Federal Reserve System

Federal Reserve System

I INTRODUCTION

Federal Reserve System, central banking system of the United States, popularly called the Fed. A central bank serves as the banker to both the banking community and the government; it also issues the national currency, regulates monetary policy, and plays a major role in the supervision and regulation of banks and bank holding companies. In the United States these functions are the responsibilities of key officials of the Federal Reserve System: the Board of Governors, located in Washington, D.C., and the top officers of the 12 district Federal Reserve banks, located throughout the nation.

The Federal Reserve’s basic powers are concentrated in the Board of Governors, which is paramount in all policy issues concerning bank regulation and supervision and in most aspects of monetary control. The board enunciates the Fed’s policies on both monetary and banking matters. Because the board is not an operating agency, most of the day-to-day implementation of policy decisions is left to the district Federal Reserve banks, stock in which is owned by the commercial banks that are members of the Federal Reserve System. Ownership in this instance, however, does not imply control; the Board of Governors and the heads of the Reserve banks orient their policies to the public interest rather than to the benefit of the private banking system.

The US banking system’s regulatory apparatus is complex; the authority of the Federal Reserve is shared in some instances—for example, in mergers or the examination of banks—with other federal agencies such as the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC). In the critical area of regulating the nation’s money supply in accordance with national economic policy, however, the Federal Reserve is independent within the government.

II HISTORY

During the 50 years before the formation of the Federal Reserve System in 1914, surging economic growth was interrupted by economic crises, frequently accompanied by the collapse of the monetary system. The US banking system was unable to respond flexibly to business cycles.

Under the National Bank Act (1864), the banking system was divided into three groups: central reserve city banks (the first was located in New York; Chicago and St Louis were added in 1887), reserve city banks (in 16 other large cities), and country banks. All national banks were required to hold reserves, but country banks could hold a percentage of these deposits in reserve city banks. When country banks required additional reserves to meet their customer’s cash demands, they would call on reserve city banks, which would in turn demand funds from central reserve city banks. Any weak block in this pyramid could lead to the collapse of the entire system. Additional liquidity could not be created anywhere, and suspension of specie (that is, gold coin) payment was the frequent consequence. Banking crises such as these occurred in 1873, 1883, 1893, and 1907. The panic of 1907 led to the formation (1908) of a bipartisan congressional body, the National Monetary Commission, whose report set the stage for the Federal Reserve Act (1913) and a decentralized, adaptable banking system.

III MONETARY CONTROL

The Federal Reserve has general controls which affect overall financial variables. The two primary instruments of general control are open-market operations and changes in the required reserve ratio. Regarding open-market operations, when actual money supply grows too slowly, the Federal Reserve purchases US government securities, thereby increasing the monetary base and thus enabling the banking system to create additional deposits, which constitute the major portion of the money supply. Conversely, should money supply grow more rapidly than is desired, the Fed will pursue a tight monetary policy, selling securities on the open market. Such sales reduce bank reserves and thus the ability of the banking system to create deposits.

Although the open-market operation is the most flexible and the most frequently used instrument of monetary policy, similar results can be achieved by changing the required reserve ratio—that is, the percentage of deposits that banks must maintain on reserve at the Federal Reserve banks. When the required reserve ratio is raised, banks are unable to create as much money as they previously were able to because a larger portion of their assets must be held in reserve; the converse is true when the reserve ratio is reduced.

Also among its general controls, the Federal Reserve can make changes in the discount rate. When banks seek additional reserves by borrowing from the Reserve banks, a significant escalation in the discount rate makes such borrowing more expensive and consequently reduces bank demands for reserves. A discount rate change may, at times, reinforce open-market operations. It may also, at times, have an “announcement effect”, signaling a change in the Federal Reserve’s underlying evaluation of economic conditions.

The Federal Reserve has only a selective control—the margin requirement, or the ratio of cash that must be provided by the buyer to the purchase price of securities. This requirement, a legacy of Depression legislation, aims to curb stock market speculation.

The Credit Control Act (1969) authorizes the president to give additional controls to the Federal Reserve. In 1980, the act was enforced as a means of controlling various types of consumer credit.

IV EFFECTS OF FEDERAL RESERVE POLICIES

Economists today tend to feel that, over the long run, the policies of the Federal Reserve have had both positive and negative effects: (1) Federal Reserve policy decisions have occasionally increased rather than decreased economic instability; (2) minute adjustments of monetary instruments are not productive and may well be destabilizing; (3) over time, Federal Reserve policies that slow down the growth rate of money supply will reduce the rate of inflation; and (4) some national problems facing the United States in the 1980s, such as an energy shortage, are supply-related issues that central banks are ill-equipped to resolve. Generally, economists feel that the Federal Reserve’s record is mixed. Many economists would agree, for example, that the Federal Reserve is partly to blame for the severity of the depression of the 1930s. On the other hand, the record of price stability during the late 1950s and early 1960s is partly due to the Fed’s effective monetary policy. Critics were more vocal during the 1970s and early 1980s, as monetary authorities seemed alternately unable to halt the rise of inflation or interest rates. In the mid-1980s, however, many economists and others felt that the Federal Reserve’s anti-inflation policies were quite effective.

V RELATIONS WITH THE GOVERNMENT

The Federal Reserve is sometimes considered a fourth branch of the US government because it is made up of a powerful group of national policymakers freed from the usual restrictions of governmental checks and balances. Indeed, the Board of Governors is formally independent of the executive branch and protected by tenure well beyond that allotted to the president. In fact, however, a working relationship has evolved; the Federal Reserve works according to the objectives of economic and financial policy established by the executive branch of the government.

The relationship between the Federal Reserve and Congress is more complex. On the one hand, the central bank is unmistakably a creature of Congress, being responsible to it for its mandate and its continued existence. On the other hand, the self-financing feature of the Federal Reserve removes from Congress its primary source of influence, the agency budget. Thus, the Federal Reserve is relatively free from partisan political pressures, but it must report frequently to the Congress on the conduct of monetary policy.

Federal Reserve System