The Federal Reserve System, often called Federal Reserve, or simply Fed, is the central bank of the United States. It was established when Congress passed the Federal Reserve Act in 2013. The Federal Reserve’s stated main goal is to promote full employment and provide price stability.
While other countries have central banks as well, the Federal Reserve System is unique because it consists of multiple banks and branches and issues the United States dollar, the world-reserve currency.
The Federal Reserve wasn’t the first central bank of the United States. There had been several attempts at establishing a central bank prior to the formation of the Federal Reserve. This includes the First Bank of the United States which was founded as early as 1791 but failed shortly after. United States House of Representatives: “The First Bank of the United States” Accessed Feb. 25, 2022.
The history of the Federal Reserve is somewhat mystical and surrounded by conspiracies.
In November of 1910, representatives of the major financial institutions of Wall Street held a secret meeting at J.P. Morgan’s private resort on Jekyll Island in Georgia. During this meeting the basic plan for the Federal Reserve System was drafted. Federal Reserve History: “The Meeting at Jekyll Island” Accessed Feb. 25, 2022.
Before 1910, banks frequently suffered from currency drains and bank runs. As part of the fractional reserve banking system, banks were only obliged to keep a small percentage of deposits in their reserves.
The majority of money was lent out. Some banks were more conservative and kept 10% as reserves while others pushed the limit down to 1%. Griffin, Edward G.: The Creature from Jekyll Island. A Second Look at the Federal Reserve (2010), pp. 14.
In order to prevent currency drains and bank runs, the Federal Reserve System was established. This way, individual banks kept their reserves at the Federal Reserve. In case of liquidity problems, the Federal Reserve could support private banks.
While the Jekyll Island meeting has been confirmed, some critics state that its importance has been misrepresented.
It gave the Federal Reserve the ability to print money and provided it with monetary policy tools to support the banking system and intervene in the economy during economic downturns.
Congress has the ability to amend the Federal Reserve Act, which it has done several times in the past.
The Federal Reserve Act provides the legal framework for the Federal Reserve System, which consists of multiple Federal Reserve Banks and Federal Reserve Branches.
In Europe central banks already existed before 1913. The Bank of England, the oldest central bank in history, was established in 1694.
The Federal Reserve was set up following the European model of central banks. However, while most countries have a single central bank, the Federal Reserve System consists of 12 Federal Reserve Banks and 24 Federal Reserve Branches throughout the United States. Federal Reserve History: “Federal Reserve Banks” Accessed Feb. 25, 2022.
The Federal Reserve Banks include:
Another important distinction is that in 1944 the US dollar was declared world-reserve currency under the Bretton Woods System. This resulted in the Federal Reserve becoming the most important central bank in the world.
Its monetary policy impacts all other countries and currencies.
The goal of the Federal Reserve is to promote maximum employment and price stability. This is known as the Federal Reserve’s dual mandate. Federal Reserve Bank of Chicago: “The Federal Reserve’s Dual Mandate” Accessed Feb. 25, 2022. The Federal Reserve aims to fulfill its dual mandate by conducting monetary policy.
The main two ways the Fed conducts monetary policy is by setting short-term interest rates, known as the Federal Funds Rate, and by controlling the money supply.
Full employment and inflation are often contrary goals. To stimulate the economy and promote maximum employment, the Federal Reserve often lowers the Federal Funds Rate to provide the economy with cheap money. This, however, can lead to the formation of bubbles and overheat the economy. Quinn, William and Turner, John D.: Boom and Bust. A Global History of Financial Bubbles (2020), pp. 5ff.
Under the fractional-reserve banking system, private banks can lend money into existence by issuing new loans. When short-term interest rates are low, more individuals and institutions borrow money. This leads to more new money being lent into existence. When interest rates are kept artificially low or when the Federal Reserve prints money, this lead can lead to inflation.
Since price stability is the second mandate of the Federal Reserve, it must keep inflation under control. The dual mandate of the Federal Reserve is a balancing act between promoting maximum employment and keeping inflation in check.
The Federal Reserve has historically aimed for a 2% inflation rate. If there is maximum employment and 2% inflation, the Federal Reserve has fulfilled its dual mandate.
The Federal Reserve is an independent organization that isn’t directly controlled by the US government.
Despite this there are limitations on what the Federal Reserve can do, which are set forth in the Federal Reserve Act. For example, the Federal Reserve can’t buy stocks. And it can’t directly buy corporate debt. During the Global Financial Crisis in 2008 and the Covid-19 crisis in 2020, several Special Purpose Vehicles (SPVs) were set up. Federal Reserve Bank of St. Louis: “A Look at the Fed’s Emergency Lending Programs” Accessed Feb. 25, 2022.
These SPVs allowed the Federal Reserve to intervene in the economy in ways that go beyond traditional monetary policy tools.
While the Federal Reserve is a separate entity, it is closely linked to the government. When the government needs more money, it’s unlikely that the Federal Reserve will deny it. And if the Federal Reserve wants more flexibility to intervene in the economy, the United States Treasury can approve it.
Properly coordinated, and depending on who is secretary of the treasury, the Federal Reserve and United States Treasury can act as one unit. This is often the case and necessary during economic crises.
Shortly after the Federal Reserve was founded in 1913, the United States experienced its most devastating economic crisis in history.
The Great Depression lasted for almost a decade. At the time, the Federal Reserve was still a young organization.
Although efforts were made to stimulate the economy, according to the Federal Reserve’s own accounts, the monetary policies during the Great Depression came too late and weren’t decisive enough. Federal Reserve History: “The Great Depression” Accessed Feb. 25, 2022.
When the world was hit by the Global Financial Crisis in 2008, an economic crisis comparable, and arguably even more severe than the Great Depression, the Federal Reserve took fast and decisive action. Bernanke, Federal Reserve chairman at the time, believed that the Federal Reserve didn’t do enough during the Great Depression and wanted to make sure he didn’t repeat the same mistakes.
During the Global Financial Crisis, and for the decade following it, the Federal Reserve kept the Federal Funds Rate close to zero. It also deployed a new and uncommon tool to deal with the crisis called Quantitative Easing.
More recently, the Federal Reserve pulled off the largest scale economic intervention in history. In response to the Covid-19 pandemic, the Federal Reserve once again lowered the Federal Funds Rate to zero and engaged in unprecedented levels of Quantitative Easing.
The Federal Reserve has been criticized for doing more harm than good since its inception.
After the United States went off the gold standard in 1933, the government could expand the money supply by having the Federal Reserve print money. Since then, the US dollar has lost over 95% of its purchasing power. Statista: “Purchasing power of one US dollar (USD) in every year from 1635 to 2020” Accessed Feb. 25, 2022.
Critics of the Federal Reserve view inflation as a hidden tax that adversely affects low and medium income households. Inflation gradually erodes the savings of citizens and punishes those that don’t have investable assets like stocks or real estate. At the same time it benefits those who gain access to new money before it causes inflation.
This is known as the Cantillon Effect.
Governments, banks and individuals benefit from an increase in purchasing power at the cost of the general public’s purchasing power.
Those who criticize the Federal Reserve System view it as one of the greatest drivers of inequality.
|↑1||United States House of Representatives: “The First Bank of the United States” Accessed Feb. 25, 2022.|
|↑2||Federal Reserve History: “The Meeting at Jekyll Island” Accessed Feb. 25, 2022.|
|↑3||Griffin, Edward G.: The Creature from Jekyll Island. A Second Look at the Federal Reserve (2010), pp. 14.|
|↑4||Federal Reserve History: “Federal Reserve Act Signed into Law” Accessed Feb. 25, 2022.|
|↑5||Federal Reserve History: “Federal Reserve Banks” Accessed Feb. 25, 2022.|
|↑6||Federal Reserve Bank of Chicago: “The Federal Reserve’s Dual Mandate” Accessed Feb. 25, 2022.|
|↑7||Quinn, William and Turner, John D.: Boom and Bust. A Global History of Financial Bubbles (2020), pp. 5ff.|
|↑8||Federal Reserve Bank of St. Louis: “A Look at the Fed’s Emergency Lending Programs” Accessed Feb. 25, 2022.|
|↑9||Federal Reserve History: “The Great Depression” Accessed Feb. 25, 2022.|
|↑10||Statista: “Purchasing power of one US dollar (USD) in every year from 1635 to 2020” Accessed Feb. 25, 2022.|