The time has come for us to talk about the Fed—that is, the US Federal Reserve—and its current chairman, Jerome “Jay” Powell. Yes, the thing (and person) that has been all over the headlines endlessly for over a year now, for seemingly inscrutable reasons if you don’t have a ton of context on what it’s all about. And few normal people have much context on what it’s all about—it’s too useful a subject to have been taught in school. Because if you understand all this, you’ll understand why the things that are happening are happening with the money of, basically, everyone in the whole world, including your own.
It is probably noticeable and uncontroversial to most people that inflation has been happening. But why is inflation happening? When the news says that the Fed decided to raise interest rates (again), what does that mean? When the news says that Jerome Powell is hinting that the Fed might decide to raise interest rates, what does that mean? Why are the last two questions distinct from each other? Why does the stock market go the opposite way that interest rates are going? What IS the Fed?? How do they decide on these things? What does it mean when someone says, “Such-and-such was the product of a zero-interest-rate environment?” Will everything ever go back to normal (“normal” as defined by whoever’s asking this question)?
We’ll cover all of the above and more, though not all in Part 1 (heavens!). By the way, although I’ve learned bits about the Fed from numerous different sources and am fact-checking on Wikipedia, my main source for this series is the book The Lords of Easy Money, by Christopher Leonard, so I’ll just say that here instead of citing it on every sentence. If you want to read about all the same things I’m saying, but in a more detailed, less witty form, just go read that book. No, but it’s a really great read.
The book only goes up to 2021 or so, so the true test of whether I’ve understood what I read is that I will take you the rest of the way, from 2021 when the book stops, all the way up to our present moment in 2023! Terrifying! (For both of us!)
What if I’m not an American? Should I care about the Fed?
I can’t tell you what you should or shouldn’t care about, but probably yes. The Fed’s decisions affect what’s going on with USD. Most trade and most debt in the world, even between non-US countries and not involving the US at all, is actually priced in USD. Also, lots of other central banks in the world look at what the US Fed is doing to help decide what they’re going to do. So the general concepts here, but also the US Fed specifically, probably affect your life in some way, no matter where you live.
What is the Fed, and why does it exist?
The Federal Reserve is the closest thing the US has to a central bank (that is, a bank that oversees all of the country’s money). Why do we have a central bank? Well, we actually tried to go without one for over a hundred years. The United States, having been founded by people who apparently found their previous government overly controlling, was founded with the intention of being as decentralized as possible, to prevent that from happening again. So folks weren’t keen on introducing anything that had the word “central” in it. But there were several big issues with not having a central bank.
For one, there wasn’t one shared currency. USD didn’t exist. Instead, every bank got to issue its own currency! There were over 8,000 different currencies in the US, and none of them was the official one! And you thought the proliferation of crypto tokens was bad. Imagine, you go traveling to the next state, and your money isn’t recognized anymore. A central bank can issue one currency that all banks in the system are required to recognize and accept as money.
Second: there are, in probably every banking system, occasional rare events known as “bank panics” or “bank runs,” where everybody gets freaked out and tries to withdraw their money from the bank at the same time. The immediate reason is that some sort of news has caused people to not trust that they’ll be able to withdraw their money later if they don’t do it now (maybe they think the bank is failing, etc). But musings on the root causes of bank panics in general, and whether they are inevitable, probably can and do fill whole books, so I won’t go into it here.
Anyway, a bank run is a problem for the bank, because most banks don’t keep the entire value of their deposits on hand, so they don’t have enough cash on hand to let everybody withdraw at the same time. They keep only a certain fraction on hand or “in reserve” (this practice is called “fractional reserve”), because it’s so extremely rare that everyone would want to withdraw all their money at once, and meanwhile the money would be much more “productive” somewhere else—meaning, they can lend it to someone else and give their customers (depositors) interest. The specific % that they keep in reserve is mandated by regulation.
(By the way, even though it’s easiest to understand if you picture a physical bank running out of physical cash, and I did use the word “cash” above, technically speaking, even if everyone is trying to withdraw online to other online accounts, the bank can’t allow more money to be withdrawn than it has in its own “online account”—in other words, it’s not allowed to go negative, not even with magic money in digital accounts.)
If a single bank experiences a bank run, other banks can lend it money to help it get through the day, so that it doesn’t have to freeze withdrawals. Theoretically, the bank can get all the rest of its money back from wherever it had put it, and thus can pay back any of these emergency lenders before too long. (Right, Sam? Sam??*)
But what if it’s a BIG, nationwide panic, and there’s a bank run on ALL the banks at the same time? In that case, the Fed’s job is to step in as the “lender of last resort,” to be the one to lend money where needed so that the banking system doesn’t collapse. The Fed is able to do this not only because it’s got a big, well, reserve (hence the name), but because it has a special power that none of the other banks have: it can print money. (This is a statement that pedantic people, including those who work at the Fed, might argue with unless I qualify what I mean by “print money,” which I promise to do in Part 2! So if you are tempted to argue over this point then please wait until the next installment to do so.)
Guess what? If you can print money, then you never run out of money. The concept is both simpler than it seems, and more complicated than it seems. Digging into the nuances of this concept is ultimately what most of this series will be about.
(Can’t the bank panic be even bigger than nationwide in one nation, can’t it include other countries too? Yes, but it starts to get complicated there when we talk about international moneys, so for the time being. let’s go back to pretending, as we do, that the US is the only country that exists.)
Finally, in addition to “one currency to rule them all” and “lender of last resort,” a third benefit of having a central bank is that it can manage the supply of this single currency, by injecting more money into the system when demand is high, and taking money out of the system when demand is low. It does this to address seasonal needs, but also to incentivize certain outcomes it wants to see in the economy, which is also tied to the “printing money” concept above, and thus will also be a focus of most of this series.
The Federal Reserve was created in 1913 to address all of the above. Remember that: it’s only just over a hundred years old.
Who is the Fed?
Ok. A lot of people work at the Fed, but when we talk about the Fed, we’re usually saying “the Fed” as shorthand for a specific group of the top decision-makers, known as the FOMC (Federal Open Market Committee if you must know, but feel free to forget this immediately).
The Fed, even though it’s a central bank, was still set up to try to be a bit decentralized. To that end, it actually consists of 12 regional Federal Reserve banks, some based in big cities like New York and Chicago, some based in such down-home middle-America places as Cleveland and Kansas City. These banks oversee the privately-owned (ie. non-government) banks in their respective regions, and make sure the latest decisions of the Fed (aka, the current monetary policy) are implemented in their region.
There are 12 regional Federal Reserve banks. There are 12 seats on the FOMC. So one seat per bank, right? Wrong! That would be too easy. The seats on the FOMC are distributed as follows: 7 seats go to the Fed’s entire Board of Governors, who are each appointed by the president of the US, and who work out of the Fed headquarters in Washington, DC. The Chair of the Fed (currently Jerome Powell) is always one of these Governors. 1 seat permanently goes to the president of the New York Fed, because it’s New York (lol).
The remaining 4 seats go to the remaining 11 presidents of the other Fed banks that are not New York, who rotate into them from year to year. How do you rotate 11 people into 4 spots, when it doesn’t even divide evenly? Your guess is as good as mine, but I like to imagine it’s like 11 people trying to rotate into a game of 4-player Overcooked, where the 7 people who aren’t currently playing get to backseat-drive and yell “helpful” things without being able to directly play. (This is literally how it goes in the Fed: the regional bank presidents who aren’t currently sitting on the FOMC still get to talk and give their opinions at the meetings, they just don’t get a formal vote.) In fact I suspect there are a lot of parallels between the FOMC and Overcooked, a primary one being that everything is almost always about to be on fire—but that’s an essay for another time, I think.
Isn’t it interesting that the group of seats that are just large enough to be a voting majority (7 out of 12) are assigned to the part of the Fed that is centralized? (That is, the Board of Governors.) What a coincidence! It’s a nice bit of decentralization theater: a supposedly decentralized entity, that isn’t.
In practice, though, it never comes down to such a close vote. Perhaps surprisingly, the FOMC is nothing like the Supreme Court, where it’s not crazy to see a 5-4 vote with a strong dissenting group. Instead, the FOMC has a weird culture/tradition of being obsessed with aiming for unanimous votes as much as possible, even though it’s not technically required. As if they need to present a united front and assure everyone else that their decisions really aren’t contentious at all. To that end, they will pre-negotiate the thing to be voted on until they’re confident that they can get a unanimous or near-unanimous vote. Even 3 or 4 dissenting votes out of 12 would be considered a disaster. (See the voting history, where the overwhelming majority of votes have only 0 or 1 vote against.)
Personally, the obsession with unanimity and consensus feels to me like the mark of a group that is dying to be seen as technocrats, not judges.. in other words, to be seen as people who know exactly what they’re doing, instead of as people who kinda maybe don’t know what they’re doing and are just going off their best judgment and gut instinct? Just saying.
You may have noticed, dear observant reader, that zero of the seats or chairs of the FOMC are voted on directly by the public. The regional bank presidents are appointed by the banks; the Board of Governors is appointed by the president of the US and confirmed by the Senate. While we do vote for the president and senators, we probably mostly wouldn’t be voting for these offices based on who the candidates’ FOMC picks are. More importantly, most voters don’t know or care who gets appointed to the FOMC, and I wager the FOMC likes it that way, in a “nothing to see here” sense. Yet this committee controls the parameters of the entire world economy. NBD!
The dual mandate and the soft landing
The Fed has a “dual mandate,” which just means that it has two jobs. One is to ensure maximum employment (aka, a low unemployment rate), and the other is to ensure price stability (aka, low inflation). Sometimes these goals are at odds with each other, like, seemingly, right now. The pandemic caused unemployment to go up dramatically. Then the Fed did some stuff (which will be elaborated on in great detail in the posts to follow), which resulted in unemployment going down, but also caused inflation to go up. Now it needs to do some more stuff to try to get inflation to go down, without causing unemployment to go up again (ie., without causing a bad recession).
So the Fed is currently in a position where it needs to try to “thread the needle” or “walk the tightrope” (whichever analogy you prefer) between its two goals; if it is able to do so, that’s the ideal outcome, the one that the Fed would call a “soft landing” (to mix as many metaphors as possible). In other words, in the Fed’s mental model of the situation, it’s flying a plane that the rest of us are all sitting in, and things have gone haywire, and if they navigate things juuuust right, they might be able to land the plane without crashing it into the ground and killing everyone.
In our current economic situation, does a soft landing even exist? Like, is it even theoretically possible to get there from where we are right now, even with the best of the best piloting skills? Nobody knows. That’s why you see articles in the news every day debating the existence and likelihood of various landings of different hardnesses.
In this landing analogy, my role is that of Tyler Durden in the Fight Club airplane scene, explaining to you the mechanics of plane crashes as we enjoy this flight together.
In this post I’ve talked about why the Fed exists, who the Fed is, and what the Fed is trying to do. In the posts to follow, we’ll get into how the Fed actually does what it does.
Until next time—enjoy your flight!
* “Sam??” A reference to the collapse of FTX. An exchange, and not a bank, but people more or less had all the same expectations of its reserves that they would expect from a bank.