The Federal Reserve is an independent agency that operates the nation’s central bank, regulates banking, and manages monetary policy in the US. Here I’m going to focus mostly on the the monetary policy part, but this also touches on the banking side as well.
To direct its monetary policy decisions, Congress has given the Fed a dual mandate to maintain full employment and stabilize prices. Essentially, this means then need to regulate the growth rate of the economy. The goal is keep the economy from growing too slowly or too fast, because the economy destabilizes in either direction.
When there is little or negative growth (ie recession), prices go down and unemployment goes up. When there is too much growth, prices spike higher and unemployment gets so low we run out of workers, causing wage to go up which leads to even more inflation.
The Fed’s goal for sustainable growth is a target inflation rate of 2% and unemployment near or under 4%. (They actually look at many other metrics, but these are the two most talked about.)
The Fed manages growth primarily through controlling the money supply and managing interest rates. Generally, lower interest rates encourages borrowing and investment in risky, higher yield assets which helps the economy grow. Higher interest rates discourages borrowing and makes safer investments such as bonds more attractive due to higher interest payments.
The most fundamental interest rate the Fed controls is the Federal Funds Rate. This is the target short-term interest rate banks use to loan money overnight to other banks.
They also maintain the discount rate, which is the rate banks pay when they borrow directly from the Fed. It’s based on the Fed Fund Rate, and is typically around 100 basis points more.
Side note - why are banks borrowing money? Banks are required to maintain a certain percentage of cash on hand, also called reserve. Every day they calculate the amount of reserve they need, and if they are short then they to make up the difference with an overnight loan. Ideally they want to borrow from another bank at the Fed Fund Rate, but if that’s not available they go directly to the Fed and borrow at the discount rate. The Fed prefers to be lender of last resort, though, so the inter-bank rate is kept lower to encourage borrowing from banks whenever possible.
Typically a bank will use the federal funds rate as a basis for their prime rates for the best loans, and that is the base rate for all of their other types of loans. So when the fed rate changes, this change essentially trickles downstream to other interest rates in the economy.
Interest rates are connected to the money supply because when a loan is created this increase the money supply by the size of the loan. Paying off decreases the money supply over time.
Since lower interest rates leads to more loans, they also increase money supply. Higher rates means less loans and motivation to pay off loans faster to reduce the money supply or at least not grow as quickly.
The Fed can also adjust money supply by changing the reserve requirements. If the lower the requirements then banks will more excess reserves they can lend or invest which increases money supply. And the opposite when reserves are increased.
A relative new and somewhat controversial method for managing money supply is for the Fed to purchase long term government bonds from large banks and depositing payment into their reserves. Assumings have already met their minimum reserves, then the bank is free to use this new excess reserve for lending or investing or nothing at all. It’s up to the bank to decide, though they are encourage to do something with it.
Note, this is not a subsidy or taxpayer gift. The Fed is buying back bonds the bank has already paid the government for. It’s just converting a long term investment back into a liquid asset and, as a result, directly increasing money supply.
Once the need for excessive liquidity, the Fed will reduce Its balance sheet by selling the bonds back to the banks. This reduces money supply.
For example, during recession, economic activity slows down, people lose jobs, and this reduces demand. This tends to be deflationary, so inflation drops. The Fed typically responds by lowering the interest rate to heat up the economy again. Basically interest rate is like the gas pedal, and dropping the rates is putting the foot down. So what does lowering the rates actually do? On one hand, it makes risk-free assets (like treasury bills) very unattractive because they have very little return. So investors will be change to riskier assets like bonds and even stocks that have a higher return. On the other hand, it means borrowing money is a lot cheaper, so this encourages more loans and this in increases money supply and is part of the excess liquidity added by the Fed. Once the interest rate goes down to zero, though then the Fed has to do something else. At this point they start buying long term government bonds from banks and depositing money new reservers into the banks. The intention here is for the banks to lend and/or invest the reserves to further increase liquidity in the economy.
When covid hit in March 2020 and unemployment went over 14%, the Fed dropped the rate to near 0 and started buying bonds. Initially in April-May they bought $700 billion and then in June 2020 they started buying $80 billion of bonds and $40 billing of mortgage securities per month, indefinitely. It’s still going as of this writing in January 2022, though at this point it looks like they will tapering the buying soon and start raising rates by March. Did it work? US GDP growth in 2019 was 2.2%, in 2020 -3.0%, and as of 3rd quarter 2021 the annualized rate was 2.3%. Unemployment is 3.9% vs 3.5% in January 2020, and U-6 (underemployment) is 7.3% vs 6.9% January 2020 (and down from a peak of 22.9% in April 2020). Of course the cost of growth comes as inflation, and this was a lot of growth from -3.0 GDP back to 2.3.