The Federal Reserve is the central bank of the United States. It was created by Congress in 1913 in response to a series of financial panics that had repeatedly destabilized the American economy. Its job, broadly, is to keep the financial system stable and the economy running without either overheating into inflation or stalling into recession. It does this primarily by influencing the cost of borrowing money.
The Fed is not a government agency and not a private bank. It occupies a deliberately awkward middle ground: a quasi-governmental institution that is independent from day-to-day political pressure but ultimately accountable to Congress. The chair is appointed by the president and confirmed by the Senate, but once in office, the Fed makes its policy decisions without requiring approval from anyone in the executive branch.
The Dual Mandate
Congress gave the Federal Reserve two objectives: maximum employment and stable prices. These goals are often in tension. A very strong job market can push wages up and fuel inflation. Fighting inflation by raising interest rates can cool job growth and tip the economy into recession.
The Fed is constantly calibrating between these two goals. When inflation is the primary concern, it raises rates. When unemployment is the primary concern, it lowers them. Most of modern monetary policy is the management of that trade-off.
The Fed's informal inflation target is two percent per year. Not zero. A small amount of inflation is considered healthy because it encourages spending and investment rather than hoarding cash. Deflation — falling prices — sounds good but can be economically catastrophic, since people delay purchases expecting prices to fall further, which causes the economy to seize up.
The Federal Funds Rate
The Fed's main policy tool is the federal funds rate — the interest rate at which banks lend money to each other overnight. Banks are required to keep a certain amount of reserves. Sometimes they have too much; sometimes too little. They lend excess reserves to each other to balance out. The rate they charge for those loans is the federal funds rate.
The Fed doesn't exactly set this rate. It sets a target range and uses various tools to push the actual market rate toward that target. When it raises rates, borrowing throughout the economy gets more expensive — mortgages, car loans, corporate bonds, credit cards. When it lowers rates, borrowing gets cheaper and spending and investment tend to increase.
This is why mortgage rates move when the Fed acts. The federal funds rate is the foundation on which all other interest rates are built.
Open Market Operations
One of the Fed's primary tools for controlling the federal funds rate is buying and selling U.S. government bonds in the open market. When the Fed buys bonds, it injects money into the banking system, which tends to push rates down. When it sells bonds, it pulls money out, which tends to push rates up.
During the 2008 financial crisis and again in 2020, the Fed expanded this tool dramatically through what it called quantitative easing — purchasing not just short-term government bonds but also longer-term bonds and mortgage-backed securities in massive quantities, to push down long-term interest rates and support the housing market.
The Fed as Lender of Last Resort
One of the Fed's original purposes was to serve as the lender of last resort during financial panics — to provide emergency liquidity to banks facing runs so that a localized crisis doesn't cascade into a systemic collapse. In 2008, this function expanded in ways Congress had not explicitly anticipated, with the Fed providing emergency lending to non-bank financial institutions to prevent broader market seizure.
Whether the Fed should have this much implicit power over the financial system without more democratic oversight is a genuine policy debate. What is not debated is that the function it served in 2008 and 2020 prevented the kind of cascading failures that turned previous financial crises into multi-year depressions.