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Five things you should know about the Fed

This year marks the 100th anniversary of The Federal Reserve, which was created after President Woodrow Wilson signed the Federal Reserve Act on 23 December 1913. In this adapted excerpt from The Federal Reserve: What Everyone Needs to Know, Stephen H. Axilrod answers questions about The Federal Reserve’s historical origins, evolving responsibilities, and major challenges in a period of economic crisis.

Why is the Fed so important to the country?

The Fed is the nation’s central bank and, as authorized by law, independently determines the country’s monetary policy. It has a unique capacity to control inflation, helps moderate cycles in the economy, and acts as a buffer against potentially destabilizing financial and credit market conditions. Policy is normally implemented mainly through three traditional policy instruments: open market operations in government securities, lending via its discount window, and setting reserve requirements on bank deposits.

The Fed also has an important role in establishing the nation’s regulatory policies in the financial area, especially as they apply to commercial banks and certain related entities. Such policies can impinge on and interact with monetary policy and the use of monetary instruments. While a central bank’s monetary policy function is special, its regulatory role is similar to, and shared with, other regulatory authorities in the country. Many, but not all, central banks around the world combine both monetary policy and a certain regulatory authority.

When and why was the Fed founded?

The Fed was originally established in December 1913 under very different economic and financial conditions than currently exist in the United States and the rest of the world. At that time, the financial panics and breakdowns in the banking system that had all too frequently unsettled our economy impelled the Congress to create an institution (the Federal Reserve System) with lending, regulatory, and other powers that could, it was thought, moderate, if not avert, significant financial disruptions.

The United States Federal Reserve Building in Washington, D.C. Photo by Tim Evanson, CC BY 2.0, via Flickr.

How did the Fed evolve?

The original Federal Reserve Act was modified a number of times. As experience was gained with the central bank’s basic monetary policy instruments, their unique influence on the nation’s overall credit and money conditions became better understood. At the same time, the United States developed into a major worldwide financial and economic power, with increasingly dynamic, and unfortunately still occasionally crisis-prone, markets; the stock market crisis of 1929, the banking crisis of the early 1930s, and the credit crisis of 2008–2009 among the most notable. Practical experience and ongoing economic research helped guide legislative changes that affected the economic and financial role of the Fed and its monetary policy objectives, but not without considerable and occasionally acrimonious debate.

Monetary policy came to be clearly recognized as one of the two major so-called macro-economic tools, along with the US government’s fiscal policy, which help to assure that everyone who wants a job can get one and that the average level of prices remains generally stable. Like other central banks around the world, the Fed is especially concerned with maintaining reasonable price stability over time. In the course of the great inflation of the 1970s, the public became increasingly aware of the institution’s responsibilities to contain inflation. But it also makes decisions to help keep economic activity on an even keel and to avert dangerous financial instabilities—issues that brought the Fed under enormous public and political scrutiny as the great credit crisis of 2008–2009 and its aftermath unfolded.

The Fed of today came into its own after amendments to the Federal Reserve Act by the mid-1930s improved, among other things, the organizational basis for policy, and after 1951, when the institution was freed from agreed restraints that helped finance WWII at low interest rates.

How do the Fed’s unique policy instruments affect the nation’s economy as a whole?

In response to the emerging interest rate effects and changes in credit availability and liquidity from the Fed’s actions, the nation’s economic well-being will be eventually affected in one way or another—indicated by the behavior of economic activity, employment, and the average level of prices. In practice, it takes some time for those influences to be felt. Moreover, the Fed’s degree of influence is not easy to distinguish, given all the other influences, both domestic and international, that weigh on the economy. Over the long run, however, a central bank with its power to create money out of nothing, so to speak, does bear a clear, special responsibility for the behavior of inflation.

A central bank’s powers to create credit or money, in addition to being crucial to its monetary policy function, also serve as a buffer against destabilizing and economically disruptive financial crises. The recent credit crises in the United States and Europe, for instance, were contained, at least to a degree, through an unusually large expansion in the balance sheet of central banks as they provided funds to markets that were being dragged down by bad debts.

In general, the Fed and other central banks can be viewed as unique institutions that, in their money-and credit-creating powers, have the power independently, from on high as it were, to tilt the ongoing balance of supply and demand in financial markets. However, central banks cannot control the ensuing plot development like an author can, and the eventual outcomes of their intervention are shrouded in uncertainty even if the direction appears clear. That is essentially why good central banking depends so much on sound judgment and an almost intuitive feel for markets by its leadership as much as, or more than, practically useful results of economic analysis and research.

What major challenges face the Fed as an organization in the future?

First, the Fed needs somehow to bring regulatory issues more to the fore in considering its monetary policy. It seems to be working in that direction. That will be greatly helped when the President actually nominates a governor to become vice chairman for supervision, the position added in the Dodd-Frank Act.

Second, it behooves the Fed to continue with its efforts to regain the institutional credibility with the public and the Congress that was severely shaken by the credit crisis. It had been thrown into so much doubt that even the Fed’s viability as an independent institution or, perhaps more practically, as an institution that could pursue its independent powers as effectively as desired seemed in question.

Third, though less pressing a challenge than the previous two, would be an effort to intensify thinking about structural and operational adaptations as the startling, technologically driven innovations of recent decades continue. The structure of the Federal Reserve System itself might appear increasingly outdated, as economies and financial markets of regions of the country become more and more interdependent and the operational role of regional banks appears less crucial.

Stephen H. Axilrod worked from 1952 to 1986 at the Board of Governors of the Federal Reserve System in Washington, D.C., rising to Staff Director for Monetary and Financial Policy and Staff Director and Secretary of the Federal Open Market Committee, the Fed’s main monetary policy arm. Since 1986 he has worked in private markets and as a consultant on monetary policy with foreign monetary authorities. He is the author of The Federal Reserve: What Everyone Needs to Know.

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