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Yahoo U: What is the Fed and how does it work?

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Yahoo Finance's Brian Cheung explains the Fed's functions and how it operates.

Video Transcript

ZACK GUZMAN: Welcome back to Yahoo Finance Live. Aside from the delta variant and omicron, the Federal Reserve is being listed as another market risk for next year in terms of which direction and coming off the accommodative stance that we've seen thus far from the Fed. And for those wondering why the Fed has such enormous say in the economy, it might be a good time to take a refresher course here. Yahoo Finance's Brian Cheung has the breakdown of all the basics behind the Federal Reserve in this week's Yahoo U.

BRIAN CHEUNG: Class is in session, and you've probably seen the headlines before. The Fed lowers interest rates, the Fed raises interest rates. The Fed does some stuff because, you know, the economy. But to understand why the Fed is important, it's important to know what the Fed does and how it's structured. In 1913, the Federal Reserve Act was signed into law, creating the nation's central bank. And Congress gave the Fed two major objectives-- stable prices, so no crazy inflation or deflation, and maximum employment, making sure there aren't enough jobs for workers and enough workers for jobs.

The central bank's board of governors, so think mission control, is based in Washington, DC. The Fed Chair presides over the board, which can have up to six other governors. But with a country as big as ours with so many different regional economies, the Fed also has 12 outposts scattered across the country referred to as Reserve banks. Each of these Reserve banks has a president. The 12 presidents, plus the seven members of the board in DC, make up the Federal Open Market Committee, which meets eight times every year to set monetary policy.

And one primary way the Fed conducts monetary policy is by setting targets on interest rates. As a banker's bank, the Fed allows US banks to park money overnight. So lower interest rates spur more borrowing and lending, in theory, stimulating the economy. If the economy looks like it might overheat-- think runaway inflation-- the Fed can raise interest rates, in theory, pulling back on economic activity.

The Fed has also relied on its balance sheet by buying US government bonds and mortgage-backed securities to support liquidity in major markets. And with the US and the US dollar as the rock of the global economy, the Fed remains the world's most important central bank. Its actions have ripple effects on ordinary consumers, all the way up to forex markets in countries on the other side of the world, which makes it all the more interesting and important to know about. That's this week's Yahoo U. Class is dismissed.