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.

Related Articles
  1. Investing Basics

    Why Interest Rates Affect Everyone

    Learn why interest rates are one of the most important economic variables and how every individual and business is affected by rate changes.
  2. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  3. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  4. Markets

    What Slow Global Growth Means for Portfolios

    While U.S. growth remains relatively resilient, global growth continues to slip.
  5. Economics

    Will a Hike in Interest Rates Affect the US Dollar?

    Learn about how rising U.S. interest rates affect the U.S. dollar and where the dollar could be heading once the rising rate cycle begins again.
  6. Retirement

    What Was The Glass-Steagall Act?

    Established in 1933 and repealed in 1999, the Glass-Steagall Act had good intentions but mixed results.
  7. Economics

    What to Expect From Mortgage Rates in 2016

    Understand the factors that influence the direction of mortgage rates, and use this information to project what will happen with rates in 2016.
  8. Economics

    The Taylor Rule: Calculating Monetary Policy

    The Taylor Rule suggests how the central bank should change interest rates to account for inflation and other economic conditions.
  9. Investing

    2 Investing Implications of Higher US Rates

    While U.S. economic data continue to come in mixed, the numbers still point to decent U.S. economic growth.
  10. Stock Analysis

    What Markets Poised to Benefit if the Fed Waits?

    Late last month, the Fed reminded that a 2015 rate hike is still a possibility; there are certain segments of the market that are more sensitive to changes.
  1. What happens if interest rates increase too quickly?

    When interest rates increase too quickly, it can cause a chain reaction that affects the domestic economy as well as the ... Read Full Answer >>
  2. When was the last time the Federal Reserve hiked interest rates?

    The last time the U.S. Federal Reserve increased the federal funds rate was in June 2006, when the rate was increased from ... Read Full Answer >>
  3. Do lower interest rates increase investment spending?

    Lower Interest rates encourage additional investment spending, which gives the economy a boost in times of slow economic ... Read Full Answer >>
  4. 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 >>
  5. Who decides when to print money in the US?

    The U.S. Treasury decides to print money in the United States as it owns and operates printing presses. However, the Federal ... Read Full Answer >>
  6. 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 >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center