The Fed explained: What it does and why it matters

As the nation’s central bank, the Federal Reserve plays a crucial but oftentimes mysterious role in the lives of Americans: from controlling the money supply to regulating financial institutions and adjusting interest rates. In moments of crisis—whether a market crash, a pandemic, or a global energy shock—the Fed is often the first responder, tasked with stabilizing markets and restoring confidence.

To better understand how this powerful but largely invisible institution works, Penn Today spoke with the Wharton School’s Patrick Harker, former president and CEO of the Federal Reserve Bank of Philadelphia, and Peter Conti-Brown, a financial historian and legal scholar who specializes in central banking and the history and policies of the Fed.

A central bank nobody really wanted, but needed

After the Revolutionary War, Alexander Hamilton persuaded George Washington to establish the First Bank of the United States to stabilize the young nation’s finances. It worked, but not without backlash: Americans’ deep-seated disdain for centralized power, born from the revolution itself, fueled fierce opposition.

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This “farmers versus merchants” tension served as the 18th-century precursor to the modern “Main Street versus Wall Street” divide, Harker says.

Despite the First Bank’s success in stabilizing credit, political opposition led Congress to let its charter lapse within 20 years.

Without a central bank after 1836, the U.S. entered “the free banking era,” where any small bank could issue its own currency. “This birthed the phrase ‘wildcatterers,’” Harker explains, referring to bankers who operated “in the middle of nowhere — where wildcats were — in hopes that customers would be too fearful to redeem banknotes.”

Financial instability culminated in repeated banking panics, including a major crisis in 1906. With no central authority to stabilize the system, private financiers like J.P. Morgan stepped in to prevent collapse—an arrangement policymakers deemed unsustainable.

A uniquely decentralized central bank

When Congress created the Federal Reserve in 1913, it built something deliberately fragmented, a system unlike any other, explains Conti-Brown.

The Fed consists of a Board of Governors in Washington, D.C.—seven members appointed by the president and confirmed by the Senate—and 12 independent Federal Reserve Banks scattered across the country.

“It’s not one monolithic institution,” Conti-Brown says. “It’s a system—intentionally so—to reflect the country’s political distrust of concentrated power.”

This design ensures that monetary policy is not dictated by a single entity. Instead, the Federal Open Market Committee (FOMC) is where the 19 participants debate and decide the economic path forward.

“Every quarter, the 19 FOMC members anonymously plot their future interest rate projections on a chart known as the ‘Dot Plot,’” says Harker. “I, very proudly, was one of those dots.”

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The ‘bank of banks’

The Fed acts as a massive information technology organization, with trillions of dollars flowing through digital pipelines that process everything from consumer transactions—such as deposits into checking accounts—to massive corporate transfers.

But where does the Fed get the money to regulate the economy?

“We just make it up,” Harker deadpans. “We just create money.”

When the economy needs a boost—like during the COVID pandemic—the Fed buys U.S. Treasurys from banks and digitally deposits newly created funds into their reserve accounts. When the economy runs too hot, the Fed does the reverse, “digitally burning” the money to shrink the supply.

This digital dialing of the money supply helps the Fed target its “dual mandate” set by Congress: maximum employment and stable prices, with the latter generally defined as a 2% inflation rate target.

A common misconception is that the central bank directly sets consumer mortgage or credit card rates. In truth, the Fed only directly controls the federal funds rate, which is the interest rate banks use to lend to each other overnight. By raising rates, the Fed cools down an overheating economy; by lowering them, it spurs growth, however, market forces ultimately dictate the rest of the consumer rates.

Taking away the punch bowl

Making the right call on interest rates requires political independence. Without it, Conti-Brown says, “politicians might be tempted to use the central bank to artificially prop up the economy ahead of an election”—a move that has repeatedly ended in inflation or worse.

In the 1970s, the United States flirted with that edge as President Richard Nixon pressured Fed Chair Arthur Burns to keep rates low, helping fuel a decade of runaway inflation that was only broken when the next chair, Paul Volcker, slammed the brakes in the early 1980s, triggering a painful recession.

At its core, the Fed’s job is less party host and more reluctant chaperone, Harker chuckles, citing former Chair William McChesney Martin’s famous quip: “The central bank’s role is to take away the punch bowl just when the party really starts warming up.”

Patrick Harker is the Rowan Distinguished Professor Professor of Operations, Information and Decisions at the Wharton School and the Director of Academic Engagement at Penn Washington.

Peter Conti-Brown is the Class of 1965 Associate Professor of Financial Regulation, Associate Professor of Legal Studies & Business Ethics at the Wharton School.