Treasury Today Country Profiles in association with Citi

The Federal Reserve System

Federal Reserve building

Dating back almost a century, the central banking system of the United States has evolved substantially over the years. Since 2008 it has responded to the global financial crisis with a series of unorthodox measures that challenge its underlying monetary principles.

The Federal Reserve System (FRS) was born out of economic crisis. Its creation came in 1913, with the enactment of the Federal Reserve Act, following a series of severe financial panics before and after the turn of the century. The new system’s purpose was to ensure the financial stability of a capitalist business cycle prone to boom and bust. This is a fact that Ben Bernanke, the current chairman of the Federal Reserve (Fed), America’s central bank, is no doubt aware of as he fights to reignite the United States’ economy.

Since 2008 the Fed has responded to the so-called ‘Great Recession’ by pursuing an array of unorthodox policies. These new measures have in turn led to its balance sheet ballooning in size. But this development, which has inevitably polarised opinions about what a central bank should, and shouldn’t, be doing, also provides us with an ideal opportunity to delve into the framework behind the world’s most important monetary system.

Antebellum origins

The FRS was not the first central banking system to emerge in the United States. Indeed, there were two forerunners in the late 18th and early 19th centuries. The FRS, however, succeeded a decentralised system of national banks that was decades old. Passed into law with the National Banking Act of 1863, banks could issue their own notes backed by US government securities. It was a structure prone to bank runs and economic turmoil. Eventually, after the great financial panic of 1907, there were sustained calls for an effective, centralised banking system that could tame the financial sector.

When the FRS arrived in 1913, it acted as a lender of last resort for troubled banks, thereby ensuring a degree of financial stability. Furthermore, the FRS created a more ‘elastic currency,’ a term, since fallen out of use, which means a currency whose supply could be expanded and contracted. This allowed the central bank to react more effectively to economic booms and recessions. Thirdly, and perhaps most importantly, the new central banking system established a more thorough supervision of the financial sector.

The Great Depression

Over the decades, the scope and remit of the FRS expanded steadily. During the ‘Golden Twenties,’ an era so often associated with excess and minimal regulation, a stock market boom would soon mutate into a huge speculative bubble. Famously, just prior to the bubble’s peak in late October 1929, the respected economist Irving Fisher declared stock prices had reached a ‘permanently high plateau’. Within a matter of days the stock market crashed (along with Fisher’s reputation).

Banking crises soon spread across the country. Unemployment soared to 25%, stock prices collapsed, and deflation set in. ‘The Great Depression’ as the event soon came to be known, remains the worst economic disaster in the history of the United States. It also happens to be the defining event for the FRS.

Two shortcomings are placed at the Fed’s door. First, critics accused it of failing to stem the speculative stock market boom prior to its collapse, allowing stocks to climb to unprecedented, dangerous heights. Secondly, and more alarmingly, the Fed took catastrophic monetary policy decisions between the period 1928 and 1932. It was argued that, on several key occasions, the Fed contracted the money supply, thereby driving financial institutions into bankruptcy and turning a stock market crash into the Great Depression.

The latter charge stems largely from the 1963 work A Monetary History of the United States 1867-1960, written by economists Milton Friedman and Anna Schwartz. This interpretation has become so influential that, at the close of a famous speech in celebration of Friedman’s 90thbirthday in 2002, Bernanke apologised jokingly to Friedman and Schwartz on behalf of the Fed for its role during the Great Depression. “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

The FRS that would emerge from the depths of depression was rather different to what went before. First, not only did the radical Glass-Steagall Act of 1933 call for the bifurcation of commercial and investment banking, it also required the use of government securities as collateral for Federal Reserve notes. Furthermore, the Federal Insurance Deposit Corporation (FIDC) was set up, guaranteeing bank deposits up to a certain level, thereby establishing a secure ballast within the banking system. The act also placed ‘open market operations’ under the formal control of the Fed (see below). And it required holding companies to be supervised by the central bank; a significant development given that the holding company was to emerge as the prevalent structure for banks in future decades.

A tale of two oil crises

Post-war evolution of the FRS can be divided into two halves: before and after the oil crises of the 1970s. The years 1945 to 1973 are often referred to as the ‘golden years’ of American capitalism. They registered strong economic growth rates and smooth, predictable central banking practices that became established as routine. The US dollar underpinned the global economy with the Bretton Woods system firmly in place – until its breakdown in August 1971 – underlining the Fed’s status as the world’s most important monetary authority. It was also during this period, at the height of Keynesian economics, that the Employment Act added full employment to the Fed’s several objectives.

In October 1973, these ‘golden years’ came to an abrupt end. The world economy suffered a sudden economic shock. OPEC nations, in addition to Egypt, Syria and Tunisia, imposed an oil embargo on America, western Europe and Japan in protest against US foreign policy during the Yom Kippur War. The price of oil soared and with it inflation. America, in particular, was hit the hardest.

“The policy was a success – inflation levels declined dramatically – but not without leaving a painful legacy of high unemployment behind.”

Prior to this, it was generally accepted that an inverse relationship existed between inflation and unemployment – famously depicted by the Phillips Curve. As economic growth occurs, for example, inflation increases along with the level of employment (and vice versa). But the oil crises seemed to turn this economic law on its head. To the frustration of FRS officials, it appeared that the old monetary truths no longer applied. Instead, a new phenomenon reigned: ‘stagflation’, a volatile mixture of stagnant economic growth and inflation.

Inflation more than doubled its 1945-73 average of 3.2% in the period immediately following 1973. Indeed, by 1980, inflation hit over 13%. In response the Fed, led by Chairman Paul Volcker, contracted the money supply substantially so as to wring inflation out of the economy. The policy was a success – inflation levels declined dramatically – but not without leaving a painful legacy of high unemployment behind.

The Great Moderation

From the mid-1980s to 2005, America entered a period of stable economic growth, low inflation and short, relatively mild recessions. The era has come to be called the ‘Great Moderation’ – a reference to the often chaotic economic conditions that preceded it. Nevertheless, this period was punctuated with severe crises of its own – most notably the 1987 stock market crash and the burst of the Dotcom bubble in 2000. However, by dropping interest rates substantially, the Fed was able to avert economic disasters.

It was also during this era that substantial financial modernisation and deregulation policies were passed by both the US House of Congress and the Senate. What began with the Monetary Control Act of 1980, which required the Fed to price its financial services competitively against private sector providers and to establish reserve requirements for all eligible banks, culminated with the passage of the 1999 Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act of the Great Depression. It has been argued these policies played a key role in creating the conditions leading to the global financial crisis.

How does the FRS operate?

At the centre of America’s central banking system is the Federal Open Market Committee (FOMC). This committee determines the direction of the cost and availability of money and credit in the economy – or, in other words, monetary policy. The FOMC is composed of 12 members. Seven belong to the Board of Governors, who are appointed by the President of the United States, and the remaining minority is composed of Reserve Bank Presidents. Given that there are 12 Reserve Banks scattered across the American landscape, only five can serve at any one time. Four positions are allocated on a one-year rotational basis, while the Federal Reserve Bank of New York is uniquely placed in that it serves permanently.

The Chairman of the Board of Governors sits at the helm of the FOMC. Bernanke currently resides at the top, but not too long ago markets responded to the words of Alan Greenspan and to the policies of his astute predecessor, Volcker. In this sense, news and press conferences are important. Markets examine the Chairman’s statements closely in the hope of interpreting changes in existing policies or new initiatives. Greenspan, in particular, who was once nicknamed the ‘master of the universe’ by the American media, was famous for his mercurial announcements during press conferences. Recently the Fed has made efforts to show its decision-making process in a more transparent light, offering a clearer indication to markets on where the Fed stands on policy.

Essentially, the FOMC decides on the level of the federal funds rate, which is the primary, but not only, policy instrument controlled by the central bank. This rate in effect determines the interest rate at which banks lend balances at the Fed to other banks overnight. Only banks can maintain reserve accounts at the Fed, and only American financial institutions can borrow from the Fed’s ‘primary discount window’. Ultimately, therefore, the federal funds rate establishes the level of money supply in the American economy. It is important to note, however, that the FOMC does not ‘set’ the rate in an arbitrary sense; rather the rate itself is market determined.

By conducting ‘open market operations’ – the buying and selling of government and federal agency securities – the Fed aims towards hitting a ‘target level’ of the federal funds rate. For example, by buying up securities (thereby giving dollars in return) the Fed can increase reserves in the banking system. This in turn boosts the level of reserves in the federal funds market, which then leads to the lowering of the federal funds rate, making it cheaper for banks to borrow money. This cost reduction is usually, but not always, passed on to the public, which stimulates the economy by making borrowing on ‘Main Street’ cheaper.

A principle tailored to cut inflation

But why is the federal funds rate important? Essentially, when a change occurs, it usually triggers a chain of events affecting other economic variables, such as short-term interest rates, foreign exchange rates and long-term interest rates. More importantly, however, a change in the federal funds rate can have a large impact on employment, output and, above all, inflation.

In its fight against inflation the Fed employs a principle known as the ‘Taylor Rule’. Only recently developed – it dates back to 1993 when the economist John B. Taylor first proposed it – the ‘Taylor Rule’ determines how much a central bank should alter the nominal interest rate in response to changes in the rate of inflation. Take one example, where the Fed decides to boost its nominal interest rate by 1.5% for every 1% increase in inflation. It in effect increases the real interest rate by 0.5%, making it more expensive to borrow. This dampens inflationary expectations.

The ‘Taylor Rule’ is essentially a pre-emptive policy. It is designed to nip inflationary expectations in the bud before rising prices gain traction in the economy, sending an (indeed, psychological) signal to investors that the FRS takes a ‘hawkish’ stance on inflation.

Financial stability as an objective

Price stability is not everything, however. An additional core function of the FRS is its commitment to supervising and regulating the American financial system. Indeed, it is often overlooked that ‘supervision’ and ‘regulation’ mean two distinct things. The former revolves around evaluating the soundness of individual financial institutions on a regular basis, often by means of on-site examinations and off-site surveillance; while the latter focuses on the passage of regulatory laws tailored to produce a more stable banking system. After the savings and loans crisis in the late 1980s, for example, a number of laws were introduced to restrict irresponsible banking practices.

The FRS amid economic crisis

In recent years, however, the FRS model has been challenged severely due to the global financial crisis. This is not the place to discuss the genesis of the economic panic of September 2008. Rather, what is important is the FRS’s response to the fallout. Since the outbreak of financial panic, the underlying mechanics of America’s central banking system have effectively ground to a halt.

Conventional monetary practices, such as the lowering of the federal funds rate to 0% by the end of 2008, brought little, if any, success to combating the crisis. Open market operations were no longer the solution in such exceptional circumstances. In response the Fed has pursued a decidedly ‘activist’, unorthodox approach in its fight against the ‘Great Recession’.

Firstly, the central bank changed the way in which it provided credit to the financial system. It became a direct lender to a wide variety of financial institutions; purchasing, for example, $1 trillion in mortgage-backed securities issued by Fannie Mae and Freddie Mac, and providing considerable support for institutions including some of the largest banking groups and AIG. Secondly, in September 2008 the Fed, using its ability to lend, brought about the largest increase in bank reserves in American history so as to counter the impact of the financial crisis.

But perhaps most controversially, the Fed has launched two bouts of ‘quantitative easing’ – essentially ‘printing’ new money and purchasing financial assets with it in the hope of lowering long-term interest rates and boosting growth. Many economists argue that this practice is in effect monetising government debt – and one that blurs the line between fiscal and monetary policy. Others, however, stress the exceptional circumstances of the economic situation, and argue that an unconventional crisis calls for unconventional policies.

As a result of these measures, the Fed’s balance sheet has inflated significantly. In August 2007, 96% of the Fed’s portfolio of loans and securities existed in the form of secure US Treasury securities. These assets were exposed to minimal credit and liquidity risks. By the end of 2008, however, this figure plunged to 18% as the FRS took on more risky assets in its attempts to save the financial system.

The Fed’s books are now exposed to a substantial amount of financial risk. These unorthodox policies, therefore, have led to a fundamental change in the way which the Fed interacts with the financial system and, indeed, the wider economy.

Recent economic turmoil has also placed the Fed in a wider, international context of crisis prevention. In November 2011 the Fed co-ordinated a move with the European Central Bank (ECB) so as to alleviate funding costs for European banks, slashing the rate at which it charges the ECB for short-term dollar loans.

But the crisis has also highlighted the difference between the Fed and other central banks, such as the ECB. The former, created in the early 20th century, pays more attention to financial stability and the wider economy; whereas the latter, founded on more recent economic thought, is devoted to price stability. This is in part the reason why the ECB has pursued a more conservative, hawkish response to the financial crisis than its American counterpart.

Conclusion

It is no coincidence that the foremost scholar of the Great Depression is Bernanke, a former economics professor at Princeton University and the current chairman of the Fed. Under his stewardship, the Fed has eschewed traditional monetary policies that were once held to be unbreakable. Nevertheless, the journey into uncharted central banking territory brings urgent questions to the fore. How dangerous is it to pursue repeated rounds of quantitative easing? How, and when, should the Fed begin to unwind its enormous balance sheet? And what consequences will these policies have for inflation down the line?

The global financial crisis obliged analysts to question whether price stability should even remain the dominant focus of the FRS. By not paying enough attention to financial bubbles prior to the crisis, they argue, the Fed had been caught off guard. Nevertheless, America’s central bank is defiant in the face of its critics. The alternative to ‘quantitative easing’ and other unorthodox policies, it says, would be another Great Depression. In the words of John Maynard Keynes, “When the facts change, I change my mind. What do you do, Sir?”