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Federal Reserve System

Congress’s objective in establishing the Federal Reserve System was monetary and financial stability. They sought to create a monetary system that could respond effectively to stresses in the banking system. Banking panics had occurred every few years during the nineteenth and early twentieth centuries. Panics were marked by depositor runs, suspensions of payments to depositors, sharp spikes in interest rates, and sometimes serious economic recessions.

Panics were widely attributed to the nation’s “inelastic” currency, the concentration of bank reserves in New York City and other major financial centers, and investment of those reserves in short-term loans to stock market speculators. The Federal Reserve Act addressed these perceived shortcomings by creating a new national currency—Federal Reserve notes—and requiring members of the Federal Reserve System to hold reserve balances with their local Federal Reserve Banks.

President Woodrow Wilson signed the Federal Reserve Act on December 23, 1913. The Act required the establishment of at least eight, and as many as twelve, Federal Reserve districts and Reserve Banks. The task of determining the specific number of districts, district boundaries, and which cities would have Reserve Banks was assigned to a Reserve Bank Organization Committee consisting of the secretary of the treasury, the secretary of agriculture, and the comptroller of the currency. The Act also created a Federal Reserve Board to oversee the activities of the Federal Reserve System.

The paramount goal of the Fed’s founders was to eliminate banking panics, but it was not the only goal. The founders also sought to increase the amount of international trade financed by US banks and to expand the use of the dollar internationally. By 1913 the United States had the world’s largest economy, but only a small fraction of US exports and imports were financed by American banks. Instead, most exports and imports were financed by bankers’ acceptances drawn on European banks in foreign currencies.

The United States emerged from World War I with the world’s strongest and most vibrant economy. The Federal Reserve Banks held substantial gold reserves and discount loans to their member banks. A modest gold outflow and rising inflation prompted the Fed to increase its discount rate sharply in 1920. The price level then began to fall and the US economy entered a recession. The recession was relatively short, however, and the US economy grew at a moderately high and stable rate, with low inflation, over the remainder of the decade.

In their classic book, A Monetary History of the United States, Milton Friedman and Anna J. Schwartz (1963) attribute the good performance of the US economy in the 1920s to enlightened Federal Reserve policy. Under the leadership of Federal Reserve Bank of New York Governor Benjamin Strong, Friedman and Schwartz write, the Federal Reserve developed its first macroeconomic stabilization policy aimed at moderating the business cycle and maintaining price stability.

The Fed’s founders had not conceived of monetary policy in the modern sense. Although each Reserve Bank set a discount rate, subject to Federal Reserve Board approval, Federal Reserve credit was supplied at the initiative of member banks when they came to the discount window to borrow reserves or obtain currency. The Federal Reserve Act did permit Reserve Banks to purchase (and sell) government securities in the open market, however; by the early 1920s, Strong and other Fed officials had discovered that these operations influenced market interest rates and credit conditions. The Reserve Bank governors began to informally coordinate their operations in government securities. In 1923 the Open Market Investment Committee was established, with Strong as chair, to determine open-market operations for the System. The Fed then began to use open-market operations proactively to achieve broad economic objectives—that is, to conduct monetary policy.

The United States had been on a de facto gold standard since the 1830s and de jure gold standard since 1900. In 1913 the gold standard was built into the framework of the Federal Reserve. The law required the Federal Reserve to hold gold equal to 40 percent of the value of the currency it issued (technically termed the Federal Reserve Note but colloquially called the dollar) and to convert those dollars into gold at a fixed price of $20.67 per ounce of pure gold. The Federal Reserve typically held more than enough gold to back the currency it had issued. Bankers called the excess “free gold.” The Federal Reserve needed a stock of free gold sufficient to satisfy redemption requests that might occur in the near future.

During the Great Depression, Roosevelt’s policies directed the Federal Reserve. In this period, the president, Congress, and the Treasury directly controlled monetary policy. The Federal Reserve sat “in the back seat” and implemented policies dictated by the federal government.

In March 1951, the US Treasury and the Federal Reserve reached an agreement to separate government debt management from monetary policy, laying the foundation for the modern Fed. On March 4, 1951, the Treasury and the Fed issued a statement saying they had “reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose and to assure the successful financing of the government’s requirements and, at the same time, to minimize monetization of the public debt”.

At the time, it was not known how profound an effect that statement would have. But the accord marked the start of the development of a strong free market in government securities, which continues today. In addition, the debate over the consequences of interest rate pegging marked a shift in thinking at the Fed. Monetary policymakers began focusing actively on bank reserves and the control of money creation in order to stabilize the purchasing power of the dollar. But most important, by establishing the central bank’s independence from fiscal concerns, the accord set the stage for the development of modern monetary policy.