One of the most common misconceptions about money is that the Federal Reserve (or Fed) “sets” interest rates. In reality, the Fed has a dual mandate to keep inflation in check while maintaining a strong labor market. It has numerous mechanisms to handle this task, though we tend to focus on how it influences interest rates.

While you don’t need to understand the intricacies of the Fed to build wealth, knowing how things work behind the scenes can help you make sense of the headlines, speculation, and market moves surrounding the central bank.

What is the Federal Reserve?

The Federal Reserve is the U.S. central bank, run by a Board of Governors. This board is made up of presidential appointees who serve 14-year terms. Jerome Powell is the current Chairman.

The Federal Reserve system also includes 12 regional banks. For instance, the Federal Reserve Bank of New York (NY Fed) serves Wall Street, and you may remember seeing headlines about its chairman, Tim Geithner, during the Financial Crisis.

Five regional bank presidents join the seven board governors to form the Federal Open Market Committee, or FOMC. The FOMC is key to any conversation on interest rates.

How the Fed influences monetary policy

The Fed has three primary ways in which it influences monetary policy:

Funds rate

The federal funds rate refers to the interest rate at which banks, credit unions, savings institutions, and government-sponsored entities can borrow and lend money to one another overnight. The Fed simply sets the target for these rates; it’s ultimately up to the banks to comply. (This is why we say the Fed affects interest rates or raises/lowers its target rate. It’s incorrect to simply say the Fed sets interest rates.)

The FOMC holds eight meetings a year to decide on a target rate. You may see these meetings summarized by Chairman Powell during press conferences, but he doesn’t act alone. The FOMC spends its meetings discussing current economic conditions, how the economy is likely to evolve moving forward, and potential changes to monetary policy.

The Committee releases its minutes a month after the meeting takes place, and many analysts and economists scrutinize the language for clues about where rates are headed.

Discount rate

Occasionally, banks need to borrow money directly from the Federal Reserve for up to 90 days. They do this when it’s hard to borrow on the open market; during periods of uncertainty many financial institutions prefer to keep capital on hand to help manage risk.

For instance, bank’s restricted lending following 9/11, the Financial Crisis, or the collapse of the Silicon Valley Bank (SVB). Firms that needed money may have turned to the Fed’s “discount window.”

The Fed’s Board of Governor’s determines the discount rate, or the interest charged on these loans.

Reserve requirements

One reason banks need to consistently lend money amongst themselves or borrow from the discount window? They must keep a certain amount of cash on hand, or in reserve. In other words, they have a reserve requirement set by the Federal Reserve.

Reserve requirements are a percentage of the deposits made by customers; they must be located physically on site (in vaults) or held at the nearest Federal Reserve bank—one reason the regional Fed branches are so important.

Ultimately, the Fed uses these tools to influence money supply. The higher the reserve requirements, or the rate at which banks borrow money, the less money flows through the system on any given day. The goal is to restrict spending and demand, which should in turn bring prices down and reduce inflation. Lower rates and lower reserve requirements tend to have the opposite effect—but sometimes policies intended to spur growth can trigger inflation.

Still, it’s worth noting that the Federal Reserve doesn’t print money. Critics assert this because the Treasury Department, which prints money, follows the Fed’s guidance. Beyond that, when Treasury issues bonds, it does so at auction, meaning the market ultimately sets the rate. Bond rates are influenced by the funds rate, but cannot be set or predetermined by the Fed.

The dual mandate

Most of the time, politicians and economists talk about the Federal Reserve in the context of interest rates or money supply. However, it can be helpful to take a step back to remember the main objectives of the Federal Reserve.

The Fed has two jobs, or a dual mandate: Keep inflation in check while keeping Americans employed. While the bank monitors, and ultimately hopes to positively influence, the economy and stock market, those objectives are secondary to inflation and jobs.

Which of the two—inflation or jobs—is more important depends on current conditions.

In 2023, the Fed’s primary focus is inflation, which jumped in 2021. Initially, the Fed thought inflation was a temporary response to COVID-19 and supply chain disruptions (the word they used was transitory). By 2022, they changed their analysis, and the FOMC started raising the target federal funds rate. There have been 11 rate hikes between March 2022 and July 2023.

While rate hikes have worked well to bring down inflation historically, they can also trigger recession, something the Fed works to avoid.

In 2009, the Fed was focused on the other half of the mandate: jobs. The central bank hoped to spur investment and growth following the financial crisis. It cut the target federal funds rate to zero.

In theory, lower interest rates make it easier for companies to borrow. Those companies can then invest in growth, including hiring new employees. Consumers have more access to money, too, which they can use to buy goods and services, which creates an increase in demand, which in turn creates jobs. Go too far in that direction, however, and you can create inflation.

What indicators does the Fed watch?

While we don’t recommend clients get too caught up in short-term economic or market data, headlines about jobs, inflation, and economic growth are everywhere. To that end, we want to explain which indicators the Fed watches and how we, as advisors, follow along.

First, inflation. While individuals tend to follow the Consumer Price Index (CPI) as a primary economic indicator, the Fed’s main metric is the personal consumption expenditures (PCE), which measures consumer spending.

Still, the Fed doesn’t limit itself to PCE. Chairman Powell notes that the Fed watches multiple metrics when it comes to consumer prices—CPI; the Producer Price Index (PPI), which tracks inflation for businesses; and the University of Michigan’s Inflation Expectation, which measures how much consumers expect prices to change in the future.

When it comes to jobs, the Fed uses monthly Labor Department reports to look at three key factors: the unemployment rate, labor force participation, and the employment-to-population ratio. While the Fed certainly looks at nonfarm payrolls (or the jobs added and lost each month), it’s not listed as a key criterion despite its popularity among media outlets and economists.

The Fed also reports tracking gross domestic product (GDP) and watching asset prices, including stocks, bonds, and various commodities.

The Fed and your portfolio

The Federal Reserve plays a big, albeit indirect, role in the economy and stock market. As a result, Fed decisions will impact your portfolio in the short term. However, we don’t build financial plans or portfolios for the short term. Our goal is to create a holistic plan that sets you up for long-term success.

While we monitor the Fed, as well as key economic indicators, when it comes to building and adjusting client portfolios, our discussions with you are more likely to focus on your personal circumstances. Still, if you have questions about the Federal Reserve, interest rates, or how any of this impacts your personal finances, schedule a call with our team.


Read more:

What is the yield curve (and why does it matter)?

Inflation risk: What it is and why it matters

Are we headed to a recession?