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A History of the Federal Reserve & Its Effect on the Economy

September 10, 2019 · 6 minute read

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A History of the Federal Reserve & Its Effect on the Economy

If you’re a borrower, a saver, a consumer, and/or an investor—and let’s face it, that’s just about everybody—your life is affected by the Federal Reserve.

And yet many people may not understand what the Fed does or how it uses the federal funds rate—the central interest rate in the United States—to control economic growth.

According to its website, the Fed has several jobs, including using the nation’s monetary policy to “promote maximum employment, stable prices, and moderate long-term interest rates.” In other words, it tries to keep inflation in check by raising and lowering the cost of borrowing money.

Banks base their prime rate on the Federal funds rate, and the prime rate is generally 3% higher than the Federal funds rate. Which means it really does have a lot to do with your day-to-day finances—from how much you might pay if you carry a credit card balance, to how much the mortgage on your new house may cost, to the amount you could earn on a certificate of deposit or what you might pay for a bond.

The Federal Open Market Committee (FOMC), the monetary policy-making body of the Federal Reserve System, meets eight times a year (and more often if necessary) to determine the federal funds target rate.

And it is constantly gathering the data that informs those decisions—monitoring trends in prices and wages, employment, consumer spending and income, business investments, and foreign exchange markets. Then it votes on where the rate should be set.

By raising interest rates, the Fed makes it more expensive to borrow money, which keeps spending low and prices down. When the Fed raises rates consumers may also earn more interest on their savings investments. When interest rates are lowered, borrowing gets easier, but interest earned on savings could diminish.

When the Fed lowers rates, consumers may be more likely to take out loans for cars, home improvements, or other purchases, and businesses also are more apt to borrow funds to expand or make improvements.

The sweet spot is a “neutral” rate that keeps a delicate balance; it neither stimulates growth nor curtails inflation. But that balance is hard to find.

Currently, the Fed’s target rate is 2.0 to 2.25. But there have been times in its history (such as in the 70s and 80s) when the federal funds rate leapt to double digits in an attempt to control inflation. And for nearly a decade (from 2008 to 2017) it sat close to zero in an effort to stimulate economic growth.

How Has the Federal Reserve Impacted U.S. History?

In 1913, President Woodrow Wilson signed the Federal Reserve Act into law, creating a “decentralized central bank” meant to look out for the interests of both bankers and the public.

Before the Fed was born, bank runs and financial panics—caused by speculation and rumors—led to the call for a central banking authority that would support a healthier banking system.

It isn’t a perfect system. Since then, the country has experienced depressions and recessions, market crashes and financial crises. Here’s a brief history of how the Fed dealt with some of those events:

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 interest rates led to increased borrowing by businesses and households during this period, which stimulated economic growth. But the increased money supply eventually led to rising prices, and when the war ended, the Fed again took action to control that inflation.

Stock Market Crash of 1929

On Oct. 28, 1929, now known as “Black Monday,” the “Roaring 20s” ended with a thud when the Dow Jones Industrial Average dropped nearly 12%. The market collapsed the next day.
Many economists and historians blame government policies , and particularly the Fed, for the crash, because of its efforts to control over-speculation (what today might be called “irrational exuberance”) in the stock market.

Those moves included decreasing the money supply starting in 1928, and in 1929, putting pressure on member banks to pull back on their loans to brokers and charging a higher interest rate on broker loans.

The Great Depression, 1929 to 1941

The banking panics in 1930 and early 1931 were regional in nature. The nature of the financial crisis changed in the fall of 1931, when the commercial banking crisis spread throughout the entire 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 four-day bank holiday that closed all banks and the stock market. Legislative intervention soon followed.

In 1933, the Glass-Steagall Act separated commercial from 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 Corporation (FDIC) and regulation of deposit interest rates. The Banking Act of 1935 led to the creation of the Federal Open Market Committee.

World War II, 1941 to 1945

The Fed’s role during the World War II was similar to its role in World War I. Its main mission became financing the war, and it helped the Treasury 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 a half percent for loans secured by short-term government obligations. During the war years, the Fed kept its eye on inflation, as well, 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 with financing the war effort.

In Feb. 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 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 Chair Paul Volcker took over in 1979, and switched the Fed’s goal from targeting interest rates to targeting the money supply. And it was painful. The prime lending rate 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-80s.

The Great Recession, 2007 to 2009

Are you starting to notice a trend here? When a period in U.S. history is labeled “great,” it’s often anything but. During the Great Recession, home prices fell. Unemployment rose. The gross domestic product (GDP) fell. And, of course, in 2008, the market crashed.

It 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 Sept. 2007 to Dec. 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 it continued that effort in 2009. Also in 2008, President George W. Bush signed the $700 million Troubled Asset Relief Program (TARP) into law. Two more rounds of quantitative easing (QE2 and QE3) started in 2010 and 2012, under President Barack Obama.

Will the Fed’s Decisions Affect Your Finances?

Which brings us to today, when you’re just as likely to get the latest Fed news from a Facebook friend or presidential tweet as you are to hear it from more traditional media.

The central bank usually announces rate decisions after it concludes its policy meeting. And the Fed chair (currently Jerome Powell ) typically holds a press conference around that time.

You might not notice big changes right away if there’s a rate decision, although you may decide to hurry up a home loan or dump some debt faster than you planned if there’s a substantial enough increase.

The stock market often reacts to new or expected changes, so your investments may be affected. But those impacts—whether from a bump or a cut—can be hard to predict.

And the Fed funds rate isn’t the only one that could affect your wallet. The London InterBank Offered Rate (LIBOR) is one of the most common interest rate indexes used to make adjustments to adjustable rate mortgages and business loans.

Historically, the LIBOR runs pretty close to the Fed funds rate, but the two occasionally diverge—and they are calculated in different ways. The Libor is set in the UK and the Fed Funds Rate is set in the U.S.

Which is why, whether you’re borrowing money or saving it, it may be helpful to comparison shop. It may be wise to be aware of what’s affecting the big financial picture, but when it comes to making decisions about your own financial life, it’s also about finding the best rate and terms for your goals.

Want to see what the numbers look like when you refinance your existing mortgage? Check out what SoFi Mortgage Refinancing has to offer.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Third Party Trademarks: Certified Financial Planner Board of Standards Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design), and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.


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