How does a central bank actually work?

The Federal Reserve opted to leave rates unchanged this week, and additional comments from Jerome Powell indicated that they would be open to raising rates further in the near term depending on the trajectory of inflation.

Let’s talk about exactly what is a central bank, and how does it work.

The quick history

Before the creation of the Federal Reserve, bank runs and bank crises were far more common than today. If you think about it, the banking system recently has been fairly stable relative to history in terms of frequency of events. The year 2008 saw a significant banking crisis, and 2022 ushered in the age of inflation with a handful of bank failures, but outside of that, consumers have generally not operated with the fear of losing their money in a savings account since World War 2 (we’re not talking about the ebbs and flows of the stock market, just banks here like where you put your savings).

But take a look at this chart. The shaded areas are years that saw a bank panics, it seems like they happened all the time in the late 1800’s. Imagine every five years losing all your savings because your bank failed.

This was the intent behind the creation of the Federal Reserve. To bring stability to the banking system by preventing situations where people’s savings were constantly getting wiped out over and over again. Before the Fed, a bank’s capital came entirely from its investors/owners, and when the bank didn’t have enough capital from that source to handle extreme outflows, the bank folded. Now, banks still have investors, but for the day-to-day inflows and outflows, banks can quickly and efficiently borrow and repay money from the Fed to handle things like managing quickly moving deposit and loan balances. Banks operate by taking deposits from customers then lending that money out to borrowers. It’s a long and drawn-out process to source investor capital, so it’s not feasible to go to your investors for capital every time a depositor comes in and wants to withdraw more cash than the bank has on hand. In modern times, banks now can source cash and capital from the Fed instantly to meet their needs. This is the primary value-add of the Fed.

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Before the Fed, 1800’s

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After the Fed, 1900’s-today

It is managed by a board of governors appointed by the President and confirmed by the Senate.

That’s who Jerome Powell is – he’s the chairman of the board of governors of the Fed.

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“Papa” Powell saying “deal with it”

How the Fed interacts with banks, simplified

There are a ton of intricacies to how the system works, but we’ll try to stay on the very basics and why the rates set by the Fed matter.

In simplest terms, the Fed will lend to banks at a rate called the Federal Discount Rate. That is the rate that we talk about when we say “the Fed left rates unchanged at 5.5% this week”. This is the rate that your bank is getting to borrow from the Federal Reserve. Your bank then turns around and uses that rate as a basis for its own operations. For example, if your bank can borrow at 5.5%, it will lend to you at a higher rate, say, 7%, and that 1.5% difference is called a spread. Managing spreads across all its products, from loans to deposit obligations, is exactly how banks make money – lending it out at higher rates than it sources capital

Now you can see how a higher rate set by the Fed causes a chain reaction that makes borrowing more expensive, so the cost of investing and doing business becomes more expensive. It is critical to note here that when we say expensive it is not the same thing as expensive in the context of inflation. Here, we mean expensive in that an investment project generally should expect to “pay more” for capital (e.g. higher interest rates on borrowing), hence, “expensive” investments.

Conversely, when the Fed lowers interest rates, the cost of investing decreases. This is what we mean when we say “cheap money” in a low interest rate environment. In subsequent letters we will go more into the money supply, inflation, and other details of how the world works.

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