Federal Reserve System

Federal Reserve System central banking system of the United States. Established in 1913, it began to operate in Nov., 1914. Its setup, although somewhat altered since its establishment, particularly by the Banking Act of 1935, has remained substantially the same.

Structure

The Federal Reserve Act created 12 regional Federal Reserve banks, supervised by a Federal Reserve Board. Each reserve bank is the central bank for its district. The boundary lines of the districts were drawn in accordance with broad geographic patterns of business, and the banks were placed in Boston, New York City, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. In addition some of the regional banks have one or more branch banks attached to them.

All national banks must belong to the system, and state banks may if they meet certain requirements. Member banks hold the bulk of the deposits of all commercial banks in the country. Each member bank is required to own stock in the Federal Reserve bank of its district and must maintain legal reserves on deposit with the district reserve bank. The required reserves are proportionate to the member bank's own deposits, the proportion varying according to the location of the member bank and the character of its deposits.

Each reserve bank is managed by a board of nine directors (three appointed by the Federal Reserve Board, six by the local member banks). The Federal Reserve System's Board of Governors designates one of the federally appointed directors as chairman and Federal Reserve agent; it is the chairman's duty to report to the Board. The board of directors appoints the bank's president and other officers and employees. The operations of the Federal Reserve banks, although not conducted primarily for profit, yield an income that is ordinarily sufficient to cover expenses, to pay a 6% cumulative dividend annually on the stock held by member banks, to make additions to surplus, and to provide the U.S. Treasury with over $1 billion a year in revenue.

The Board of Governors of the Federal Reserve System—the national supervisory agency—is composed of seven members appointed for 14-year terms by the President. A chairman and vice chairman, who serve four-year terms in those posts, are named by the President from among the seven members. The board's offices are in Washington, D.C. The Federal Open Market Committee, created later (1923) than the system's other divisions, comprises the seven members of the Board of Governors and five representatives of the Federal Reserve banks; it directs the purchases and sales by the reserve banks of federal government securities and other obligations in the open market. The Federal Advisory Council consists of 12 members, one appointed annually by the board of directors of each reserve bank; it confers from time to time with the Board of Governors on general business conditions and makes recommendations with respect to Federal Reserve affairs. In 1976, the Consumer Advisory Council was created; consisting of both consumer and creditor representatives, it advises the Board of Governors on consumer-related matters.

Function

The most important duties of the Federal Reserve authorities relate primarily to the maintenance of monetary and credit conditions favorable to sound business activity in all fields—agricultural, industrial, and commercial. Among those duties are lending to member banks, open-market operations, fixing reserve requirements, establishing discount rates, and issuing regulations concerning those and other functions. In a sense, each Federal Reserve bank is best understood as a bankers' bank. Member banks use their reserve accounts with the reserve banks in much the same way that a bank depositor uses his checking account. They may deposit in the reserve accounts the checks on other banks and surplus currency received from their customers, and they may draw on the reserve for various purposes, especially to obtain currency and to pay checks drawn upon them (see clearing ).

More importantly, the required reserves also enable the Federal Reserve authorities to influence the lending activities of banks. So long as a bank has reserves in excess of requirements, it can enlarge its extensions of credit; otherwise it cannot increase its extensions of credit and may be impelled to borrow additional funds. Inasmuch as the Federal Reserve authorities have power to increase or decrease the supply of excess funds, they are able to exercise considerable influence over the amount of credit that banks may extend. By controlling the credit market, the Federal Reserve System exerts a powerful influence on the nation's economic life. Federal Reserve activities designed to expand bank credit may lead to an upswing in the business cycle, which tends to lead toward inflation; conversely, a restriction of credit generally results in decreased business growth and deflation.

The principal means through which the Federal Reserve authorities influence bank reserves are open-market operations, discounts, and control over reserve requirements. Open-market purchases of securities by Federal Reserve authorities supply banks with additional reserve funds, and sales of securities diminish such funds. Through the power to discount and make advances, the Federal Reserve authorities are able to supply individual banks with additional reserve funds. They may make the funds more or less expensive for member banks by raising or lowering the discount rate. Discounts usually expand only when member banks need to borrow. Raising or lowering requirements—within the limits imposed by law on the Board of Governors—concerning the reserves that member banks maintain on deposit with the reserve banks has the effect of diminishing or enlarging the volume of funds that member banks have available for lending. Such powers directly affect the volume of member bank funds but have no immediate effect in the use of those funds.

In the field of stock market speculation the Federal Reserve authorities have a direct means of control over the use of funds, namely, through the establishment of margin requirements . Another of the important functions of the Federal Reserve System is furnishing Federal Reserve notes (now the chief element in the nation's currency) for circulation. Most economists and bankers agree that the Federal Reserve System has achieved marked improvements in American monetary and banking institutions.

Bibliography

See U.S. Board of Governors of the Federal Reserve System, The Federal Reserve System (5th ed. 1963); D. S. Ahearn, The Federal Reserve Policy Reappraised 1951-1959 (1963); S. W. Adams, The Federal Reserve System (1979); W. J. Davis, The Federal Reserve System (1982).

Federal Reserve System (USA) A regulatory body of the US banking sector, set up by the 1913 Federal Reserve Act in an effort to stabilize the hitherto relatively unregulated US banking system. It comprised twelve federal reserve banks, which were all owned by private banks, but with power to issue federal reserve notes as currency. They were supervised by a Federal Reserve Board consisting of the Secretary of the Treasury, a Controller of the Currency, and five members of a Board of Governors appointed by the President. The regional banks had the power to alter regional interest rates, expand or contract the money supply, and expand or contract credit. The system still contained many weaknesses. The relationship between the regional banks and the center remained ill-defined, and thousands of small banks continued to operate relatively freely. By 1929, only about one third of all banks were members of the Federal Reserve System (FRS). The FRS was thus unable to respond effectively to the Great Depression after the 1929 Wall Street Crash. Its reorganization was thus a central issue in the New Deal. The Banking Act of 1933 reorganized and strengthened the central Board of Governors, who were given control over interest rates, reserve requirements, and all activities of the twelve federal reserve banks. The successes of the US postwar boom owe much to the Federal Reserve System, which had supported the war through a policy of cheap money. From the 1950s, the Federal Reserve System received autonomy in setting interest rates, and in the late 1970s it responded to the oil price shocks by pursuing a policy of monetary stability and low inflation. This inaugurated a period of monetary stability which characterized the 1980s and 1990s, interrupted only by an economic downturn in the late 1980s. The Federal Reserve System has enjoyed much greater freedom than other central banks such as the European Central Bank, since it is not bound by any predetermined economic targets.

Federal Reserve System. Congress created the Federal Reserve System, the central bank of the United States, in 1913. It consisted of twelve regional banks and the Federal Reserve Board in Washington, which had ill‐defined powers of oversight. Lawmakers expected the system to regulate the supply of money and credit (monetary policy), mitigating the effects of the business cycle; to oversee, in concert with other federal and state agencies, the operations of commercial banks; and to carry out the government's international financial transactions. Ideally, the system's decentralized structure would reduce the influence of New York City banks over the nation's credit system.

During World War I, the Federal Reserve financed government deficits by expanding the money supply, and it broke the postwar inflation by raising interest rates and sharply restricting credit. In the 1930s, however, the shortcomings of the Federal Reserve's decentralized structure became apparent. During the Great Depression, infighting between the regional banks and the central board prevented a coordinated response to the crisis. Incoherent monetary policy permitted the money supply to contract by a third, contributing mightily to the catastrophe.

Accordingly, President Franklin Delano Roosevelt and Marriner Eccles, his appointee as chair of the Federal Reserve Board, initiated reforms. Eccles persuaded Congress to enact new legislation confirming the board's authority over the regional banks, solidifying the position of its chair, and vesting in the Open Market Committee (a group consisting of members of the Federal Reserve Board and the presidents of the regional banks) control over monetary policy.

Despite its new organization, the Federal Reserve soon fell under the influence of the Treasury Department. Throughout World War II and for many years after, the central bank at the behest of the Treasury “pegged” long‐term interest rates at a low level, permitting Washington to finance its debt cheaply. This policy became controversial after 1945 because, by accommodating every demand for credit, it threatened to fuel inflation. Surging prices during the Korean War forced the Treasury to relent and grant the Federal Reserve the authority to set interest rates as it saw fit. The subsequent increase in the cost of money, engineered by the central bank, helped stabilize prices.

Over the next twenty years, the Federal Reserve exercised its newfound autonomy carefully, following policies described as “leaning against the wind”. Put simply, during recessions it cut interest rates to stimulate production, and when inflation threatened it increased rates to cool demand. But the stagflation of the 1970s—simultaneous inflation and recession—stymied the central bank. After years of vacillating between expansion and contraction, the Federal Reserve in 1979 under Chairperson Paul Volcker embraced a policy of fierce monetary stringency, driving interest rates to near 20 percent and triggering the worst recession since the 1930s. Hard times inspired calls for reforms to make the Federal Reserve more responsive to elected officials. Economic recovery after 1983, however, coupled with stable, low inflation, bore out the wisdom of Volcker's policy and garnered the Federal Reserve immense prestige. Subsequently, the central bank followed policies designed primarily to keep prices stable. Under the leadership of Alan Greenspan, the Federal Reserve continued this policy through the long boom of the 1990s.
See also Banking and Finance; Depressions, Economic; Economic Regulation; Federal Government, Executive Branch: Department of the Treasury; Federal Reserve Act; New Deal Era, The; Progressive Era.

Bibliography

John T. Wooley , Monetary Politics: The Federal Reserve and the Politics of Monetary Policy, 1984.
Donald F. Kettl , Leadership at the Fed, 1986.

Wyatt C. Wells