Happy Birthday Federal Reserve – 100 years old

December 23, 2013 will mark the 100th year for the U.S. Federal Reserve System which was created in 1913 when President Woodrow Wilson signed the Federal Reserve Act into law. A lot has happened in the past 100 years, and the Fed has adapted to conditions along the way. Whether or not you agree with their current policies on quantitative easing (QE), the Fed is a necessary system, and its goal of providing economic and monetary stability remains unchanged.

The U.S. Federal Reserve is certainly not the oldest central banking system – Sweden’s central bank began 345 years ago in 1668. The Bank of England dates back to 1694, predating the U.S. Declaration of Independence by about a century! The U.S. Fed came about in response to the Panic of 1907 (see Exhibit 1). After the U.S. narrowly escaped a deep depression and credit crisis, it became clear that a centralized bank was needed to maintain stability and intervene if necessary.

The Fed was created to be independent from other areas of government. The central bank must be able to work toward long-term economic health without pressure from short-term political interests. However, the Fed alone does not have all the tools to keep the economy on track, so it must work closely with Congress to maintain economic stability.

FED: Influences the economy by changing the supply and demand of money (Monetary Policy).
CONGRESS: Uses tax and spending powers to affect the economy (Fiscal Policy).

It is important to keep our monetary system stable and growing with low inflation. This allows people and businesses to make better buying/spending decisions, which fosters further growth. If the economy is not healthy and money is tight, people and businesses may be afraid to spend, and the economy will slow. We have experienced numerous periods in our history when the Fed has had to intervene in order to provide stability.

What Does the Fed Do?
Today, the Fed is made up of the Board of Governors based in Washington, DC, and 12 regional Federal Reserve Banks across the country. About every six weeks, members of these two groups meet, forming the Federal Open Market Committee (FOMC). They discuss and determine monetary policy. Over time, the outcome of the meetings has become more and more publicized with the official release of minutes along with today’s 24/7 media coverage.

The Fed Has Three Main Jobs Today

  1. Sets monetary policy through decisions that affect the flow of money and credit in our economy.
  2. Contributes to the safety and soundness of our nation’s financial system by supervising and regulating banks.
  3. Serves as a bank for depository institutions and the federal government, helping the payment system work efficiently.

In this capacity, the Federal Reserve System serves as the lender of last resort – a place banks can turn if they are unable to obtain credit elsewhere and their inability to obtain credit could put the nation’s economy at risk. The Fed’s duties also help contain risk that may arise in financial markets. Ultimately, it carries out its dual mandate given by Congress — to keep prices stable and promote full or maximum employment.

Future of the Fed
The third quarter marks the fifth anniversary of the global financial crisis, and the U.S. economy has recently come through the worst period since the Great Depression of the 1930s. Over this time, the Fed’s actions represented a significant break from its past practices. The Fed used unprecedented intervention and stimulus to help stave off deflation and depression. Today the Fed is focused on when to begin winding down this stimulus. If the Fed tightens too quickly and the economy is too fragile, it could stifle the recovery. This is what happened in 1937 – the Fed tightened too quickly and prolonged and deepened the Great Depression. If the Fed waits too long to tighten, and the economy grows quickly, it could cause excessive inflation.

We can only say with certainty that as the economy continues on its path toward getting stronger, the Fed will and should become less accommodative in its activities. As the Fed tightens and no longer needs to intervene, it means the economy is finally getting back to normal.

The Panic of 1907

In 1907, the nation went through a severe financial panic, known as the 1907 Bankers’ Panic or Knickerbocker Crisis. It was a six-week stretch of bank runs in New York City and other U.S. cities in October and early November of 1907. It was triggered by a failed speculation that caused the bankruptcy of two brokerage firms and eventually the downfall of the nation’s third-largest trust company – Knickerbocker Trust Company.

The real shock that set the events in motion to create the panic was the 1906 earthquake in San Francisco. The devastation of that city drew gold out of the world’s major money centers. This began a liquidity crunch that created a recession starting in June of 1907.

Enter JP Morgan, a 70-year-old, extraordinarily successful and independent financier who engineered the mergers of firms that we would recognize today as still dominant—U.S. Steel, AT&T, General Electric. He had past experience with crisis as he helped rescue the U.S. Treasury during the Panic of 1893. JP Morgan pledged large sums of his own money and convinced other New York bankers to do the same to shore up the banking system.

Several years later, the U.S. President and Congress decided they needed a system that would help the economy run smoothly instead of relying on private citizens. A small group of nationally known politicians and financiers gathered secretly off the coast of Georgia in 1910. Here, they constructed the outline that became the plan for development of the Federal Reserve System.

Sources: Federal Reserve Bank of Atlanta, First Trust Advisors

This article is an excerpt from the SAVANTalk 3Q2013 newsletter created by Savant Capital Management.

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