What do you really know about the Federal Reserve? Sure, you have heard of it and if you are like most people, you probably have a basic understanding of how it works. You might know that the Fed has something to do with interest rates and that it is an independent body, but you might have some ideas about the Fed that are not accurate.

First, the Federal Reserve is a central bank. The function of the Fed and central banks all over the world is to regulate the country's money supply. In addition to placing money into and removing it from circulation, central banks keep a watchful eye on the value of money by taking steps to control inflation.

The Federal Reserve (or Fed) is the central bank of the United States. In 1977, Congress amended The Federal Reserve Act, creating what is now known as its dual mandate. The Fed is charged with creating an environment for maximum employment and stable prices.

How well it has met this mandate since the most recent recession is a subject of discussion among armchair politicians and economists everywhere, but one thing is clear: there are many fallacies about the Fed. The following misconceptions are among the most popular.

1. The Fed Is Not Audited
According to Eric Rosengren, President and CEO of the Federal Reserve Bank of Boston, all 12 Federal Reserve Banks employ internal auditors along with an outside auditing firm, Deloitte & Touche. The Federal Reserve's Inspector General, as mandated by Congress, also audits the Fed.

2. The Fed Operates in Secret
In the same speech, Rosengren addressed this issue. He acknowledged that when he joined the Fed 25 years ago, transparency was not a priority. He went on to say that when the economy was essentially melting down in 2008 and 2009, diverting the crisis was the priority. Communicating with the public was secondary.

However, he later cites the addition of published federal funds rate targets, minutes of committee meetings, and the latest announcements of interest rate targets and how long the Fed sees those targets remaining in place.

These changes, along with now-regular press conferences with the Chairman of the Federal Reserve, have put it on the path of increasing transparency.

3. The Fed Is Immune to Politics
The Fed, by mandate, is independent from other areas of government, but government pressure is very real. Former President George W. Bush appointed current Fed Chairman Ben Bernanke. President Barack Obama later reconfirmed Bernanke's appointment. Bernanke regularly testifies before Congress, where he often faces pressure from lawmakers to take steps to lower unemployment and stimulate the economy.

4. The Fed Sets Interest Rates
On Oct. 24, the Fed announced that it would keep interest rates unchanged at near 0%. Reading the many articles in the financial media would seem to indicate that the Fed unilaterally sets interest rates and the banks follow, but that is not true, according to the Federal Reserve.

There are two types of interest rates to consider. The federal funds rate is the rate at which banks borrow money and the prime rate is the rate at which banks lend the money they borrowed. Just as a retail store is free to sell most merchandise at any price it chooses to achieve the profit margin it needs, a bank can do the same thing.

The prime rate reported by the Fed is the average interest rate reported by the 25 largest banks. Many of those banks choose to set their rates based on the federal funds rate. Although the Fed does not directly set interest rates, its actions have an effect on them.

5. The Fed "Prints" Money
The treasury is the government agency that prints money. The Fed injects or removes money by printing or collecting physical currency. Today, electronic transfer injects money into the economy. Just as most consumers look at a computer screen or bank statement to view their money, so do banks that do business with the Fed.

6. More Money Equals More Inflation
Conventional wisdom holds that when more of something enters the market, the value falls and this creates inflation. This view may be oversimplified. Since banks do not "print" money, they buy financial products from a bank and deposit that money into the bank's account. The bank, based on how it views its own financial health, may choose to lend that money out or hold on to it. If the bank holds the money, then it does not enter circulation. If it is not in the economy, it cannot cause inflation.

7. Unwinding the Stimulus Measures Will Cause Negative Economic Effects
The argument is something like this: U.S. financial markets are at artificially high levels because the Fed has intervened and stimulated them through programs like Quantitative Easing, Operation Twist and the lowering of interest rates. When that entire stimulus is removed, the markets will plunge, taking any real economic growth with them. There will be no gradual unwinding because at some point, inflation will rise, forcing the Fed to take drastic measures.

According to Philly Fed President, Charles Plosser, it is not that the Fed does not have the tools to wind down the stimulus; he is worried that it may not act at the right time. He asks, "Will we have the fortitude to take the heat when it comes time to utilize [the tools]?"

The Bottom Line
Republican Presidential candidate, Ron Paul, in his book, End the Fed, argues that the Fed is a corrupt institution that does more harm to the economy than good. Others argue that the Fed, like central banks around the world, is essential to keeping a country's currency stable.

This controversy, much like all political debates, will live on. One thing is certain. The Fed is misunderstood by many, even some of those with financial professions.

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  1. How is the Federal Reserve audited?

    Contrary to conventional wisdom, the Federal Reserve is extensively audited. Politicians on the left and right of a populist ... Read Full Answer >>
  2. Who decides when to print money in the US?

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  3. Why do some people claim the Federal Reserve is unconstitutional?

    The U.S. Constitution does not mention the need for a central bank, nor does it explicitly grant the government the power ... Read Full Answer >>
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