The Federal Reserve
In the years before the institutionalization of the Federal Reserve System, the US banking system was at the verge of collapse given the panics and failure of the banks that were operational. In essence, the US banking systems began in 1782 following the licensing of the Bank of North America in Philadelphia (Mishkin 229). This became the first bank in the US. The success of the BNA opened ways for the establishment of other banks, which became operation in the then lucrative banking industry. There were concerns however, on the chartering of banks and whether the charters were supposed to be given by the State or Federal government. Drumming for the centralized control, Federalists argued for federal chartering of the banks, which culminated in the 1791 establishment of the Bank of United States, a hybrid private and central bank, charged with the responsibility of regulating the amount of credit and money in circulation within the economy (Mishkin 229). Concerns were however rife of this centralized role of the banks, especially from agricultural interests, which led to non-renewal of the Bank of United States in 1811. While a second central bank was chartered in 1832 (the Second Bank of United States), the Federal System came to be in 1913 following panics in the banking industry and loss of credit by depositors (Mishkin 229). The purpose of the Federal System was therefore to promote a more secure banking system, with the condition that all national banks be members of the Federal System. State banks on the other hand, were given a choice of either joining or not joining the system. In its broad mandate, the Federal System (Fed) was established to perform three traditional functions. These include conducting a monetary policy, supervision and regulation of financial institutions and providing payment services to financial institutions (Federal Reserve System 10).
To perform these, the Fed is structured in a way that allows it to effectively perform on its constitutionally sanctioned mandates. At the top of the System is the Governors’ Board, a team of seven, who serve as the decision-making organ of the Fed. These members work for a 14-year tenure, structured in a way that the 14 years are further divided into 2-year renewable terms (Federal Reserve System 10). The board has a chairperson appointed by the president, but with approval of the Senate. Below the chair is a vice-chair also appointed by the president to perform their mandate, and both serve 4-year renewable terms. Presently, Janet L. Yellen heads the Fed, having been appointed by President Obama.
Guided by law, the appointments to the Board are to ensure that there is fair representation of diverse interests from different sections of the economy. Therefore, it is necessary that the presidential choice of members of the board be a non-biased representation of diverse interests and regional divisions of the nation (Federal Reserve 13). The restrictions, having been sanctioned by the law, ensure that there is regional and wide public and private sector interests’ consideration in regulations and policymaking. More importantly is that the Board has three advisory councils attached to it. These are “the Federal Advisory Council, the Consumer Advisory Council and the Thrift Institutions Advisory Council” (Federal Reserve System 2). The three councils advise the Board on issues of present interest. The membership of the council is drawn from the 12 Districts, with three or four annually scheduled meetings.
Below the Board is the Federal Open Market Committee, which is an important section of the US economic standing and monetary policy. The Committee is especially important since its decisions affect the general nation’s economic activities through the deliberations on the monetary policy. Membership of the Committee includes the Boards seven members and five other members from among the 12 reserve banks across the nation. Traditionally, the chair of the Board serves as the chair of the committee, while the New York Reserve Bank president, a permanent Committee member (the others serve on a one-year rotational basis), as the vice chair. Important to note is that, “While all seven members of the Board of Governors and all 12 presidents of the Reserve Banks participate in each FOMC meeting, voting rights rotate among some participants. The seven members of the Board of Governors, the president of the New York Reserve Bank and the presidents of four other Reserve Banks, who serve one-year rotations, vote on monetary policy decisions” ( Federal Reserve System 2).
FOMC meets, at minimum, four times annually in Washington, DC, with the possibility of convention of special meetings especially of matters of urgency. These meetings can happen either over a conference or by voting via phone or telegram. The Meetings characteristically discuss present and prospective changes within the national and international economic atmospheres, as well as monetary policy direction. Voting on any policy follows members’ airing of views, and once consensus has been reached, the implementation emanates from the New York Reserve Bank through the System Open Market Account (Smale2).
Another constituent of the Fed are the Federal banks located across the nation and given names in tandem with their headquarter locations. The banks are located in St. Louis, San Francisco, Atlanta, Richmond, Philadelphia, New York, Minneapolis, Kansas City, Dallas, Chicago, Boston and Cleveland. The Federal Banks “are quasi-governmental, or legally private but functionally public, corporations. Reserve Banks are “owned” by commercial banks in their region (that is, banks hold stock in their Federal Reserve Bank) but serve public goals and are overseen by the Board of Governors, a government entity” (Federal Reserve System 3).
The Reserve Banks hold a central position in the management of the economy through their president’s contributions to the Committee. Although banks own stakes in the Federal Banks, only 6 percent is given to these banks as dividend for return on their investment. This ensures that the banks (Federal Reserve Banks) are shielded from political pressure, while at the same time they remain accountable to the national citizenry (Federal Reserve System 3).
A board of directors consisting nine members manages the 12 Reserve Banks. Grouped into classes A, B and C, the directors hold office for three years. District member banks elect class A and B directors while the Board appoints the other three class C members (Smale 4). Largely directors within class A are a depiction of the member banks’ concerns. The other six represent diverse interests including industry, labor, consumers, services, commerce and agriculture. In performing its oversight mandate, the Board of Governors usually reviews every decision arrived at by the Directors’ Board for the purpose of ensuring that such decisions are in tandem with the monetary policy established by the board and the FOMC (Federal Reserve System 4).
Reserve Bank advisory committee members are entrepreneurs who provide critical grass root level input towards the economy and policy. The information provided pertains to matters in small businesses, payments agriculture and labor. Additionally, these members also are representative of a wide range of interests and industries within the districts that the Federal Reserve banks operate. Further, the overarching role of the Feds and its advisory committee inculcates the supervisory activities of the Banks and provision of payment services to other financial institutions. The Banks involvement within the economy and with other financial institutions makes them the fiscal agents of the US treasure (Federal Reserve System 4).
The configuration of the Fed System transcends the above named divisions to other institutions and the American public. Member banks form a core of the Fed’s structure since “Approximately 34 percent of American commercial banks are part of the Federal Reserve System. Nationally chartered banks are required to be members of Fed while state chartered banks can opt to become members” (Federal Reserve System 5). Other depository institution, by providing banking services to the American public as well as having access to the Fed’s monetary services are bound to comply with the System’s regulations. These institutions include credit unions, loan and saving associations, savings banks and state-chartered commercial banks, even those they are not officially part of the Fed.
Most important of the structure is the general public, which is affected by the policies passed by the Fed. Thus, the American people’s role in the Fed is of great importance; “Voters elect the leaders who appoint members to the Governors’ Board. Local business people serve on advisory councils and committees. While the actions of the Fed impact the public, Federal Reserve policymakers rely on information from a myriad of individuals to make policy decisions” (Federal Reserve System 5).
While its operations are largely independent within the government, Congress plays an oversight role on the workings of the Fed. Thus although the Fed continues to work on its own independently, it remains accountable to the Congress. Critics have specifically raised concern over this independence, drumming for more oversight in light of the Fed’s dealings with other banks during the recent economic slump (Labonte 16).
The three the traditional functions of the Fed in its regulation role of the economy as mentioned earlier include implementing a monetary policy, supervision and regulation of financial institutions and providing payment services to financial institutions. Given the dynamism and the intricate nature of the economy however, the Fed’s role has been changing especially after the recent economic recession, which saw the collapse of some of nation’s top financial institutions. The Fed’s conduction of the monetary policy follows the dual mandate principle, in which the System maintains stable prices as well as ensuring full employment of the American people (Federal Reserve System 12).
The past five years have seen the nation dip into economic recession, a situation created by the previous housing bubble prompted by the Fed’s continuance of low interest and discount rates. As part of its dual mandate, the Fed had maintained, and currently maintains low interest rates. While many have criticized this maintenance of low discount rates as a constant and organized restraint to economic activity (Lowrey), the Fed has informed that this is never a consistent monetary policy, but instead, an action towards job creation and economic stimulation notwithstanding the near bottom interest rates.
With a struggling economy, particularly at the beginning of the financial crisis in 2008, the Fed had instituted plans to help in job creation lower interest rates and increase investment in the nation. Termed as Quantitative Easing, the Fed bought $600 billion worth of Treasure bonds in 2010. This was after a similar bond purchase in 2008 that had helped in winding down the unemployment rate.
The plan had worked by giving more confidence to the banks to loan money to the public, while at the same time making it easier for the public to borrow money. This had especially been imperative given that the traditional tools such as discount rate, reserve requirement and open market operations remain unfeasible given the low interest rates. Economists have indicated that the low rates, started at the end of the 2001 recession, had been kept low for long, resulting in the price bubble (Labonte 9).
The Fed’s use of Quantitative easing was implemented after the workings of a reduced discount rate had failed to ease the inflation rate and the soaring prices. The Fed had previously reduced the federal funds target and the discount rate. With the funds target reduced to close to 0 percent and the bank reserve requirements, especially through the liquidity in the banking system that was not trickling to other points of the financial system, it was necessary to implement other non-traditional tools to stimulate the economy and ease the pressure on financial institutions. Thus, by purchasing the Treasury bonds, the Fed was implementing an evolution of the Open Markets Operation with the aim of driving down the long-term interest rates, employment creation and improving the financial conditions in the post recession period.
Even after the end of the economic crisis, the Fed continued in its bond-buying program aimed at stimulating the economy. The program that involves the Fed buying $85 billion worth of bonds monthly is trained towards the preservation of flexibility and management of the unpredictable market expectations (Hilsenrath). Current efforts in the stimulation of the economy have involved a careful exit of the Fed from the bond-buying program. The Fed plans “to trim down the quantity of bonds they buy in careful and potentially halting steps, varying their purchases as their confidence about the job market and inflation evolves” (Hilsenrath). The announcement of the exit from the bond-buying program (moral suasion) already has had effects on the stocks and bond markets, which have taken off with record closing indexes.
The bond-buying program was just among a diverse set of monetary and fiscal policies that the Fed has implemented in the past few years, especially during and after the recession. Among the first of the policies pursued by the Fed had involved the introduction of credit facilities to provide more liquidity in the financial markets and firms. The faculties, while based on the traditional and the non-traditional tools, were all geared towards economic stimulation. “The first facility was introduced in December 2007, and several were added after the worsening of the crisis in September 2008. These facilities were designed to fill perceived gaps between open market operations and the discount window” (Labonte 10).
The Fed’s loans extended to bank and non-bank institutions were short-term, an invocation of the Fed Act that allows the System to extend the loan facilities to both financial and non-financial institutions. The lending came under the justification of its mandate as provided by the act forming it as to “promote effectively the objectives of optimal employment, constant prices, and modest longstanding interest rates” (Labonte 10). Other facilities had included direct assistance to financial institutions such as Bear Stearns and AIG, which the Fed bailed out.
Another fiscal policy currently pursued by the Federal Reserve is the Central Bank Liquidity Swap created in 2007 and currently still in operation. The swaps have involved international central banks, for instance the Swiss National Bank, bank of Japan, European Central Bank, Bank of England and the Bank of Canada. For these countries, the Fed’s currency swaps with them are of unlimited size, and had been renewed in May 2010, having expired in February 2010 (Labonte 11).Under the program, the Fed and the other partner bank exchange currencies, for instance dollars for Euros. This transaction is reversed after a three-month fixed period with interests on the swap charged at 0.5 percentage points atop the dollar overnight index swap rate. Repayment of the swap is done at the prevailing rates of the initial swap, guaranteeing the absence of downside risk in case the dollar appreciates over the period (Labonte 11).
Forward commitment has been another fiscal policy pursued by the Fed as a means of monetary stimulus even with the interest rates. With a believe that its commitment to keep the federal funds rate at a low level for a long period will stimulate business into making long-term investment commitment, the Fed hopes to stimulate the economy. Even with a shift of the threshold from a date to an economic threshold, the Fed hope its pledge of retaining the low funds will continue to stimulate economic activity in the nation (Labonte 15).
Given the rate at which the economy is improving, it is necessary that the Fed start cutting back on its securities purchases. While the Fed has already started cutting back on its treasure and mortgage backed securities, further cuts will be necessary to bring the economy to its own footing. Although it may incur losses in it purchases given the expected interest rises and the fall in value of bonds owned by the Fed, it is a necessary move to stimulate the economy. Additionally, it is also necessary that the Fed slowly begin raising the funds rates that are currently stuck at 0 percent. This would be appropriate if the Fed begins the raise in the first quarter of next year, letting it rise to its normal 4 percent by the end of 2016. Given the current rates, it is important that the chair works fast to increase the rates from the current low that they are.
While the volatility and the instability of the economy is still being watched, it is necessary that the nation accepts the idea of a new normal in reference to the low rates and the Fed’s activities towards stabilizing the economy. While the unemployment rate has remained steady after the rise following the recession, its stability at the 7.6 percentage rate is a good thing given that it was expected to rise further than that. Even with a falling unemployment rate, and the supposed decline of the Fed’s stimulus program, it will take time for the economy to return to its pre-recession condition, and even then, there are no guarantees that the economy will sit at its pre-recession state. The idea of a “new normal” in the current economy is therefore an accurate statement, until the economy gets back to its normal pre-recession state.
Federal Reserve System. Federal Reserve System: Purposes and Functions. Washington, DC: Federal Reserve System, 2005
Federal Reserve System. The Federal Reserve Today, 16th ed. Federal Reserve System, 2012
Hilsenrath, Jon. “Fed Maps Exit from Stimulus.” The New York Times, 2012 May 11. Web. 31 March 2014
Labonte, Marc. Monetary Policy and the Federal Reserve: Current Policy and Conditions. Congressional Research Service, 2014
Lowrey, Annie. “Candid Criticism for Fed that Wasn’t on the Agenda.” The New York Times. 2013, November 8. Web. 31 March 2014
Mishkin, Fredric. S. The Economics of Money, Banking and Financial Markets, 8th ed. Pearson Addison Wesley, 2007
Smale, Pauline. Structure and Functions of the Federal Reserve System. Congressional Research Service, 2010