Federal Reserve history

In 1913, Congress passed the Federal Reserve Act, creating the Federal Reserve System (Fed) in response to several banking panics in the late 1800s and early 1900s. Its main purpose was to act as a lender of last resort, or supplier of liquidity when banks faced temporary financial problems. Since the early 1900s the role of the Fed in the U.S. economy has grown to one of chief economic watchdog.

There are three main parts of the Federal Reserve System: the board of governors in Washington, D.C., 12 regional Federal Reserve banks, and the Federal Open Market Committee (FOMC). The board of governors is made up of seven individuals nominated by the president and confirmed by the Senate to formulate monetary policy, supervise and regulate member banks, and oversee the smooth functioning of the payment system in the economy.

The most powerful member of the board of governors is the chairman. The 12 regional banks act as the operating branches of the Fed. They can be thought of as a banker’s bank, managing reserve accounts and currency levels in their regions.

The most well-known part of the Fed is the FOMC. The FOMC meets regularly during the year to set monetary policy. The board of governors and five of the 12 regional bank presidents make up the voting members of the FOMC. The FOMC meetings have became some of the most watched and anticipated events by financial markets. At each meeting, the FOMC now sets a target for the federal funds rate, a key overnight interest rate that affects the cost of borrowing throughout the economy. For this reason, financial market participants closely scrutinize the motives of the FOMC.

There are several key moments in the history of the Fed. Prior to 1929, the Federal Reserve had no clear notion of its role in responding to cyclical forces. This resulted in a policy that allowed the money supply to contract dramatically over the first few years of the Great Depression. After the election of President Roosevelt in 1932, the Federal Reserve System was reorganized to resemble the structure we observe today. The Eccles Act was passed in 1935, enlarging some of the powers of the Fed and giving it greater control over the system of 12 branch banks.

During World War II, the Fed pegged interest rates, lasting until the end of the Korean War, in order to manage the wartime economy. Banks were also allowed to hold TREASURY BONDS in exchange for a relaxation of reserve requirements. During the 1940s, the Federal Reserve moved from keeping Treasury borrowing costs low toward seeking to achieve full employment. The latter of these goals was in response to the Employment Act of 1946, which set as a responsibility of the federal government the stabilization of employment at near-full employment levels. These goals of low borrowing costs and stable employment at near-full employment levels sometimes clashed, until March 1951, when an “Accord” was reached between the Treasury and the Federal Reserve System in which the Fed could actively and independently set monetary policy.

The 1950s and 1960s were an era of relatively good economic outcomes for the U.S. economy. During the 1950s, the Fed developed open market operations (the buying and selling of U.S. government securities on the open market) as the main policy tool used to affect interest rates. The next major challenge for the Federal Reserve was the “Great Inflation” of the 1970s. The inflation rate in the United States rose to 12.5 percent in 1974 and was 11 percent in 1980.

In 1979, in response to the spiraling inflation rate, Federal Reserve chairman Paul VOLCKER instituted an era of “tight money” in which the growth rate of the money supply was reduced.

This policy was intended to slow the growth of output and reduce the inflation rate. It succeeded very well. In the early 1980s, the United States suffered a severe RECESSION that many economists credit (or blame) the Federal Reserve for creating. By 1984, inflation was less than 4 percent.

The final years of Paul Volcker’s term as chairman and the appointment of Alan Greenspan to replace him in 1987 mark the beginning of a very successful period of monetary policy. The main goal of inflation stability initiated during the 1979 monetary policy tightening resulted in historically high interest rates until 1984 but has since been reinforced with the additional goal of stabilizing the growth of output.

Currently the Federal Reserve actively uses open market operations as its main tool in meeting its goals. Also at the disposal of monetary policy makers are two additional tools: the discount rate (the rate at which banks can borrow from the Federal Reserve) and the required reserve ratio (the proportion of bank deposits that must be held as reserve against possible withdrawals). By far the most often used tool is open market operations. In accordance to directions given by the FOMC, the Federal Reserve Bank of New York actively enters the market for U.S. government securities as a buyer or seller in an effort to influence the level of interest rates.

The main target of the Federal Reserve is the federal funds rate, an overnight rate directly affected by open market operations. The New York bank either buys or sells securities to move the Federal Funds rate to the target level set by the FOMC. The power of monetary policy is then transmitted to the economy by the changes in interest rates. An increase (or decrease) in interest rates reduces (increases) the level of consumer and business expenditures that require borrowing. This in turn decreases (increases) the level of output in the economy, reducing (increasing) pressure on prices to rise (fall).

The FOMC sets the target Federal Funds rate in accordance with its feelings as to the direction of the U.S. economy. If the FOMC believes inflation is on the upswing, it will raise interest rates to slow the economy. If it believes unemployment is too high (reducing pressure on inflation), it will lower interest rates to increase economic activity. For this reason, financial market participants pay very close attention to economic activity to gain some insight into the future actions of the Federal Reserve in setting interest rates. The Fed also acts as agent for the U.S. Treasury in the marketplace. It intervenes in the FOREIGN EXCHANGE MARKET when requested and also auctions Treasury securities for the government.

The Federal Reserve has a long history of intervening in the U.S. economy. From overseeing a dramatic decrease in the money supply during the early years of the Great Depression, to participating in producing monetary growth rates that allowed the Great Inflation to continue, to engineering a dramatic recession to lower inflation rates in the early 1980s, the Federal Reserve has been instrumental in the evolution of economic activity in the United States. Much of the expertise used by the Federal Reserve has been developed over its long history. This has culminated in perhaps the greatest period of economic expansion in U.S. history. From 1983 to 2000, gross domestic product grew steadily with only a slight interruption in the early 1990s, and inflation steadily fell.

See also COMMERCIAL BANKING; ECCLES, MARRINER S.

Further reading

• Beckner, Steven. Back from the Brink: The Greenspan Years. New York: John Wiley & Sons, 1996. 
• Greider, William. Secrets of the Temple: How the Federal Reserve Runs the Country. New York: Simon & Schuster, 1987. 
• Meltzer, Allan H. A History of the Federal Reserve, 1913–1951. Chicago: University of Chicago Press, 2003. 
• Meulendyke, Ann-Marie. U.S. Monetary Policy and Financial Markets. New York: Federal Reserve Bank of New York, 1989. 

Steve Perez