Fed 101: What You Need to Know About the Federal Reserve

The Fed is always in headlines, but let's face it, not many people really understand what it is and how it works. Are you ready to sound like the smartest person in the room next time it comes up as a subject of conversation?

In this video segment, Alison Southwick, Morgan Housel, and Robert Brokamp go over the history of the Fed, why it was created, how it's structured, what its mandates are, what the heck quantitative easing is, and how the Fed affects inflation and deflation by buying and selling debt instruments.

A full transcript follows the video.

This podcast was recorded on Dec. 15, 2015.

Alison Southwick: I've kind of written a little term paper about the Fed and what they do.

Morgan Housel: Oh boy.

Southwick: I know! This is exciting. This is going to be really good. Alright. My term paper. So that we can all understand what the Fed is, where it came from, what it generally does. I will need your guys' help and input now and then. But, are you ready?

Housel: I'm really.

Robert Brokamp: We're ready.

Southwick: Alright, buckle your seatbelts, here we go. The Federal Reserve was created in 1913 with the goal of maintaining confidence in our monetary and banking system. So, picture it. When it was founded, there were more than 30,000 different varieties of currency in this country. That's because basically anyone could make their own money: banks, states, regional governments, and even individuals. So, the money supply in the U.S. was unstable. You'd get bank runs, cats and dogs were living together. It was bedlam. Is there anything else you'd like to add before we move on?

Housel: That's actually the whole history of the Fed. That's it.

Southwick: I crushed it. I think we can leave now, because you're already going to be the smartest person in the room when it comes to talking about the Fed.

Housel: You remembered the cats and dogs.

Southwick: Yep. So, history is done. Now we can move on to the structure. This is where I'm going to tell you to go ahead and get that pot of coffee brewing, because the Fed both public and private, it has 12 regional Reserve banks around the country, and one Board of Governors in D.C. which has seven members which are appointed by the government and confirmed by the Senate. The Board of Governors represents the public, government-y side of things, while the 12 regional banks represent the private sector, which I think is essentially like the banks in this country. Is that correct?

Brokamp: Pretty much, yeah.

Southwick: Okay. So, what am I missing before we move on to a brief ECON101 primer on inflation versus recessions? Anything else we want to add?

Brokamp: I think that's about it.

Housel: Yeah.

Southwick: Good.

Brokamp: It's not the same thing as the Department of Treasury or something like that. It does have a certain level of independence from the government, as opposed to many other aspects of what you read about, like the IRS and people like that.

Southwick: Alright. So, hopefully your coffee is ready by now, because, let's talk about the Fed's mandates. One, it is to keep prices of stuff stable. Two, it's to keep employment stable. All the while, maintaining moderate, long-term interest rates. So, Morgan, it's your turn.

Housel: Alright.

Southwick: You're the little sidebar in my term paper. Remind our listeners about supply and demand of money, and the balance between inflation and recession. Basically, everything is about to supply and demand.

Housel: That's right. So, in the economy, we make stuff. We make cars and we make services like car washes and whatnot. So, that's what the economy produces. And then, there's a certain amount of money that is chasing that stuff. And when there is too much money chasing that stuff, or too little money, or too much stuff or too little stuff, you get changes in inflation. So, if you have more money or less stuff, you could have inflation. If you have less money for more stuff, then you can have a deflation.

Brokamp: There will always be a little bit of inflation, just because of businesses. My son asked me this while we're at Johnny Rockets having hamburgers. He said, "Why is that?" People like Johnny Rockets would always love to charge you more, so they're always going to push it a little higher. At some point, you push it too high, and people will go to other restaurants. So, there'll always be a little bit of inflation. The Fed, also, doesn't want deflation. They don't want prices to go down, because then companies like Johnny Rockets are going to make less money, and they'll start laying people off. So, they want just a little bit of inflation, but not too much.

Southwick: So, the Fed has tools in their bag to have just a little inflation, and not too much. And the main one is buying and selling Treasuries. And here's where I'm really going to be looking at you guys to be like, "Am I right? Do I have this? Is this straight?" because it always gets confusing in my head. Basically, if there's too much money in circulation, which could lead to too much inflation, then the Fed sells Treasury bonds to banks.

Brokamp: Right.

Southwick: And what that does is, it pulls money out of circulation.

Housel: Yes, because the banks give them cash for those bonds.

Southwick: And they set it aside.

Brokamp: It goes away.

Southwick: It disappears?

Housel: It just disappears.

Brokamp: And the banks don't have that money to lend, which means they're not lending as much, so people can't buy as much stuff or start as many businesses, and all that.

Southwick: Alright. Now, conversely, if there's too little money in circulation, which could lead to a recession, they buy bonds from the banks in exchange for money. So, they basically give the bank the money for the bonds, and then there's more money in circulation.

Brokamp: Ideally.

Housel: So the banks give the Fed bonds, and the Fed gives them cash in return.

Brokamp: Right.

Southwick: So, was what I just explained what all that quantitative easing was about? What was quantitative easing?

Housel: Normally, when the Fed would raise or lower interest rates, they would do exactly that. They would buy or sell bonds from banks. They would do it with short-term bonds. Quantitative easing was this new thing, but it was the same mechanics of what we just talked about. They just did it with long-term bonds instead, because the Fed had already cut interest rates down to 0%, so you couldn't cut them anymore. So, they couldn't buy anymore short-term bonds. So what are they going to do? They're going to go out and buy long-term bonds. That was really the only difference between normal rate-cutting and quantitative easing.

Southwick: And we should probably make the connection here between the supply of money and interest rates. If there's less money out there, then it's more precious, and interest rates are, essentially, the price of money. So, that's why, when they're doing all of this buying and selling of bonds and changing the supply of money in the country, interest rates go up and down.

Housel: That's right.

Southwick: Do I have this?!

Brokamp: You do.

Southwick: Yes! I haven't written a term paper in so long. Okay, great! So, the Fed does a ton of stuff, by the way. They monitor banking operations in the nation, they produce a ton of economic reports, and they do housekeeping stuff. They're the clearing house for our checks.