.
Christina Phillips: [00:18:54] But that couldn't mitigate the crisis on its own. It had to do something more. So the next thing it did was keep a couple of these giant banks from failing.
Louise Sheiner: [00:19:03] It made loans to help prevent the collapse of two very important firms Bear Stearns and AIG.
News Clip: [00:19:09] The New York Fed and JPMorgan Chase have agreed to provide an unspecified amount of secured funding to Bear Stearns for up to twenty eight days. The Fed will provide non-recourse back to back financing to JP Morgan
Louise Sheiner: [00:19:22] Chase because it believed that if these firms collapse, it could greatly increase the financial panic and really damage the economy.
Nick Capodice: [00:19:30] Right. This is the expression we've heard quite a bit when it comes to the recession too big to fail.
Louise Sheiner: [00:19:34] So as bad as a recession was, and it was bad without the Fed intervening, a lot of people think it would have been another Great Depression. The Fed also created a bunch of new lending programs that would make loans to banks and other bank like institutions. And that was really to fulfill its role of lender of last resort and to pretty much say, Look, there doesn't need to be a panic. We are here to lend money if you need it and to basically calm the markets and prevent the system from kind of going into sort of chaos.
Christina Phillips: [00:20:04] It's also important to mention that Congress passed emergency legislation called the Troubled Asset Relief Program that set up systems through government financial agencies like the Treasury to give banks, businesses and millions of Americans a way to get out of that financial hole.
Nick Capodice: [00:20:19] As we are doing this episode spring of 2022. I kind of have the feeling that we are on the brink of another financial crisis. Inflation has gone up massively in the last few months.
Christina Phillips: [00:20:29] Yeah, it's important to remember that at any time in the economy, what's going on is unique to that moment. So what's happening now may look like something we've seen before, but it's not the same. And also what happened in 2008 is still contributing to some of the things we're seeing now, like rising inflation. But on top of that, we've got events like the pandemic and global conflict. They're all contributing to it as well. And the Federal Reserve will continue to use its tools, monetary policy, regulation and stabilization to adapt to the economy of right now to strive to meet that mandate by Congress. Low inflation and low unemployment. Back in Twenty Seventeen, Louise spoke about the future of the Federal Reserve, and I think her feeling is still pretty relevant now.
Louise Sheiner: [00:21:21] The reason the Fed is an independent agency in the sense that I already described is that there is a view that independence is very important for central banks, that it is important that monetary policy decisions not be subject to political, short term political considerations. I think, you know, I'm hoping that the Fed has a very healthy long term outlook. It has weathered political storms in the past, right from the beginning. It's always been an institution that is not typically all that popular and it manages to survive, and I hope it still does.