Federal Reserve System
By Richard H. Timberlake
The Original Federal Reserve System
Several monetary institutions appeared in the United States prior to the formation of the Federal Reserve System, or Fed. These were, in order: the constitutional gold (and bimetallic) standard, the First and Second Banks of the United States, the Independent Treasury, the National Banking System, clearinghouse associations, and the National Reserve Association. The Fed was the last such institution founded. Although it has endured, the present-day Fed would be unrecognizable to its founders.
The original Federal Reserve Act became law in December 1913. The “Federal” in the title implied that the law applied to the whole country, and “Reserve” emphasized the new institution’s role as a reserve holder and reserve supplier for the commercial banking system. The twelve regional Federal Reserve Banks, according to the Federal Reserve Act, were “to furnish an elastic currency” by
discount[ing] notes, drafts, and bills of exchange arising out of actual commercial transactions.. . . The time, character, and volume of sales of [this eligible] paper . . . shall be governed with a view to accommodating commerce and business and with regard to their bearing upon the general credit situation of the country.
Conspicuously absent in the title or anywhere else in the act were the words “central bank.” The primary reason for this omission was the term’s unpopularity with the populist wing of the Democratic Party. Republicans had accepted the label, but, after 1912, no longer controlled either Congress or the White House. Therefore, the new institution could not be a “central bank.” That term, many congressmen objected, implied monopolistic control by Wall Street bankers, who would keep interest rates “high” and conspire with speculators to cause panics. However, under Democratic sponsorship, the new institution could be an autonomous group of regional reserve-holding supercommercial banks, and the act passed through Congress in this guise.
The U.S. banking and financial system at this time had recognizable faults that some bankers, financial experts, politicians, and economists thought needed correcting. The major monetary institution of the era was the self-regulating gold standard, which functioned much as was expected. However, the commercial banking system included both state banks—chartered by state governments—and national banks—licensed as such by the comptroller of the currency. Because of the overlap in regulatory jurisdictions, a plethora of regulations made banking operations difficult. Legal reserve requirements, for example, varied significantly at the state and national levels, and almost always made banking less flexible and more precarious. The banking system’s fragility appeared whenever some random and unforeseen financial shock put undue pressure on the banking system to provide “emergency” liquidity.
The Federal Reserve System was the institutional answer to this perceived problem. Just as the gold standard worked through market forces to provide a proper quantity of gold-based money, so the new Federal Reserve Banks would augment the gold standard to ensure that the commercial banking system could issue the proper quantity of bank-created money in a timely fashion.
The twelve regional Federal Reserve Banks were to be located in major cities. Each bank was to operate autonomously in its region. A Fed Bank had a board of directors and an executive structure similar to that of any commercial bank or business firm. Commercial banks in a Federal Reserve district could become members of the Federal Reserve if they fulfilled certain requirements, including buying stock in their regional Fed Bank according to a formula based on their capital value. The Fed Bank then paid them a statutory annual return of 6 percent on the value of this stock. Member commercial banks therefore became the “stockholders” of the Fed banks.
Also included was a Federal Reserve Board located in Washington, D.C., and housed in the Treasury Department. Members of the board, appointed by the president, served staggered ten-year (later fourteen-year) terms. The board was to provide oversight and examination of the twelve Fed Banks, including the “nature and maturities of the paper and other investments owned or held by the Federal reserve banks.” It could also “require Federal reserve banks to rediscount the discounted paper of other Federal reserve banks at rates of interest to be fixed by the Board.” Finally, it had the power to suspend the gold reserve requirements of the twelve Fed Banks for an indefinite period.
Operations of the new Fed Banks included several important features. First, Fed Banks were to be subordinate to the gold standard, which had been in place for more than one hundred years. They were to be “lenders of last resort” and not to take the initiative in monetary affairs. They were also to be independent of political influences.
The Fed Banks’ principal function was to rediscount—that is, make loans—to their member banks when the banks were short of liquidity. In keeping with the idea of a Fed Bank as a “lender of last resort,” the Fed’s discount rate was always supposed to be above current market rates. Bankers and politicians accepted this principle for commercial bank and central bank operations. Just as the gold standard automatically provided for the monetization of gold on fixed terms—at that time, $20.67 per ounce—so the Fed Banks were to lend money to their member banks on “eligible paper.” Such paper was to be limited to short-term self-liquidating loans, bills, discounts, and advances that had appeared in conjunction with the production and marketing of real goods. This rubric, at the time known as the “commercial credit theory of banking,” is also called “the real bills doctrine” and was a key factor in Federal Reserve policy for the first twenty years of the Fed’s existence.
Unlike gold, which the owner could convert into money precisely according to the mint price of gold, the dollars that Fed Banks could lend to member banks on “eligible paper,” or “real bills,” were not specified by any formula or law. Like the gold standard, the real bills doctrine theoretically gears the production of money to the production of real goods, services, and capital. Thus, the whole strategy of the Federal Reserve System was to graft an automatic money-creating banking policy onto an automatically functioning gold standard system, with the whole money-making apparatus geared to the production of real goods and services.
The Federal Reserve System During the 1920s
The Federal Reserve Banks became operational during World War I. Their first major task was to support the U.S. Treasury’s wartime financing needs. Most of the credit they created came after the war (1918–1920) to support Liberty Loans the government floated to help finance the war and its aftermath. Their subsequent contraction of credit in 1920 contributed significantly to the recession that occurred in 1921–1922. Recovery came quickly, however, leaving the system in a position to develop certain norms of policy in the postwar period.
As the system came of age in the 1920s, both the Fed Banks and the Federal Reserve Board argued that the banks’ constant presence in the money market was necessary to prevent crises. The New York and Chicago Fed Banks, the largest of the twelve, had most of the commercial banking activity in their districts, and the president of the New York Fed, Benjamin Strong, became the dominant figure in the system.
During World War I and into the 1920s, U.S. exports of goods and capital to Europe burgeoned. As gold flowed in to pay the balances on U.S. exports, member banks deposited much of it in Fed Banks. The Federal Reserve Act specified minimum reserves of 35 percent gold against member bank reserve-deposit accounts at Fed Banks, and 40 percent gold against Federal Reserve notes outstanding. By August 1929, the Fed Banks’ gold holdings were $3.12 billion, double the legal requirement.
Growth in Fed Banks’ excess gold reserves, formally labeled “free gold,” provided a buffer for Fed policymakers. By selling off other earning assets, they could “sterilize” gold inflows so that incoming gold would not inflate the stock of common money enough to raise prices. “The” gold standard, therefore, no longer provided an effective control over the stock of U.S. money; the system was no longer autonomous and self-regulating. In place of the self-regulating gold standard were the decisions of Fed policymakers.
Throughout this era, many economists recommended that Fed policymakers use the quantity theory of money (see monetarism) as their guide to policy, and the Federal Reserve Bank of New York under Benjamin Strong unofficially implemented this practice for a short time (1922–1928). Most Fed officials vigorously opposed this idea, however, insisting that the compatibility of the real bills doctrine with economic productivity provided the optimal policy.
The downturn in business that became the Great Contraction of 1929–1933 began in 1928. Federal Reserve officials, and many financial analysts and politicians, believed that a financial purging of speculative and nonproductive bank credit was needed. They argued that the slackening of production in the economy indicated a diminished “need” for money. Since they had taken monetary control away from the gold standard, their faulty decision to do nothing to keep the money supply from falling allowed the recession to degenerate into a depression. As it did so through 1930 and 1931, the commercial banking system suffered three major crises. By early 1933, it and the economy were in shambles (see great depression).
The Banking Act of 1935
In 1935, Congress, at the behest of President Roosevelt, passed the Banking Act of 1935. This act converted the autonomous regional system of reserve-holding banks into a monolithic central bank with positive and deliberate control over the U.S. monetary system.
One major change was the creation of the Federal Open Market Committee (FOMC). This agency included the seven governors (as they were now labeled) of the Fed Board, the president of the New York Fed, and four of the other eleven Fed Bank presidents, who rotated membership on the committee. The FOMC controlled open market operations in government securities, which now became system-wide. Reserve Banks still set their own discount rates, but discounting never again figured prominently in Fed policies.
A 1917 amendment to the original act of 1913 had fixed member bank reserve requirements at 7, 10, and 13 percent for member banks in small to larger cities. The act of 1935 extended these percentages to a range double the original values, that is, to 7–14, 10–20, and 13–26 percent, the exact percentages to be set by decision of the Board of Governors. This change added to the board’s policymaking powers. While the new act gave the Fed these additional monetary controls, it nowhere specified goals or targets for Fed policy beyond the general terms in the original act.
The Banking Act also removed the secretary of the treasury and his second-in-command, the comptroller of the currency, from the Fed Board. (They had been chairman and vice chairman of the board.) However, the board’s decisions were even more under the control of the secretary of the treasury than they had been in the past. From 1935 to 1951, the secretary of the treasury, with the compliance of Fed Board Chairman Marriner Eccles, continued to dominate Fed policies.
Gold kept coming into the United States due to both the higher price (thirty-five dollars per ounce) that Congress had legislated in 1934 and the political instability in Europe. By 1936, the commercial banking system had enormous “excess” reserves—double the required amount of currency and reserve-deposit accounts with Fed Banks, which also had double the amount of required gold reserves. Observing the volume of reserves in the banking system and arguing that it would fuel inflation, the Fed Board—with the approval of the secretary of the treasury, most financial experts, and many academicians—doubled commercial bank reserve requirements in three steps: by 50 percent in August 1936, 25 percent in March 1937, and the final 25 percent in May 1937. This momentous change stifled the recovery and initiated the 1937 recession. In fact, even had the banks used all of their excess reserves to expand credit and the money supply, virtually no inflation was possible. The high unemployment of 1936 and 1937 meant that even a fully expanded banking system could not have created enough money to raise prices more than a few percent above their 1929 level. Complete economic recovery did not occur until after the start of World War II.
During World War II, the Fed concentrated on maintaining “low” interest rates so that the U.S. Treasury could sell enough bonds to finance the war. If bond prices tended to drop and interest rates on them to rise, the FOMC prevented the increase in nominal rates by using the Fed’s still-abundant excess reserves to buy the securities that the markets “would not take”—at prevailing rates. Interest rates were low: 0.375 percent on the shortest-term treasury bills to 2.5 percent on long-term bonds. Commercial banks did likewise with their excess reserves. This policy pumped large quantities of inflationary new money into the monetary system. To hide inflation, the administration and Congress imposed direct controls on prices, wages, and production.
After the war ended, the Truman administration tried to continue price-wage controls, as well as its control over Fed monetary policy. However, in the mid- and late 1940s, Congress abolished most controls, then passed a resolution that reintroduced the principle of “independence” into Fed policymaking. The resolution emphasized that the Fed would be responsible for monetary policy and the U.S. Treasury for fiscal policy, and that “they should stay out of each other’s backyards.” It also charged both bodies to aim toward the goals specified in the Employment Act of 1946— that is, to “considerations relating to [policies’] effects on employment, production, purchasing power, and price levels.” Fed and Treasury officials ratified this congressional mandate in the famous “accord” of March 1951. Around the same time, President Truman appointed William Mcchesney Martin chairman of the Federal Reserve Board.
The Martin Fed, 1951–1970
Under Martin’s chairmanship, Fed policy became very ordinary. For sixteen years, 1951–1966, the M1 money stock increased at an average annual rate of 2.4 percent, and prices rose annually by just 1.6 percent. Most of the increase in the money stock resulted from the Fed Board’s reductions of member banks’ reserve requirements, which allowed the banking system to increase its deposits proportionally. By 1962, requirements were 16.5 percent for big-city member banks and 12 percent for “country” (i.e., small-town) banks. As they reached this moderate range, the Fed Board left them there and henceforth focused on open-market operations to effect monetary policy.
But starting in 1964, President Lyndon B. Johnson’s government spending programs for welfare and the Vietnam War again put pressure on the Fed to keep interest rates down. The Fed yielded somewhat to administration pressure. Increases in M1 that had been between 2 and 3 percent in the early 1960s jumped to 5–8 percent from the mid-1960s to early 1970s.
Federal Reserve Policy under Arthur Burns
President Richard M. Nixon appointed Arthur Burns chairman of the Fed Board in 1970. Under Burns’s chairmanship, the Fed continued its policy of “stimulation-accommodation.” When a recession appeared, as occurred in 1969, the Fed increased its open-market buying activity to stimulate spending. Once recovery was in place, Fed policy accommodated revived business spending, again with open-market purchases. This combination caused higher inflation, which the Nixon administration, with Burns’s blessing, sought to restrain by statutory wage and price controls—the Economic Stabilization Act, which became law in August 1971. This program failed to tame inflation. Fed policy continued in the same pattern, however, through the 1970s, reaching its climax with the inflation spike of 1979–1981.
Burns summed up the Fed’s problems in 1987, as they had appeared during his tenure. “Currents of thought and the political environment they have created,” he lamented, give rise to government spending programs and federal fiscal deficits. The Fed has “the power to abort the inflation” at any time, and “it has the power to end it today,” he admitted. However, Burns continued,
it is illusory to expect central banks to put an end to an inflation . . . that is continually driven by political forces.. . . Persistent inflation . . . will not be vanquished . . . until new currents of thought create a political environment in which the difficult adjustments required to end inflation can be undertaken. (Arthur F. Burns, “The Anguish of Central Banking,” Federal Reserve Bulletin, September 1987, pp. 695–696)
Federal Reserve Policy Under Paul Volcker
President Jimmy Carter appointed Paul Volcker chairman of the Fed Board in August 1979, about a year before inflation peaked. By this time, everyone recognized the Fed’s complete power to control the monetary base—that is, currency outstanding and bank reserve accounts. In addition to the base, most economists accepted and used two classifications for common money: M1, consisting of the public’s holdings of currency plus checking account deposits in banks and other depository institutions; and M2, which includes M1 plus time deposits in these same institutions. These money stocks are commonly referred to as “the aggregates.”
The Fed has used its power over the aggregates principally to influence short-term interest rates—the federal funds rate and the three-month treasury bill rate. Fed policymakers refer to these rates as “money market conditions.” Two different indicators, therefore, react to the Fed’s control over base money: the “aggregates”—money stocks M1 and M2—and “money market conditions”—the short-term interest rates noted above. Seldom can both of these indicators be appropriate policy guides simultaneously.
The inflation of the late 1970s was a result of Fed attempts to use money market conditions as a guide to policy when interest rates were responding to inflationary expectations resulting from large increases in money stocks. Pumping more money into the system to keep interest rates down only added to expected inflation and increased nominal interest rates. In October 1979, the Fed shifted to its own version of monetarism. Fed “monetarism” lasted officially only until October 1982. In practice, Fed policy never abandoned interest rate targeting and never accepted any rigorous application of true monetarism.
The Monetary Control Act of 1980
Congress passed the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) in 1980. Title I of the act extended the Fed’s power to specify member bank reserve requirements to include all depository institutions. This issue was contentious because Fed Banks pay zero interest on reserves; thus, the law placed what was essentially a tax on nonmember banks. Title I also extended the eligible collateral for Fed issues of federal reserve notes to include the “fully guaranteed obligations of a foreign government or the agency of a foreign government.”
Title II of the DIDMCA generally deregulated and freed up operations in the financial industry. It allowed all financial institutions to provide checking account services to their customers, and it abolished interest-rate controls on deposits so that depository institutions could pay competitive interest rates on deposit accounts.
The combined effects of the new act’s provisions were beneficial for the U.S. economy. Demand deposit balances were now a more attractive way to hold wealth than they had been. By 1988, the Fed had phased down reserve requirements for most demand deposits to 12 percent, where they have remained.
The resulting decline in inflation rates has prompted foreigners to hold a large but immeasurable quantity of U.S. dollars. The world’s increased demand for U.S. money helped reduce inflation by decreasing the velocity of money on both M1 and M2. By 1986, inflation in the United States had ended.
Between 1985 and 1990, however, Fed policy increased the base by 9 percent per year (from $201 billion to $290 billion), while M1 increased by 7.5 percent per year (from $591 billion to $810 billion). The result was robust revenue for the U.S. Treasury, but also a resurgence of inflation by the end of the decade to annual rates of 4–5 percent.
The Greenspan Fed
In August 1987, President Ronald Reagan appointed Alan Greenspan chairman of the Federal Reserve Board. Greenspan inherited the end-of-the-decade inflation determined by the policies of his predecessor, Paul Volcker, and the FOMC. When Greenspan became chairman, he and other members of the policymaking FOMC began expressing sophisticated arguments for a monetary policy that formally concentrated on price level stability. In his reports to Congress Greenspan presented the case for such a policy on several occasions. In accordance with this prescription, the FOMC repeatedly lowered rates of growth for M1 and M2 during the 1990s. Most important, the FOMC policy directive for the day-to-day implementation of Fed policy to the Fed Bank of New York took on a new tone. Before 1988 it had stated that the FOMC “seeks monetary and financial conditions that will foster reasonable price level stability.” But in the March 1988 directive, the FOMC deleted the modifier “reasonable.” The quantity theory of money, which posits the close relationship between the quantity of money and prices, furnishes the intellectual framework for the FOMC’s new emphasis.
Certain congressmen tried to formalize the FOMC’s stable price level policy by means of a congressional resolution. Representative Stephen Neal, chairman of the House Subcommittee on Domestic Monetary Policy, was the major proponent of the resolution. He held hearings several times on the proposal between 1989 and 1991 and had Greenspan and several Federal Reserve Bank presidents testify on both its feasibility and its importance. However, neither the Reagan nor the Bush administration approved of their effort. Particularly if a recession is brewing, the incumbent executive inevitably wants the central bank to “lower interest rates” by (necessarily) pumping money into the system.
Nevertheless, the FOMC has continued to pursue price stability. Between 1991 and 2004, the annual inflation rate steadily declined from 4 percent to less than 2 percent. At the same time, short-term interest rates fell from 6–9 percent to 1–4 percent, while long-term rates decline from 8–10 percent to 4–6 percent. These data imply the near absence of expected inflation.
The Fed’s performance since 1991 has been unquestionably superior to its record at any time since 1913. However, the larger, long-run question remains: Can the Fed as an “independent” central bank maintain price stability contrary to the wishes of an executive branch that seeks to use its fiscal powers to manage the federal government’s burgeoning long-term debt?