Wharton’s Christina Parajon Skinner demystifies the Federal Reserve, one of the most influential and important institutions in the global economy. This episode is part of a series on “The Economy & You.”


What Does the Federal Reserve System Do?

Dan Loney: We talk about the Federal Reserve almost daily right now because of everything that’s going on with the economy. But for those who don’t follow it as closely, what does the Fed do?

Christina Parajon Skinner: I think this is such a great and important question. In my own research, I strive toward the goal of having everyday people understand what is the central bank and what it does, especially now when we’ve had a surge of inflation and people generally know that the Fed has grown a larger footprint in the financial markets. People are starting to pay attention and really get interested from a lay perspective. Before I really answer your question directly, I want to take a step back and make two things a little bit clearer for our listeners and viewers.

The first point is that the Fed actually shouldn’t be doing that much at all, on an everyday basis. The Fed’s main job is to keep the economy and the financial system on an even keel. So, the central bank shouldn’t be trying to micromanage the economy. But the second point here is also notable, that the Fed doesn’t have a direct relationship with people at all. It doesn’t lend directly to households. It doesn’t have bank accounts for them. The Fed is working through the banking system and the financial markets.

With all that being said, Fed policy does ultimately touch people’s everyday lives in some pretty profound ways. I’m going to give you the two most significant or big picture ways that Fed policy touches our everyday lives. Congress gave the Fed the job of pursuing price stability. That means watching out for inflation. Inflation is generally very bad for economies. It’s very bad for societies because it’s reducing the purchasing power of money, so it’s undermining our wealth. It’s making people’s real wages lower so that it’s harder for them to pay for goods and services. It’s hard for businesses to plan. This really drags the economy down.

This means that when we see a surge of inflation above the Fed’s 2% target, it’s going to do things like raise interest rates to try to cool the economy down. And when the central bank raises interest rates, that profoundly impacts people’s lives and their cost of credit for things like mortgages and cars and credit cards.

The second thing to note in terms of how Fed policy affects people’s everyday lives is that the Fed really takes its job seriously of stepping in during economic shocks to provide liquidity for the financial system. This really matters for everyday people because if the financial system freezes up, this severely impacts the rest of the economy, trickles down to households and businesses.

For example, lots of companies use a form of short-term debt called commercial paper to finance their operational needs like payroll. If you’ve got money market funds that stop buying commercial paper because they’re in distress, this means they’re effectively ceasing to lend to those small, medium, large businesses. And the Fed doesn’t want that to happen. It doesn’t want banks to stop lending to people and businesses. So, it really focuses on making sure that credit can remain the lifeblood of the economy. In a nutshell, it doesn’t do things directly for people, but it works through banks and the financial system to try and keep price levels stable, keep the financial system stable. And that’s how it helps us on an everyday basis.

Loney: It sounds like it’s not an exact science. The term “transitory” was used when inflation was first coming up, and as we’ve seen, it really hasn’t been transitory. In fact, it’s been quite the challenge for the Fed to try to bring inflation down over the last year and a half.

Parajon Skinner: Absolutely. It would be nice if it were a science. But like so much of public policy, combatting inflation, thinking about inflation targeting, it involves a healthy dose of human judgment, and sometimes it requires a lot of plain old common sense.

Interestingly, transitory became almost a dirty word in the past few months because it was the rationale that slowed the Fed down in responding to inflation. The idea was that inflation would pass us by, would quickly dissipate, because most of the inflationary surge was due to Covid-related things like supply chain bottlenecks, spikes in energy pricing. On the basis of that rationale, the Fed – and all the other leading central banks — waited too long to start raising interest rates and/or slowing down the pace at which they were buying bonds in their program of quantitative easing.

Because the Fed was using macroeconomic models and forecasting that said inflation would basically go away on its own, the Fed waited too long. But we now know that there are some demand-side aspects to the inflation that largely have to do with a very rapid and significant increase in the money supply that came from fiscal stimulus in Congress. And the Fed tools can be used to do something about that demand side of inflation.

Loney: Monetary policy is truly one of the key components that the Fed has to focus on daily.

Parajon Skinner: Absolutely. When people tend to think about central banks, they generally think about monetary policy and inflation. Now, to dig in a little bit deeper, giving a little bit more context and nuance here, the Fed has a dual mandate as part of its price stability. It has responsibility, as Congress has drafted the Federal Reserve Act, both for price stability and maximum employment. That’s interesting because most other central banks don’t have this two-legged mandate, where they have to look out for both price stability and unemployment. However, the course of history has taught us that we really can’t have maximum employment if we don’t have price stability. So, the Fed tends to think first about how it can keep inflation steady, at that 2% target, and then other ways that it can address the employment side of its mandate.

Within this umbrella of monetary policy, the Fed has a couple of different tools. I mentioned some of them already. It thinks about setting interest rates, not just to deal with inflation, but in the ordinary course of things. The Federal Open Market Committee will meet and decide what interest rates should be. It’s important to note here that, going back to my earlier remarks, the Fed isn’t directly setting market interest rates that people see when they’re applying for a mortgage or a car loan. But the Fed does set the interest that it pays on bank reserves, which then influences the market rates, and tends to mirror that rate pretty closely.

The Fed also does things like buys bond. It buys government securities, treasuries, in the open market. And it usually does this in the context of quantitative easing. It buys a bunch of bonds to try to stimulate the economy if it needs to when lowering interest rates is no longer sufficient to juice the economy. It also does some other more complicated and nuanced things. For example, it will lend to banks through the discount window in normal times. It will lend to banks and other kinds of financial institutions or companies in an emergency context. And through something called the Overnight Reverse Repurchase Agreement Facility, it will also effectively lend to other kinds of institutions, like money market funds, in a way that mirrors lending to the discount window.

This is pretty much all the stuff that the Fed does under its monetary policy umbrella. It’s all geared toward that monetary policy mandate, which is price stability, which the Fed has defined as inflation at an average of 2 percent — and maximum employment.

How Does the Federal Reserve Work With Other Entities, Like Congress?

Loney: Part of what we have been talking about in recent months in regard to the Fed also ties back into what we’ve seen with some of the issues within the banking sector, with Silicon Valley Bank and the like.

Parajon Skinner: Absolutely. In the 2010 Dodd-Frank Act, Congress was essentially responding to the global financial crisis. The Fed gained much more supervisory and regulatory authority over systemically important financial institutions. These are financial holding companies — think Citigroup — and also other non-banks that the Financial Stability Oversight Council might designate as systemically important.

The point here is that the Fed is now also a regulator and a supervisor for really large financial holding companies. This is a completely separate function that it has from its monetary policy mandate. The case of Silicon Valley Bank was really interesting and challenging for the Fed, because in that incident you saw the Fed’s monetary policy mandate for price stability, conflicting with its responsibility to be a supervisor of the banking system, to maintain and procure financial stability.

Why is that? The rise in inflation required that the Fed raise interest rates quite rapidly and quite steeply, which is what it had been doing for the past 18 months. There’s a famous saying when the Fed raises rates, “When you slam on the brakes, someone’s going to go through the windshield. We just don’t know who.” That’s referring to the fact that something’s going to break in the financial system, causing financial instability.

In a nutshell, raising interest rates was part of the reason why this interest rate risk materialized for Silicon Valley Bank in a way that they had improperly managed, causing that bank’s failure and some bumps in the rest of the banking system. You saw this clash between the Fed wanting to maintain financial stability and needing to ensure price stability. That’s something new that the Fed has to wrestle with since this 2010 piece of legislation that basically said to the Fed, “You’re responsibility for financial stability, for making sure that the banking sector is stable. But also, we still need you to make sure we don’t have inflation.”

Loney: What about the relationship between the Federal Reserve and Congress?

Parajon Skinner: That’s a great question. Central banks are supposed to be independent, right? We learned this lesson a couple of decades ago. Independence is really a nuanced thing when you’re talking about a central bank because independence doesn’t mean not accountable. The Fed has a sometimes tricky relationship between its boss, which is Congress on the one hand, and the executive branch. When we tend to refer to the central bank, we say it’s independent from the executive branch. It’s not supposed to take instructions or pressure from the President, who has short-term political goals. And it’s not really supposed to take political instruction from Congress, ideally.

But at the same time, Congress created the Federal Reserve, and the Fed is an agent of Congress, so the Fed has to be accountable to Congress. Congress exercises oversight over the Fed. But just like we don’t want the executive branch giving the Fed political jobs to do — finance the transition to a green economy. Finance a wall on the border. Those are partisan issues that we prefer to keep the central bank out of, as a technocratic economy policymaker. So, its relationship with Congress is kind of a dance. It has to answer to Congress, and Congress could technically ask it to do any range of things. But historically, Congress has sort of said, “These are your responsibilities. Price stability, and employment, and financial stability.” The Fed has to stay in that lane that Congress has set for it while trying to navigate the political issues that get put on its plate from time to time.

Loney: What about the relationship between the Federal Reserve Bank and the regional Federal Reserves. We have one here in Philadelphia.

Parajon Skinner: I think it’s an aspect of our central bank that a lot of people overlook, yet it’s incredibly distinctive. Our central bank has this federalist structure, which mirrors the federalist structure of our country. The Fed Board in Washington is a government agency. It sets policy. Jay Powell, the chair of the Fed Board, is the one testifying before Congress.

Then there are these 12 regional reserve banks that have this interesting public-private structure. They are located in regions all across the country, and they have a board of directors appointed by their private member banks. The banks in the region of the reserve bank are members of that reserve bank. In that sense, it has a private element. At the same, it’s carrying out these public policy goals — it is supposed to be responsive to the board of governors. The way to think about it, the board of governors is setting the policy, but those reserve banks are operationalizing policy. You’ve got the New York Fed doing open market operations pursuant to instructions from the board of governors. And you have the regional reserve banks supervising banks in their district on a day-to-day basis, even though the board of governors is setting the overarching supervisory policy.

This quirk of history, that the reserve banks are public policy organizations but have this private board of governors, come up from time to time, and people wonder whether we should revisit that structure. I’m not one of those people, but it’s worth noting that the debate is out there, because we are one of the only central banks that has this unique public-private element. For example, it became a live issue again in the context of Silicon Valley Bank. When people start asking questions about, what was the regional Federal Reserve Bank of San Francisco doing in not pushing harder on SVB to deal with some of its unrealized losses, some of its unhedged interest rate risk. So, it’s an interesting quirk of our central bank, which I tend to think makes it stronger, because you have this diverse set of viewpoints coming in from all over the country, feeding into the board of governors.

The last point I should mention about our structure is that the Federal Open Market Committee, which is the organ of the Fed that is setting interest rate policy, draws on the expertise and the knowledge of the regional reserve bank presidents. And several of the presidents will sit on the FOMC on a rotating basis.

What Are Some Major Concerns for the Federal Reserve Moving Forward?

Loney: The Fed also has to adjust to the changes in our economic structure, like cryptocurrency.

Parajon Skinner: Absolutely. Like so many hot topics in our economy right now, the Fed hasn’t escaped this one either. It’s front and center in the cryptocurrency debate. It really is a debate right now, both in terms of how to regulate and construct a legal framework around the various forms of cryptocurrencies and crypto assets, and specifically what the central bank should do in its corner of the regulatory universe.

There are two issues in particular that are live for the Fed. The first is what to do about stable coins. I don’t mean whether to classify them as a security or a commodity. That’s a separate debate. The debate that’s relevant for the central bank is whether it should provide access to accounts at those regional Federal Reserve banks for stable coin issuers. The reason why this matters is because from a payments system perspective, no payment is final until it’s settled in central bank reserves, in central bank money. Settlement has to happen on the ledger of the central bank before any payment transaction is final.

If you aren’t a bank or another financial institution that has an account at the Federal Reserve, then you can’t engage in payment settlement finality yourself. You have to go through another intermediary. That’s an inefficiency for a stable coin issuer. There’s a debate right now about whether the Fed should open up access to these stable coin issuers, bring them into the fold alongside the banks, let them engage in payments work. And the question the Fed is still trying to figure out is, is doing so going to be net beneficial for the economy? Is it going to increase financial stability risk or not? Is it going to increase payment efficiency or not? And how to weigh those costs and benefits.

The other crypto issue that’s live for the Fed right now is one that’s relevant for almost all central banks around the world, which is whether the Fed should create something called a central bank digital currency, referred to as a CBDC. A CBDC would be similar to a stable coin except it would be a sovereign form of money. You could think of it in very simplified terms like digital cash, although it’s not completely similar. But the idea is, should the government create something that is a digital dollar? And that’s not the Fed’s decision to make. That’s Congress’ decision to make. But the Fed can’t avoid thinking about the issue, having an opinion on the issue, being aware of the fact that other central banks around the world are advanced in developing a central bank digital currency.

Loney: It seems like the Federal Reserve gets more attention now than ever before.

Parajon Skinner: I think that’s absolutely the case for a number of factors. It’s the fact that we’re having inflation for the first time since the ‘70s. It’s the fact that the Fed is an incredibly effective and powerful institution, so people will naturally look to it to do things that they want governments to do, whether or not that is within the Fed’s statutory mandate. And because our financial system is really large and complex, and the Fed has become a counterparty to so many institutions.