How Does the Federal Reserve Work?

When you buy through links on our articles, Future and its syndication partners may earn a commission. Credit: Getty Images Eight times a year, a group of 19 bankers, finance experts and economists gather for a two-day confab in an elegant cream- and-gold boardroom about a mile from the White House. After they’re done analyzing the outlook for inflation and employment, Federal Reserve chairman Kevin Warsh, the leader of the group known as the Federal Open Market Committee, emerges and announces what the committee has decided to set as a target range for short-term interest rates.  The committee’s goal — known as the dual mandate — is to set an interest rate that enables the economy to achieve price stability and full employment. It is enormously important to investors, savers, borrowers and business leaders whether — and how — the Fed achieves this delicate balance. Books have been written on how exactly the Federal Reserve influences investment markets, but here’s a quick and rough summary.  The first thing to understand is what the FOMC’s vague-sounding goals actually mean. Fed officials have historically said they consider the economy to have price stability when a Department of Commerce calculation of U.S. consumer spending, called the Personal Consumption Expenditures Price Index, rises by 2% a year.  Fed economists like the PCE price index because it considers how shoppers substitute, say, lower-cost chicken when beef prices rise, thus reflecting the prices consumers actually pay. That’s one reason the PCE measure tends to run lower than the more widely cited Consumer Price Index (CPI). As of May 2026, the CPI had risen 4.2% over the previous 12 months while the PCE price index was up 4.1%. The Fed has not set a specific ideal full-employment number. Instead, Fed officials say they look at a variety of measures, such as wage trends and the percentages of workers employed in different population groups, to aim for the maximum employment level that doesn’t kick off wage inflation. Tools the Fed has to use  The most powerful tool the Fed has to achieve those goals is the influence it has on short-term interest rates.When the Fed meeting happens and the FOMC announces its target range for the federal funds rate, it is indicating what it wants banks to charge each other for lending or borrowing cash overnight.  But the Fed can’t force banks to charge each other its chosen interest rate. Instead, it steers banks toward the target by adjusting the interest rates it pays to and charges from banks for the reserves that banks are required to keep with the Fed and any overnight Fed loans to member banks.  Story Continues Maneuvering all of the nation’s 4,600 banks to its ideal interest rate isn’t an exact science, hence the target range for the federal funds rate, spanning roughly a quarter of a percentage point. As of June 27, the range was between 3.50% and 3.75%.  The federal funds rate is essentially a floor for all other interest rates in the economy. For example, the prime rate, which is the rate banks charge their best customers, is typically set three percentage points above the high end of the federal funds target rate. And the prime rate serves as a floor for many bank lending rates, including credit cards and auto loans.  To influence longer-term interest rates, the Fed has another strategy: managing the securities it keeps on its balance sheet. In an effort to lessen the pain of the 2008 Great Recession and, later, the COVID shutdowns, the Fed sought to drive down long-term interest rates by buying up trillions of dollars of Treasury bonds and mortgage-backed securities.  The massive purchases helped push bond prices higher and send yields, which move in the opposite direction, lower. The process, quantitative easing, helped drive interest rates on the 10-year Treasury bond to as low as 0.55% in 2020.  But as inflation took off, the Fed made a U-turn and, starting in 2022, strove instead to cool the economy by pushing up rates, raising borrowing costs. It switched to quantitative tightening, allowing some bonds in its portfolio to mature each month without replacing them.  By reducing its purchases, the Fed relied on lower demand to cool bond prices, allowing long-term rates to rise. Since March 2023, the Fed has reduced the total value of securities on its balance sheet by $2 trillion, to $6.7 trillion. As quantitative tightening winds down, the Fed’s influence on longer-term rates diminishes. The Fed’s “soft landing” The market impact of Fed actions can be immediate. The September 2024 pivot from hiking to cutting was met with what some veteran Fed watchers worried was a bit of irrational exuberance (a phrase coined by former Fed chairman Alan Greenspan). Several stock indexes hit new highs, and bonds rallied as investors cheered the possibility that the Federal Reserve had pulled off a difficult “soft landing,” raising interest rates enough to cut inflation without setting off a recession.  “This was a very thin needle to thread,” because Federal Reserve interest rate hikes have caused most of the recessions in the past 50 years, said Mark Zandi, chief economist of Moody’s Analytics. Barring a shock such as an energy price spike or worsening geopolitical hostilities, “they may have pulled it off,” he said.  Note: This item first appeared in Kiplinger’s Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here. Related Content View Comments