You may give little thought to the Federal Reserve, but the Fed looms large over your life as you borrow, save, spend, and invest.
The Fed’s mission is to control inflation and maintain maximum employment. The goals can be at odds with each other.
Let’s look at the Federal Reserve’s origin story and what the central banking system is currently up to.
How It All Began
A secret meeting in 1910 on an island off Georgia laid the foundation for the Federal Reserve. After a series of financial panics and recessions in the Gilded Age, six men gathered at the Jekyll Island Club to write a plan to reform the nation’s banking system.
At that time, U.S. banks held large reserves of cash, but they were scattered. During a crisis, the reserves would be frozen. In addition, the supply of currency was inelastic and supplies of gold limited. And U.S. banks could not operate overseas.
The Panic of 1907 — a worldwide financial crisis surpassed only by the Great Depression — galvanized Congress, and particularly Senate Finance Committee Chairman Nelson Aldrich. In the fall of 1910, Aldrich and his Jekyll Island colleagues developed a plan for a central bank with 15 branches. The national body would set discount rates for the system and buy and sell securities.
Political wrangling ensued, but Congress passed, and President Woodrow Wilson signed, the Federal Reserve Act in 1913. The bill resembled the Aldrich plan.
The law called for a central banking system with a governing board and multiple reserve banks. The hybrid structure endures.
A golden factoid: Banking panics before 1913 tested the mettle of Manhattan banks, but what is now the most influential of the 12 reserve banks, the Federal Reserve Bank of New York, is home to the world’s largest gold storage reserve, with about 500,000 gold bars owned by the U.S. government, foreign governments, other central banks, and international organizations.
Before the Federal Reserve
Before the Fed was born, financial panics caused by speculation and rumors led to the call for a central banking authority that would support a healthier banking system.
World War I, 1914 to 1918
The Federal Reserve Board and the 12 reserve banks were just getting organized as war broke out in Europe. But once the nation entered World War I, the Fed quickly became a major player by supporting the U.S. Treasury’s war bond effort and offering lower interest rates to member banks when the proceeds were used to buy bonds.
The Fed also gave better interest rates to banks purchasing Treasury certificates. Lower rates led to increased borrowing by businesses and households, which stimulated economic growth. But the increased money supply eventually led to rising prices. When the war ended, the Fed took action to control that inflation.
Stock Market Crash of 1929
On Oct. 28, 1929, now known as “Black Monday,” the Roaring Twenties ended with a thud when the Dow Jones Industrial Average dropped nearly 13%. The market collapsed the next day. It was the most devastating stock market crash in U.S. history.
Many economists and historians blame the Fed for the crash because of its decision to raise interest rates in 1928 and 1929 to control over speculation (what today might be called “irrational exuberance”) in the stock market.
Leaders decreased the money supply starting in 1928 and pressured member banks in 1929 to rein in their loans to brokers and charge a higher rate on broker loans.
The Great Depression, 1929 to 1941
The deepest downturn in U.S. history lasted from 1929 to 1941. The contraction began in the United States and reverberated around the globe.
The banking panics in 1930 and early 1931 were regional, but in late 1931 the commercial banking crisis spread throughout the nation. The Fed’s efforts to contain the collapse were not enough, and the situation reached rock bottom by March 1933.
On March 6, 1933, President Franklin Roosevelt — who’d been inaugurated just two days before — announced a weeklong suspension of all banking transactions. Legislative intervention soon followed.
In 1933 the Glass-Steagall Act separated commercial and investment banking and gave the federal government and Federal Reserve enhanced powers to deal with the economic crisis, which led to the creation of the Federal Deposit Insurance Corp. and regulation of deposit interest rates. (At an FDIC-insured bank today, deposits are insured up to $250,000 per depositor, per institution, and per ownership category.)
The Banking Act of 1935 gave the Fed more independence from the executive branch; shifted power from the regional reserve banks to the Board of Governors, based in Washington, D.C.; and led to the modern form of the Federal Open Market Committee (FOMC), the Fed’s main monetary policymaking committee, which consists of the Fed governors in Washington and the presidents of the 12 regional banks.
World War II, 1941 to 1945
The Fed’s role during World War II was similar to its role in World War I. Its main mission became financing the war, and it helped the Treasury Department market war bonds in cooperation with commercial banks and businesses.
The reserve banks also reduced their discount rate to 1% and set a rate of half a percentage point for loans secured by short-term government obligations. During the war years, the Fed kept its eye on inflation by regulating consumer credit. It required large down payments and shorter terms on loans used to buy a variety of consumer goods.
Korean War, 1950 to 1953
At the start of the Korean War, inflation was a growing concern. But the Fed was once again under pressure — this time from the Truman administration — to help finance the war effort.
In February 1951, the Fed declared its independence in fiscal matters, and in March, the Treasury and the Fed announced that they had reached an accord on how they would handle “debt management and monetary policies” going forward.
The Great Inflation, 1970s and ’80s
Keeping inflation under control has always been an important role for the Fed, but in the 1970s, when the stock market slumped and the country found itself in an inflation crisis so deep it was known as the “Great Inflation,” it became a special challenge.
Check the history books and you’ll find plenty of finger-pointing. It was President Richard Nixon’s fault for disengaging from the gold standard. Or maybe it was the Fed’s fault for employing a confusing stop-go monetary policy that had interest rates going up, then down, then back up.
Then new Fed chairman, Paul Volcker, took over in 1979 and switched the Fed’s goal from targeting interest rates to targeting the money supply. It was painful. The prime lending rate (the rate banks offer their most creditworthy customers when they’re looking to take out a line of credit or a loan) skyrocketed to over 21% at one point.
Unemployment reached double digits in some months. The country went through two recessions. But eventually, prices stabilized.
And the federal funds rate hasn’t been in the double digits since the mid-1980s.
The Great Recession, 2007 to 2009
When a period in U.S. history is labeled “great,” it’s often anything but. During the Great Recession, home prices fell. Unemployment rose. Gross domestic product fell. And in 2008, the market crashed.
Home prices had peaked at the beginning of 2007, and the subprime mortgage market had been busy.
This recession was, for many Americans, the worst of times; they lost their jobs, their homes, and their confidence in the economy.
Enter the Fed, which started by tackling the slump with a traditional response: From September 2007 to December 2008, the Fed lowered the federal funds rate from 5.25% to zero to 0.25%, and FOMC policy statements noted that it would be keeping the rate at exceptionally low levels for a while. But it didn’t stop there.
In 2008 it also began its first round of quantitative easing, buying $600 million in mortgage-backed securities, and continued that effort in 2009. Also in 2008, President George W. Bush signed the $700 million Troubled Asset Relief Program into law. Two more rounds of quantitative easing started in 2010 and 2012 under President Barack Obama.
Recommended: Common Recession Fears and How to Cope
The Covid Crisis, the Fed, and Inflation
At the onset of the Covid-19 pandemic and resulting recession in 2020, making sure the U.S. economy did not fall into a prolonged recession became a higher priority than maintaining inflation at the Federal Reserve’s 2% target rate.
The Fed seeks to control inflation by influencing interest rates. When inflation is too high, the Fed typically raises its benchmark interest rate to slow the economy and tame inflation. When inflation is low, the Fed often lowers the federal funds rate — the interest rate that banks lend money to one another overnight — to stimulate the economy.
After keeping the rate near zero, in March 2022, the Fed approved its first rate increase in more than three years. The FOMC increased the benchmark rate from 0.25% to 4.5% during seven meetings from March to December 2022, the fastest tightening campaign since the 1980s.
They weren’t done. Fed officials predicted that they would need to raise rates more in 2023 to bring down inflation.
Banks base their prime rate on the federal funds rate; the prime rate is generally 3 percentage points higher.
And rising inflation affects mortgage rates because Fed rate hikes increase the cost of borrowing money for a house. Or a car, or for carrying a credit card balance. Rate increases also create a more volatile stock market that could hurt 401(k) plans, increase the amount you earn on a CD, or affect what you might pay for a bond.
So how to protect your money from inflation? With planning, you may be able to reduce its impact on your day-to-day and long-term finances.
It might be hard to believe, but being a homeowner vs. a renter may help protect you from inflation. If you buy a house, you’re likely to have a fixed monthly payment long term. And the value of your home may increase along with inflation.
Owning a home not only gives you a place where you enjoy living, but homeownership can help build generational wealth in your family thanks to appreciation over time.
OK, but how to invest during a time of inflation? It might mean adjusting your investment portfolio allocations to adjust for rising prices and an uncertain economy.
Recommended: What to Learn From Historical Mortgage Rate Fluctuations
If you’re planning a vacation, you might not want to tuck away a book on the history of the Federal Reserve. (Or maybe you will. No judgment.) The Fed has a dual mandate to aim for maximum employment and price stability, and it believes that raising interest rates is the antidote for rising inflation.
If you find yourself musing about buying a home soon, it’s important to look at the history of mortgage rates to put the current conditions into context, and it helps to read up on the benefits of homeownership.
SoFi offers a variety of mortgages at competitive rates. Qualifying first-time homebuyers can put as little as 3% down.
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