Federal Reserve: Overview

Introduction

The Federal Reserve, a system established in 1913, was created for the following reasons: to introduce currency into the economy; to maintain currency reserves; to promote economic stability, strength and growth; to monitor, supervise and regulate the nation’s banking and credit systems; and to operate the nation’s payments for debts. The Federal Reserve Board of Governors manages and regulates the nation’s economy through fiscal policy that manages the interest rates for borrowing money. There are twelve Regional Reserve Bank Districts, which are identified by the twelve Federal Reserve Banks located in the following cities: Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis, and San Francisco.

Understanding the Discussion

Bank Panics: Bank panics occur when a large number of consumers, concerned by economic instability and worries of a possible bank failure, attempt to withdraw their deposited funds from the banks, thus worsening the economic instability.

Credit: The ability for businesses, consumers, and merchants to purchase goods without the immediate exchange of currency, which is based on the guarantee of future payment with interest on the initial amount of the purchase price.

Federal Reserve Act: US Congress established Federal Reserve Banks under this act, which makes reserve banks responsible for the supervision of US banks and provides a means for the circulation and valuation of currency, as well as rediscounting of commercial bank notes.

Federal Reserve Banks: Twelve central banks, which are chartered and contracted by the US government, and are not-for-profit. The twelve regional banks are set up like a private corporation, with shares of stock issued to member banks in their respective districts.

Free Market Capitalism: An economic system highlighted by a market managed through supply and demand. The value of a good or service in this market is determined by the available supply and the consumer demand.

Interest Rates: The percentage rate charged by banks when loaning money.

Regulation: Rules that are legislatively passed for oversight and management by a government agency or a contracted representative.

Supply & Demand: The ratio of consumption of a good or service and its availability to the consumer.

History

At the establishment of the United States in 1787 with the US Constitution, there was a movement supporting the creation of a strong central bank. The benefit of this central bank was in establishing and stabilizing currency and credit, which in turn would improve the economy by creating confidence and stability. Alexander Hamilton was a primary advocate of the organization of these Federal Reserve Banks, which enjoyed the broad support of merchant and shipping interests of the early American Republic.

With Hamilton’s appointment in 1789 to the post of secretary of the Treasury in the Washington Administration, Hamilton directed the formation of the first Federal Reserve Bank with the establishment of the first US bank in 1791. Congress issued the charter for the bank, and prescribed the bank to establish the following: domestic and foreign credit; financial order; and stabilized currency value. This original charter was established for twenty years, at which time it would be up for renewal by the US Congress.

Challenges to this charter were consistent, starting with the 1811 attempt to renew the charter, and concluding with President Andrew Jackson’s refusal to resubmit the charter for renewal before Congress in 1836. In 1817, the Supreme Court heard McCulloch vs. State of Maryland, which was a challenge to the authority of Congress in the establishment of a federally chartered bank. The Supreme Court found in favor of Congress’ authority for establishing this charter.

Throughout the nineteenth and early twentieth centuries, the free market capitalist system faced periodic cycles of rapid expansion and sudden decline, resulting from the laws of supply and demand. This created financial and currency instability, threatening financial panics and bank closures as a result of customers’ withdrawing their savings. Bank crises such as the Panic of 1907, or the Knickerbocker Bank Crisis, led to progressive support for banking reform initiated by the federal government.

In 1913, Congress passed the Federal Reserve Act. The act provided for the establishment of a Federal Reserve Board and twelve Federal Reserve Bank districts. The Federal Reserve System was established to introduce and regulate the flow of currency into the economy, discount commercial bank notes, stabilize the value of currency, and monitor the US banking system.

In the ensuing decades of the twentieth century, the US Congress initiated additional legislative acts that continued to expand the powers and role of the Federal Reserve in managing the economy and its oversight of the US banking system. This oversight has been directed by the Federal Reserve Board of Governors and its chairman, who is nominated by the president and confirmed by the US Senate. The Federal Reserve has developed the authority to manage the currency and markets, while monitoring the compliance of the banking system to the laws of the United States. The Federal Reserve has used currency flow combined with interest rates to control rapid inflationary growth, while moderating the recurring turns of the economy. The Federal Reserve Board has supported this practice in the last thirty years, as a means to maintain stability in the currency and the marketplace.

The Federal Reserve has evolved as the face of government oversight in the economy. With the combination of declining disposable income, and the increasing use of credit to purchase daily needs, a debt crisis began to develop in the late 1990s. In the first decade of the twenty-first century, mega mergers of banks and the relaxation of credit restrictions on mortgages were all meant to improve competition. This created the potential for an economic crisis with potentially risky loans and speculation by banks. Growing competition in housing loan markets worked to encourage a greater demand for housing, which drove up property prices. Many of these properties became overvalued, and banks made loans to higher risk clients.

Many of the mortgages issued during the early part of the first decade of the twenty-first century were identified as “adjustable rate mortgages.” This means that the interest rate would be adjusted at different periods during the life of the loan. Many individuals who could be considered high-risk for loans, due to credit history or property priced above the potential income levels of the consumer, were candidates for these mortgages. Interest rates were established at a higher rate for these riskier consumers.

The risk was high on these loans, but the adjustable mortgages offered potentially high returns. This encouraged speculation and manipulation in the acquisition and sale of these loans on what were quickly becoming overvalued properties. With growing delinquency and foreclosures, banks became overextended in their outstanding debt, and unable to sustain themselves. As American consumers became less capable of continuing to make high mortgage payments, and property values started to drop, more consumers were unable to refinance their mortgages on these adjustable rate loans. As a result, a foreclosure crisis ensued.

With a growing number of devalued properties and bad loans, banks lost their financial reserve assets and began to fail. These bank failures were not just small local banks; larger major banks began to struggle and collapse with the Federal Deposit Insurance Corporation (FDIC) stepping in and taking over operations. This intervention was initiated to prevent a total collapse of the US economy, and later became known as the “Subprime Mortgage Crisis.” There appeared to be a major economic crisis and national recession looming when Lehman Brothers, a global financial services firm, filed for bankruptcy on September 15, 2008.

Federal Reserve Today

The US Congress stepped forward in the fall of 2008 with a bail-out plan that would stem the looming financial crisis. The Emergency Economic Stabilization Act of 2008 assisted financial institutions in protecting themselves in the economic downturn. The Federal Reserve, as the government’s economic point agency, exercised a leading role in the stabilization of the banking sector. The key component of the legislation was the federal government’s acquisition of $700 billion of hard-to-convert, mortgage-based securities, which would provide accessible cash flow for the financial institutions. Critics argued that the relationship between the Federal Reserve and the banking sector was too interconnected.

In 2009, as an outcome of the financial crisis and the resulting financial “bail out,” members of Congress began speaking out about reform and expansion of the regulatory authority of the Federal Reserve in the financial sector and banking. This debate was fueled by frustration and fear from the public, who felt the Economic Stabilization Act of 2008 was more focused on protecting banks than homeowners facing foreclosure.

There has been a great deal of controversy and criticism of the financial bailout and the growing role of the Federal Reserve in oversight and regulation. The political debate about initiating banking reforms, as well as enhancing the regulatory authority of the Federal Reserve over the banking sector and the financial markets, has generated a great deal of debate. Some elements have supported the idea of an expanded authority for the Federal Reserve, citing the subprime mortgage crisis as an example of the changing nature of the financial sector in the twenty-first century. The interests opposed to expanded oversight and regulation argue that the Federal Reserve already has specific regulatory authority, which it failed to utilize efficiently. These interest groups are supporting lobbying efforts to limit any potential increases in regulatory authority by the government, identifying that the oversight will limit the opportunity for development and growth in the financial sector. In an effort to quell outside criticism and to improve general functionality, the Federal Reserve announced in 2012 that it would be outlining specific economic objectives for its policies. This move toward transparency stood counter to the tradition of secrecy surrounding central banking institutions. In December 2015, the Federal Reserve announced it would raise interest rates for the first time in almost ten years, to 0.25 percent. The rates continued to rise through December 2018, when they reached a range of 2.25 to 2.50, before they began to decrease again in 2019. That year, despite a low unemployment rate and overall growth in the economy, the Fed cut rates three times to insulate the national economy from the turbulence caused by US president Donald Trump's trade war with China and uncertainty about the strength of the global economic outlook. On October 31, 2019, the rates were 1.50 to 1.75 percent.

In 2022, the Federal Reserve began raising interest rates to combat high inflation that set in following the emergence of the COVID-19 pandemic in 2020. In April 2024, NBC News reported that the Federal Reserve was maintaining the elevated key interest rate of 5.25 to 5.5 percent that it had previously established as it sought to continue limiting inflation to the previously identified rate of 2 percent.

These essays and any opinions, information or representations contained therein are the creation of the particular author and do not necessarily reflect the opinion of EBSCO Information Services.

Bibliography

Baker, Colleen. “The Federal Reserve as Last Resort.” Univ. of Michigan Journ. of Law Reform, vol. 46, no. 1, 2012, pp. 69–133.

Greider, William. “The Federal Reserve Turns Left.” Nation 294.18 (2012): 15-21. Academic Search Complete. search.ebscohost.com/login.aspx?direct=true&db=apn&AN=ALTP873911&site=ehost-live&scope=site. Accessed 18 Dec. 2012. Hetzel, Robert. The Monetary Policy of The Federal Reserve: A History. New York: Cambridge UP, 2008. Studies in Macroeconomics History.

Kahn, George A., and Lisa Taylor. “Evolving Market Perceptions of Federal Reserve Policy Objectives.” Economic Review, 2014, pp. 5–64.

Lowenstein, Roger. “The Villain. (Cover Story).” Atlantic Monthly (10727825), vol. 309, no. 3, 2012, pp. 48-60. Academic Search Complete. search.ebscohost.com/login.aspx?direct=true&db=lfh&AN=73566277&site=ehost-live&scope=site. Accessed 18 Dec. 2012.

Michel, Norbert J. “Fed Failures.” USA Today Magazine 143.2840 (2015): 32. Points of View Reference Center. search.ebscohost.com/login.aspx?direct=true&db=pwh&AN=102806643&site=pov-live. Accessed 21 Dec. 2015.

“Policy Tools.” Board of Governors of the Federal Reserve System, 31 Oct. 2019, www.federalreserve.gov/monetarypolicy/openmarket.htm. Accessed 25 Nov. 2019.

Russell, Karl, and Binyamin Appelbaum. “Why the Fed Raised Interest Rates.” New York Times, 16 Dec. 2015, www.nytimes.com/interactive/2015/business/economy/fed-interest-rates.html. Accessed 21 Dec. 2015.

Schwartz, Nelson D. “Rates Are Going Up. What Could Go Wrong?” New York Times, 20 Dec. 2015, www.nytimes.com/2015/12/21/business/economy/effects-of-past-interest-rate-increases-offer-guide-to-future-risks.html?login=email. Accessed 21 Dec. 2015.

Selgin, George A. “Operation Twist-The-Truth: How the Federal Reserve Misrepresents Its History and Performance.” CATO Journal, vol. 34, no. 2, 2014, pp. 229–63.

Smialex, Jeanna. “Federal Reserve Cuts Interest Rates for Third Time in 2019.” The New York Times, 30 Oct. 2019, www.nytimes.com/2019/10/30/business/economy/federal-reserve-interest-rates.html. Accessed 25 Nov. 2019. Wells, Donald R. The Federal Reserve System: A History. Jefferson: McFarland, 2004.

Wile, Rob. "Federal Reserve Keeps Interest Rates at Current Levels as Inflation Holds Its Grip." NBC News, 30 Apr. 2024, www.nbcnews.com/business/economy/federal-reserve-interest-rate-decision-may-2024-what-happens-next-rcna150027. Accessed 31 May 2024.