How the Federal Reserve Works: The FOMC, Rates and the Dual Mandate

The United States spent most of the nineteenth century without a central bank. It did not enjoy the experience. Banking panics arrived with some regularity. The one that began in October 1907 was severe enough that the rescue had to be organized privately, in a library on Madison Avenue, by J. P. Morgan and whichever bankers he could summon. Congress concluded that a wealthy country should not depend on the continued availability of one elderly financier, and after six years of argument it passed the Federal Reserve Act of 1913.

That argument is still visible in the result. People who wanted a single national institution and people who wanted no central bank at all compromised on a system with a federal board in Washington and twelve separately incorporated Reserve Banks spread across the country, and the Banking Act of 1935 rearranged those pieces into roughly the shape they hold now. Most of its oddities date from that quarrel.

A system assembled from three parts

The Board of Governors sits in Washington and is a federal agency with seven members, nominated by the President and confirmed by the Senate, serving 14-year terms staggered so that no single administration appoints the whole board at once. The Chair and Vice Chair are governors designated to those roles for renewable four-year terms, which means a chair whose designation lapses can in principle stay on as a governor, an arrangement that has almost never been used.

The twelve regional Reserve Banks are in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco. The map was drawn in 1914 around the commercial geography of the time, which is why Missouri has two Reserve Banks and the entire West Coast has one. Each bank has a president chosen by its own directors and approved by the Board, supervises banks in its district, moves currency and payments, and produces a great deal of the research the system runs on. The New York Fed also houses the trading desk that carries out whatever the committee decides, a role it acquired in the 1920s largely because Benjamin Strong, its first governor, took it.

The Federal Open Market Committee is where those two halves meet. It sets policy.

The mandate, and the single number attached to it

The statutory language, written into the Federal Reserve Act by amendment in 1977, instructs the system to promote “maximum employment, stable prices, and moderate long-term interest rates”. That is three goals. The third follows from the first two. That is how a triple mandate came to be universally described as a dual one.

Stable prices acquired a number in January 2012, when the committee published a framework statement saying that inflation of 2 percent a year, measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with its mandate. PCE is produced by the Bureau of Economic Analysis and differs from the better-known consumer price index in its weights and in how it handles consumers substituting one good for another, and markets react far harder to the CPI release, because it arrives first, though the target itself is written on PCE. That framework statement is reviewed on a regular cycle and has been rewritten more than once, so the version worth reading is whichever one is posted on the Board’s website.

Maximum employment has never had a number. The committee has been explicit about why: the highest level of employment the economy can sustain without generating inflation moves with demographics, immigration, productivity and the industrial mix, so it has to be assessed from a range of indicators. The monthly jobs report is the largest single input into that judgement. It is nowhere near sufficient on its own.

The two halves can point in opposite directions, which is the whole difficulty of the job, because when inflation is high while unemployment is rising, tightening to bring prices down worsens the employment side, and easing to protect jobs worsens the price side. The 1970s were the long lesson in what happens when a central bank keeps choosing the employment side, and the disinflation engineered under Paul Volcker between 1979 and 1982, which carried unemployment to its highest level since the Depression, was the lesson in what the correction costs. Both sit underneath the language used now.

Twelve votes, and what a dissent means

Seat	Votes	Notes
Governors on the Board	7	Permanent voters, including the Chair
President, Federal Reserve Bank of New York	1	Permanent voter and vice chair of the committee
Presidents of the other 11 Reserve Banks	4	One-year rotations in fixed groups
Total voting members	12	A simple majority carries the decision
Non-voting Reserve Bank presidents	0	They attend, speak and submit projections

Eight scheduled meetings a year, spaced roughly six weeks apart, normally running Tuesday into Wednesday, and four of them are accompanied by the Summary of Economic Projections, in which every participant, voting or not, submits forecasts for growth, unemployment, inflation and the policy rate each thinks appropriate. That scatter is the dot plot. Reading it against what the futures market expects has a guide of its own in fed funds futures and the dot plot.

Dissents are recorded by name at the foot of the statement, and they repay attention because the committee would generally prefer not to have any. A single dissent is ordinary housekeeping. Two or three pulling in the same direction is a committee that has genuinely split, and the historical pattern is that a divided committee sits closer to changing course than a unanimous one.

Making the target range real

The federal funds rate is what banks charge each other for overnight loans of the reserve balances they keep at the Fed. The committee cannot order anyone to lend. It announces a target range, normally 25 basis points wide, and then uses rates it administers directly to hold the market rate inside it.

Before 2008 this was done by scarcity. The New York desk added or drained a few billion dollars of reserves each morning through repurchase agreements, and because reserves were scarce, small changes in supply were enough to move the overnight rate to a single point target. That method stopped working once the crisis response left the banking system holding reserves in the trillions, and the mechanism was rebuilt around a floor.

Interest on reserve balances is the rate the Fed pays on reserves left with it, and a bank has little reason to lend overnight to another bank for less than it can earn risk-free from the central bank, so that rate works as a floor under the market. The overnight reverse repurchase facility does the same job one layer down, for money market funds and government-sponsored enterprises that cannot earn interest on reserves and would otherwise lend at whatever they could get, since the facility lets them park cash with the Fed against Treasury collateral. The discount window sits on the other side, priced above the top of the range and available to sound banks against collateral, which in theory caps how far the market rate can run. In practice banks avoid it. Borrowing there has been read as a sign of distress since long before 2008, and that stigma is why the ceiling holds less firmly than the arithmetic suggests.

Reading the statement against the one before it

The statement lands at 2:00 pm Eastern on the second day and runs to a few paragraphs in a structure that changes very little from meeting to meeting. The first paragraph describes activity and inflation. Then comes the sentence that almost never changes, some version of “the Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run”, followed by the decision itself, written as a decision to maintain or to adjust the target range. Then the balance sheet instruction, then the conditions under which the committee would reconsider, then the roll call of voters and any dissent.

Nearly all the information is in what changed. When the committee describes activity as expanding at a “moderate” pace having said “solid” six weeks earlier, that is a deliberate act by people who choose adjectives in a room together, and the history of the guidance sentence is the clearest demonstration of how much weight single phrases carry.

Period	The phrase	What it committed to
2004 to 2006	Accommodation removed “at a pace that is likely to be measured”	A quarter point per meeting, repeated seventeen times
From March 2009	Rates low “for an extended period”	An open-ended promise with no date attached
August 2011	Low rates “at least through mid-2013”	A calendar date the market could price directly
December 2012	Thresholds tied to unemployment and projected inflation	Conditions in place of dates
March 2015	The word “patient” removed	Notice that a first hike had become live

Each of those changes moved Treasury yields on the day it appeared, several moved them more than the rate decision published alongside, and this is why experienced readers open the previous statement in a second window before they read the new one, a habit worked through line by line in reading an FOMC statement.

What one percentage point does to a valuation

The reason equity investors care about a committee that sets an overnight rate is the discount rate, since a share is worth the cash it will produce, discounted back to today, and that discount rate begins with the risk-free rate the Fed influences most directly.

Take a perpetuity. A company is expected to produce $10 per share of free cash flow next year, growing at 3 percent a year forever. Value is CF / (r - g).

At a discount rate of 8 percent: 10 / (0.08 - 0.03) = 10 / 0.05 = $200. Raise it one point, to 9 percent: 10 / (0.09 - 0.03) = 10 / 0.06 = $166.67.

One percentage point removed 16.7 percent of the value, nothing whatever happened at the company, and the effect grows the further into the future the cash sits, which is the mechanical reason long-duration growth companies move more on rate news than utilities do, and the identical discounting arithmetic governs bond prices, worked through in how bonds work.

Afterwards: the press conference, the minutes, the transcripts

The chair takes questions thirty minutes later. That runs for roughly an hour. The prepared remarks restate the statement. The useful material is in the answers, and specifically in the moments when a chair describes what would have to happen for the committee to move, because that is conditional information a two-page statement is too short to carry.

Minutes follow three weeks later. They give the shape of the discussion: how many participants favored what, which risks were raised, what was said about the balance sheet. The vocabulary is worth learning. Words such as “a few”, “several”, “some” and “most” are used consistently to indicate how many people held a view.

Full transcripts appear after five years. Their existence was not widely known outside the building until 1993, when congressional pressure led the Fed to acknowledge that recordings had been kept and to begin releasing them on a lag. They are the reason we can read exactly how the committee argued through 1979, or through September 2008, without inferring it from the minutes.

Where the Fed’s control ends

The committee sets one overnight rate. It does not set the 10-year Treasury yield, which is the bond market’s own judgement about growth, inflation and policy over a decade, and which you can watch change shape on the yield curve tool. Long rates moved remarkably little through the 2004 to 2006 tightening cycle even as the policy rate rose at every meeting, a divergence Alan Greenspan called a conundrum in testimony at the time, and long rates have also risen while the committee was cutting, so treating them as a lever the Fed pulls will mislead you in both directions.

Monetary policy also works with what Milton Friedman described as long and variable lags, so a change in the funds rate reaches hiring and capital spending over quarters, which means a committee is always setting policy for an economy it cannot yet observe, and that is the root of the overtightening complaint which follows every cycle.

Supply shocks sit outside the mandate altogether. A central bank cannot produce oil, semiconductors or shipping capacity, so when prices rise because supply has been damaged, the only available tool works by suppressing demand, which is a poor answer to a problem on the other side of the market. Fiscal policy is set by Congress and can pull hard against whatever the Fed is doing, and the balance sheet has limits of its own, having grown to roughly $9 trillion by 2022 and proved considerably slower to shrink than to build, as quantitative easing and tightening sets out.

The honest summary is that the Fed has strong influence over short-term borrowing costs, real but partial influence over financial conditions, and almost none over supply, and its statements are drafted with such care because language is the one instrument that works instantly.

Follow the chain into asset prices with how interest rates affect stocks, or learn which releases the committee is reacting to in the economic calendar guide, and the Fed and the economy quiz covers this material in ten questions.