The Fed

1
The Fed

• Chapter 5

2
Fed

• The Fed is the central Bank of the US
• CONSTANTLY in the news
• Has been called the 4th branch of Government
• major role in economy

3
How it all got started

• Idea of Central Bank (Federal Bank) is not new.
• Federalist Alexander Hamilton vs. Republicans
  Thomas Jefferson, Madison, and Monroe
• Hamilton lost but eventually won

4
History

• Hamilton wanted a stronger Federal Government
  including a National Bank
• Jefferson et al feared the cities (and bankers)
  would become too powerful
• Repeatedly a National Bank was approved but then
  not re-ratified
• Many small state chartered banks

5
History

• Small banks led to diversification problems
• Lack of coordination led to boom-bust cycles.
• Combination led to frequent bank panics.
• The 1907 bank panics led to the creation of the
  Fed

6
Banking panic

• Stereotypical run on the banks
• One way around this was to print new money
• 1908 study of the banking industry found nearly
  200 samples of bank currencies created to stem
  the 1907 panic

7
Abram Andrew Secretary of the National Monetary
Commission

• The banks were so singularly unrelated and
  independent of each other that the majority of
  them has simulatenously engaged in a life and
  death contest with each other, forgetting for the
  time being the solidarity of their mutual
  interest and the community at large

8
Abram Andrew Secretary of the National Monetary
Commission

• Continued
• Two-thirds of the banks in the country entered
  upon an intencinestruggle to obtain cash, had
  ceased to extend credit to their customers, had
  suspended cash payments, and were hoarding such
  money as they had. What was the result?...

9
Abram Andrew Secretary of the National Monetary
Commission

• Continued
• Thousands of men were thrown out of work,
  thousands of firms went into bankruptcy, the
  trade of the country came to a standstill, and
  all of this happened simply because the credit
  system of the country had failed to
  operate...from Minneapolis Feds web-site

10
Conclusions of the National Monetary Commission

• The banking system was flawed
• prone to panics
• currency was not responsive to changes in demand
• Called for increased lending TO banks

11
History of the Fed (continued)

• From the time of the National Monetary
  Commissions recommendations (1908) to 1913
  various measures were presented to Congress.
  Example National Reserve Association

12
Politics as usual

• These failed for a number of reasons but largely
  the same mistrust of bankers and the Eastern
  establishment that had been prevalent since the
  Jefferson-Hamilton era
• the 1912 election of Democrats to house, senate
  and President led to the passage in 1913 of the
  Federal Reserve Act
• Woodrow Wilson signed it into law on 12/23/13

13
Federal Reserve Act

• Many opposed the Act.
• NY Times editorial
• ...reflects the rooted dislike and distrust of
  banks and bankers that has been for many years a
  great moving force in the Democratic Party.

14
Federal Reserve Act

• Created a central bank a bank for banks that
  could lend funds to commercial banks in the
  event of an emergency
• elastic currency or lender of last resort

15
The act stated

• to furnish an elastic currency, to afford means
  of rediscounting commercial paper, to establish a
  more effective supervision of banking in the
  United States, and for other purposes.

16
We have to start somewhere!

• Due to the nature of necessary compromise, the
  law that was signed by Wilson was not that strong
• Basically served as the lender of last resort
  but, as future calamities showed, the Fed was not
  yet ready for prime time. (Depression)

17
Creepcreepcreep

• During the Great Depression (when 8000 banks
  failed from 1930-1933) it became abundantly clear
  that the Fed was not ready
• As a result, the banking Reform Acts of 1933 and
  1935 both changed the purpose of the Fed and
  added more tools in repertoire

18
New Mission

• Fed now became a full-fledged central bank.
• It was to regulate and supervise the operation
  of the financial system in order to (1) foster a
  smooth-running, efficient, competitive financial
  system (2) promote the overall health and
  stability of the economy

19
Composition

• Board of Governors-7 members appointed by
  President with Senate approval
• Serve 14 year terms for independence
• Headquartered in DC
• They have the real power

20
Federal Reserve Banks

• 12 districts
• 3 largest are NY, SF, and Chicago
• wanted to decentralize power (still the
  anti-federalist speaking)
• Within each district there are Federal Reserve
  Branch banks (ex. Buffalo)

21
Federal Open Market Committee

• FOMC
• principal policy-making body
• 12 members 7 board of governor members plus 5 of
  the 12 Fed bank presidents (revolving except for
  NY who is always on)
• Meets in DC 8 times a year
• Issues policy directive

22
Member banks

• Member banks (approximately 5000) elect 6 of the
  9 Board Members for the Regional Fed Banks

23
Feds Functions

• Formulation and Implementation of Monetary Policy
• Supervision and Regulation of the Financial
  System
• Facilitates payments
• Acts as Fiscal agent for US Government
• See Exhibit 5-3

24
Regulation

• As time has passed, the number of regulations
  have increased. With this the power of the Fed
  increases.
• Must approve bank mergers, branching requests,
  look out for bank customers, etc

25
Payments system

• Provides Currency
• clears checks

26
Fiscal Agent

• The Governments bank
• maintains a Treasury transactions account (think
  checking account)
• clears Treasury checks, issues and redeems
  government securities, foreign exchange

27
Tools

• Open Market operations
• Discount rate
• Reserve Requirements
• Jaw-Boning

28
Tools

• Open Market Operations- buying and selling
  securities
• Buying securities increases the money supply
• Selling reduces the money supply

29
Tools (continued)

• Discount Rate and Discount Rate Policy
• Discount rate rate at which the Fed loans to
  depository institutions.
• Discount Window
• Ultimate power to set rates is with the Board of
  Directors
• Pressure to avoid borrowing from Fed

30
Borrowing from the Fed

• Under normal circumstances borrowing is
  designed to be short-term in nature and only for
  purpose of meeting a short-term financing
  shortfall.
• In extraordinary circumstances this changes
  example bank failure, hurricane, etc.
• Prior to 1980 fewer banks had access to the
  discount window now most depository institutions.

31
Reserve Requirements

• Banks must hold some money outand not lend
  against it
• Designed to prevent bank-runs
• Requirements are set by Fed
• Money is held by Fed
• Rarely changed-roughly 10
• Currently no reserve requirements on time and
  savings deposits

32
Division of Labor (exhibit 5-5)

• Board of Governors
• sets reserves requirements, approves discount
  rates, regulates member banks and bank-holding
  companies, protects consumers, oversees Federal
  Reserve Banks
• Federal Reserve Banks
• Propose discount rates, lend funds to depository
  institutions, furnish currency, clear checks and
  transfer funds, handle US govt debt and cash
  balances.

33
Division of Labor (Continued)

• Federal Open Market Committee
• composed of Board of Governors and 5 bank
  presidents
• Directs open market operations
• vast majority of trades take place in government
  security markets (size and liquidity reasons)

34
A day in the life of the Fed

• Day begins with a report on current conditions
• 1115 conference call between Board of Governors
  and a representatives of FMOC.
• 1130 decision is made and communicated to FMOC
  (particularly to the Trading Desk in NY). Then
  dealers are notified and necessary trades are
  executed.

35
Independence

• Controversy
• pros and cons
• Long tenure is probably a good thing. Do not
  want to expose members to political pressure of
  short-term fixes.
• Seems to work