The Federal Reserve—known as “The Fed”—sets interest rates. But how does it work, and why is the Supreme Court weighing in on the Fed’s independence? Visiting Professor of Economics Mico Loretan spent 13 years as an economist with the Federal Reserve Board in Washington, D.C., including several as a section chief in the Board’s International Finance division, and 12 years at the Swiss National Bank in Zurich. He sheds light on the work of the Fed and why it matters so much to the economy. This interview is edited for length and clarity.
What are the central functions of the Federal Reserve?
The Federal Reserve is the central bank of the U.S. and has five main functions: conducting monetary policy for the country; promoting the stability of the U.S. financial system; promoting the safety and soundness of individual financial institutions; fostering innovation, safety and efficiency in U.S. dollar-based electronic payment systems; and promoting consumer protection and community development.
Why was it established?
Increasingly damaging financial crises in the late 19th and the early 20th centuries led Congress to pass the Federal Reserve Act in 1913, establishing the Federal Reserve System. It made the Fed accountable to Congress, not the executive branch.
The Federal Reserve System consists of a seven-member Board of Governors and 12 Federal Reserve Banks located throughout the country. Both the Board and the Federal Reserve Banks employ economists who support the work of the decision makers.
The governors are nominated by the president and confirmed by the Senate. They are appointed to serve for the unexpired portion of a term that can last up to 14 years. Staggered terms expire every two years.
What is the Federal Open Market Committee that we hear about regularly in the news?
Monetary policy is carried out by the Federal Open Market Committee (FOMC), made up of the seven Fed governors and the 12 Federal Reserve Bank presidents. One of the seven governors—currently Jerome “Jay” Powell—acts as chair of the FOMC. While the FOMC has 19 participants, only 12 (the seven governors and five of the 12 presidents) can vote on monetary policy decisions at any given meeting.
The FOMC meets eight times a year to decide monetary policy. During periods of financial market turmoil, the FOMC can also act outside of scheduled meetings, most recently at the onset of the Covid pandemic.
How are interest rates set?
U.S. law directs the Federal Reserve to keep inflation stable and low and to support full employment. The FOMC’s main policy tool for achieving that is to raise or lower interest rates.
The FOMC only directly controls overnight interest rates, which are the rates that financial institutions charge each other for overnight loans.
However, household and business borrowing and spending decisions are dependent on longer-term instruments, such as mortgages and government and corporate bonds. Thus, the ultimate success of the Fed’s monetary policy is determined largely by how much changes in overnight interest rates influence changes in longer-term interest rates.
To make its overnight rate decisions, the FOMC carries out elaborate economic forecasting exercises. Ultimately, though, it is financial markets that determine the outcome.
Is the Federal Reserve independent?
The Federal Reserve sets its own budget. It also has policymaking independence. It can freely make decisions on interest rates and other monetary policy instruments to achieve its mandate without needing to obtain approval from either the administration or Congress.
Central bank independence is vital for economic stability. Every instance of hyperinflation over the past 250 years was preceded by large government deficits coupled with the ability of authorities to force the central bank to monetize the debt—that means replacing interest-bearing securities with money. A runaway process of printing money almost always ends in a surge of inflation and, in extreme cases, hyperinflation. Historically, when a central bank is sufficiently independent, hyperinflation doesn’t happen.
The change in the Federal Reserve Act in the mid-1930s explicitly sought to strengthen the Federal Reserve’s independence by stipulating that its governors can only be fired by the president for cause. It was generally understood that the president had the burden of proof that his claim of cause had merit.
Have Fed governors ever been fired?
Last year, President Trump sought to fire a Federal Reserve governor, Lisa Cook. He alleged, without proof, wrongdoing on a mortgage application. Cook sued to have the dismissal voided, and so far two lower courts have sided with her. The administration has appealed those decisions, and the Supreme Court has agreed to fast-track the case. Should the Court side with President Trump, the for-cause clause would cease to have meaning. The job security of Federal Reserve governors would be no different from that of at-will appointees in the government’s executive branch.
What would be lost if the Federal Reserve ceased to be independent?
Over the past decades, the Federal Reserve has earned the confidence of financial market participants. But should markets believe the Fed has lost its independence and is giving in to short-term political demands, they might fear a rise in inflation. The Fed would quickly lose the markets’ confidence and, therefore, its influence over long-term interest rates.
The Federal Reserve’s track record has made it one of the world’s most highly respected central banks. Any perceived loss of its independence would immediately damage its hard-earned credibility along with its influence in international monetary policy discussions.