John Locke Update / Research Newsletter

100-Year Anniversary of the Federal Reserve

posted on in Fiscal Insight

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The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. North Carolina is located in the 5th District, which is headquartered in Richmond, Virginia.  Charlotte has a branch office that is considered the regional center for the Carolinas.  

The Fed was created on December 23, 1913 with the enactment of the Federal Reserve Act.  Over time, the roles and responsibilities of the Fed have expanded, and its structure has evolved.  Events such as the Great Depression were major factors leading to changes in the system.  Today, the Fed’s primary duties are conducting the nation’s monetary policy, supervising and regulating banks, and providing financial services and liquidity to depository institutions (retail banks) and the federal government.

History

There were a number of financial panics in the late 1800s and early 1900s; these panics led to many bank failures and bankruptcies.  The large amount of financial insecurity caused disruptions in the economy, and Congress decided to create a government entity to regulate and hopefully give more confidence to the financial environment in America.  The first serious discussions were in 1907 when Congress established the National Monetary Commission.  This commission proposed the creation of a central bank and eventually led to the Federal Reserve Act in 1913.

Operations

The Fed has responsibilities, commonly known as a ‘dual mandate,’ yet the Fed actually has three main goals: maximum employment, stable prices, and moderate long-term interest rates.  The Fed was created to be independent from both the president and congress.  Decisions by the Fed do not have to be ratified by the president or his administration, and it does not rely on Congressional appropriations for its funding, yet the Fed is not immune to the powers of Washington; it is subject to limited Congressional oversight in the form of semi-annual reporting to both the House Financial Services Committee and the Senate Banking Committee.

The Great Recession and the Fed’s role

The House Financial Services Committee held a hearing on the Federal Reserve, where they went into detail of the Fed’s role during the recession.  This is one of the better explanations of the Fed’s actions during the recession I have seen, and I thought sharing it would give better insight into the power and impact the Fed has on today’s economy.

At the height of the financial crisis and in its aftermath, the Federal Reserve took extraordinary measures to inject liquidity into the financial system. Beginning in September 2007, the Fed lowered the target federal funds rate from 5.25 percent to between 0 and .25 percent.

Though the Federal Reserve pushed the federal funds rate to zero, economic growth remained sluggish, even after the acute phase of the crisis ended. Because conventional monetary stimulus was no longer available to the Federal Reserve because the funds rate could not go below zero, the Federal Reserve turned to "quantitative easing". By purchasing government securities with long maturities, the Federal Reserve hoped to stimulate the economy by injecting more money into the financial system and driving down long-term interest rates, including rates on mortgages and business loans.

Economic conditions did not improve. In particular, the unemployment rate climbed from 8.6% in March 2009 to 9.6% in October 2010. On November 3, 2010, the Federal Reserve announced its plan to purchase an additional $600 billion in longer-term Treasuries, a move popularly known as "QE2" because it was the second effort at quantitative easing since the onset of the financial crisis.

Despite the criticism of its unconventional monetary policy, the Federal Reserve implemented another program in September 2011, known as its Maturity Extension Program or "Operation Twist." Under the program, the Federal Reserve buys longer-term Treasury securities and sells off an equal amount of shorter-term securities in an effort to further reduce longer-term interest rates (thus "twisting" the yield curve) without expanding the overall size of the Federal Reserve’s balance sheet.

In September 2012, the Federal Reserve announced that it would further "increase policy accommodation by purchasing additional agency mortgage-backed securities.  Known as "QE3" or "QE infinity," this new policy was open-ended, lacking either a target date or a specific unemployment rate threshold that would trigger its end. Federal Reserve officials had mixed views about the third round of quantitative easing. Some supported ending the policies when the unemployment rate fell to a particular level, and others opposed any target dates or performance-based thresholds.

Since then, the Federal Reserve has set a target unemployment rate of 6.5 percent and announced that it wanted to keep the inflation rate no higher than 2.5 percent over a one to two-year horizon. This indicates that the Fed does not expect to shift from its low-interest rate stance until those targets are met.

I hope you found this information about the Fed interesting and will discuss some of the Fed’s impacts on our economy while you visit with friends and family over the Christmas holiday.  Merry Christmas to all, and I wish you all a very safe and happy New Year.

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Sarah Curry is Director of Fiscal Policy Studies at the John Locke Foundation. Previously, she worked for the North Carolina State Senate as a research assistant for the chairs of the Senate Agricultural Committee and headed the research efforts for… ...

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