The Federal Reserve: A Century of U.S. Monetary Evolution

The Federal Reserve’s 110th anniversary is not just a testament to a century of monetary policy but to its place in the evolution of the U.S. economy. Established Dec. 23, 1913, through the Federal Reserve Act, the Fed has since acted as the beating heart of the nation’s financial system.1

The anniversary marks more than just a chronological milestone. It symbolizes the adaptability and influence of an institution that has weathered economic storms, navigated through periods of significant change, and played a pivotal role in shaping the financial landscape of the U.S., often in ways opaque to the American public.

History of the Federal Reserve System

The Federal Reserve System is the central bank of the United States, established by Congress in 1913. Its primary purpose is to enhance the stability of the American banking system. The Federal Reserve System is composed of a central, independent governmental agency, the Board of Governors, in Washington, D.C., and 12 regional Federal Reserve Banks located in major cities throughout the U.S.2

The Federal Reserve System has evolved over its more than 100-year history. It has expanded its roles and responsibilities in response to events such as the Great Depression in the 1930s and the Great Recession during the 2000s.

Foundation and Early Years (1913 – 1920s)

• 1913: The Federal Reserve Act of 1913 passed Congress, aiming to stabilize the American banking system and address issues like “inelastic currency.”3
• Post-1913: The Fed introduced Federal Reserve notes, which became the predominant form of U.S. currency and legal tender.
• World War I era: The Fed played a crucial role in financing the war effort by selling bonds, and its policies began shaping the U.S. payments system and monetary policy.

The Great Depression (1930s)

• 1929 to 1933: The U.S. economy faced the Great Depression, severely affecting gross domestic product, employment, and banking stability. The Fed faced criticism for not adequately responding to banking panics and the economic downturn.4
• 1933 to 1935: Banking Acts are passed, altering the Fed’s structure and redistributing power within the system. This centralized power in the Board of Governors and revised its role in regulating the banking system.5

World War II and Post-War Period (1940s to 1950s)

• 1941 to 1945: The Fed supported the war effort, maintaining low interest rates for government borrowing.6
• Post war: The Fed grappled with post war growth and inflation, adjusting interest rates, regulating the money supply, and using other monetary policy tools to control inflation and ensure sustainable economic growth. The Fed faced a tug-of-war with the Treasury over interest rate control and monetary policy autonomy.

After the Treasury-Fed Accord (1951 – 1960s)

• 1951: The Treasury-Fed Accord of 1951 between the U.S. Department of the Treasury and the Federal Reserve established the Fed’s independence in setting monetary policy, separate from the Treasury’s debt management responsibilities. The accord marked a new era in which the Federal Reserve had greater independence and was crucial for its ability to address inflation and other economic challenges in the ensuing decades.7
• 1950s to 1960s: The Fed navigates changing economic conditions, balancing the goals of price stability and economic growth.8

The Great Inflation (Late 1960s – 1970s)

• Late 1960s to 1970s: The Fed initially struggled to control inflation, partly because of political pressure from the Nixon administration and internal arguments that there was a trade-off between unemployment and inflation (Phillips curve).
• 1970s: Toward the late 1970s, the Fed began to argue for tighter monetary policy to curb inflation under Paul Volcker, one of the most important chairs to lead the Fed. This led to significant interest rate hikes.9

The Great Moderation (1980s to Early 2000s)

• 1980s to 2000s: The Fed, especially under Chair Paul Volcker, took aggressive actions to tame inflation, and what followed was a period of relative economic stability and low inflation.10
• Legislative Changes: Several acts passed that changed the banking and Fed Reserve landscape. The Gramm-Leach-Bliley Act, passed in 1999, repealed part of the Glass-Steagall Act, allowing banks, securities firms, and insurance companies to combine, leading to vast mergers in the financial services industry.11

The Great Financial Crisis and Recession (2007 to 2009)

• 2007 to 2009: In response to the financial crisis, the Fed lowered interest rates to near zero and implemented quantitative easing to inject liquidity into the economy.12
• 2010: The Dodd-Frank Act brings significant regulatory changes, and the Fed adapts its supervisory role to these new regulatory frameworks.13

The COVID-19 Pandemic and Beyond (2020 to Present)

• 2020: Faced with economic shutdowns at the beginning of the COVID-19 pandemic, the Fed cut interest rates to near zero and bought vast amounts of government and mortgage-backed securities to support the economy.14
• 2021 and Beyond: The Fed continues to adapt and navigate the post-pandemic economic landscape, adapting policies to support recovery. As supply chain disruptions and geopolitical events unfolded in the early 2020s, inflation once again surged. The Fed reacted quickly, raising rates aggressively to combat inflation.15

The Fed’s Centennial Celebration

The Federal Reserve typically keeps a low profile and doesn’t ordinarily celebrate its birthdays. However, its centennial allowed it to publicize its history and role in the economy.

The Federal Reserve marked its centennial on Dec. 23, 2013, by launching new resources designed to increase the public’s understanding of its role and history. The Fed also launched its History Web Gateway, which contains its archives and helpful information on essential moments and figures in its development. The Fed also used the opportunity to launch education initiatives aimed at schools and the public.

Significance of the Federal Reserve System

The Federal Reserve serves as the central bank of the United States. Here are three primary roles:

1. Managing monetary policy: The Fed’s most visible role is controlling the nation’s monetary policy. By adjusting interest rates and influencing money supply, the Fed’s mandate includes achieving maximum employment, stabilizing prices (i.e., controlling inflation), and moderating long-term interest rates.
2. Bank supervision and regulation: The Fed supervises and regulates banks to protect the integrity of the nation’s banking and financial system and to protect the credit rights of consumers.
3. Financial services: The Fed provides various financial services, operating the national payments system, distributing the nation’s currency, and acting as a fiscal agent for the U.S. government.

The Federal Reserve plays a critical role in shaping the U.S. economy through its monetary policy decisions. By influencing interest rates and controlling the money supply, the Fed can either stimulate economic growth or apply the brakes in times of inflation. During economic downturns, the Fed often lowers interest rates to encourage borrowing and investment. Conversely, in periods of inflation, it may raise rates to cool off the economy.

How the Fed Influences Interest Rates

The Fed influences interest rates primarily through its monetary policies. Here’s how it works:

1. The fed funds rate: The most direct tool the Fed employs is setting the target for the interest rate at which banks lend to each other overnight. While the Fed doesn’t set the rate directly, it influences it through its open market operations.16
2. Open market operations: The Fed buys and sells U.S. Treasury securities on the open market, thus increasing the money supply in the banking system. In turn, this has the effect of lowering the fed funds rate. Conversely, if it sells Treasury securities, this lowers the amount of funds in the economy, tightening the money supply and increasing the fed funds rate.16
3. Discount rate: This is the interest rate the Fed charges commercial banks for short-term loans. Lowering the discount rate makes borrowing cheaper for banks, which should encourage them to lend more while lowering interest rates for consumers. Raising the discount rate would, of course, do the opposite.17
4. Reserve requirements: The Fed can alter the amount of reserves a bank is required to hold, which influences how much money banks have available to lend. Lower reserve requirements should lead to more lending and lower interest rates, while higher requirements might restrict lending and raise rates.18
5. The Fed’s guidance: The Fed has an outsized role in how investors, representatives, and the public read its guidance, projections, and any tea leaves found in speeches by various Fed officials. This all sets expectations about future interest rates, especially if it’s the Fed’s official guidance, and shapes market expectations for the economy in the near future.

Through these mechanisms, the Fed can greatly influence the credit conditions in the economy, including interest rates on consumer loans, mortgages, and bonds.

Notable Fed Actions

Throughout its history, Fed actions have played a significant role in the economy and its trajectory. For instance, The Federal Reserve’s moves during its first decades were found too timid to protect the economy from the crises of the late 1920s and 1930s. Initially, the Fed didn’t provide enough monetary support to prevent a banking collapse, which exacerbated the economic downturn that led to the Great Depression since there was little to no liquidity. This caused a vicious spiral of bank collapses and bank runs.19

After World War II, the U.S. was transitioning to a peacetime economy. The Fed worked to maintain low inflation and stabilize the economy. This period was considered a success as the economy became a juggernaut while experiencing relatively low inflation. Its actions at this time set a precedent for the Fed’s role in managing post-crisis economic transitions.

However, by the 1970s, the U.S. economy faced major crosswinds, including the vast increase in spending on the Vietnam War and oil price shocks. In the late 1970s and into the early Reagan administration, Volcker and the Federal Reserve raised interest rates significantly to combat inflation, leading to a short-term economic recession. Ultimately, the Fed took credit for its actions in controlling the inflationary spiral, despite the economic pain of the period, and set an extreme precedent for how the Fed dealt with inflation. The lesson investors took away was that, if it came to it, the Fed would make tough decisions to curtail inflation, even at the cost of short-term economic pain. Since inflation can spike simply on the back of worries that inflation will continue to spike, this has had no small effect since the Volcker era.20

In the 2000s, the Fed’s next great crisis was the Great Recession, the most severe economic downturn since the Great Depression, one set off by the collapse of a housing bubble and subsequent financial crisis. The Fed, under its chair, Ben Bernanke, took unprecedented steps, including lowering the Fed funds rate to near zero and implementing quantitative easing, buying large amounts of government and mortgage-backed securities to inject liquidity into the economy. These actions were credited with preventing a worse economic crisis and aiding recovery.21

In 2020, the COVID-19 pandemic led to a virtual halt in much of the economy, threatening a significant global economic downturn. The Fed rapidly cut interest rates to near zero and restarted quantitative easing. It also set up several emergency lending programs to support businesses, states, and local governments. As inflation emerged during the post-COVID recovery, the Fed raised interest rates. The swift and extensive nature of these interventions highlighted the Fed’s role in the major political and economic crises since its founding.22

The Future of the Federal Reserve

The coming decades of the Fed are likely to see many changes. The Federal Reserve, like other central banks, faces the challenge of adapting to rapid technological advances, including the rise of digital currencies, both private (e.g., cryptocurrencies) and potentially public (e.g., central bank digital currencies). The Fed will need to explore how these innovations fit into the existing financial system and what regulations are necessary to ensure stability and systemic integrity. The development and potential adoption of a digital dollar is a particularly significant area to watch.

The evolving global financial landscape may also demand new or updated regulations. The Federal Reserve will likely refine its approach to monetary policy, banking supervision, and systemic risk management. This could involve more stringent capital requirements for banks, updated frameworks for dealing with financial crises, and re-evaluating how monetary policy tools are used, especially in low-interest-rate or high-inflation environments.

The Federal Reserve’s traditional roles in controlling inflation and supporting full employment thus remain critical. Meanwhile, there’s growing speculation about how central banks, including the Federal Reserve, should respond to climate change and other ecological and social crises through its policies. This could mean integrating climate risk into financial stability monitoring or exploring how monetary policy can support broader societal goals not necessarily related to employment, policies that won’t be without controversy.

Why Was the Federal Reserve Created?

The U.S. has had a long history of debates about having a central bank. The Federal Reserve System was eventually established Dec. 23, 1913, with the signing of the Federal Reserve Act by President Woodrow Wilson.1 The motivation for its creation was to address the financial instabilities and banking crises that had periodically plagued the U.S. economy, particularly the Panic of 1907. The Federal Reserve was designed to provide a safer, more flexible, and more stable monetary and financial system.23

Was the Fed the First Central Bank of the United States?

No, the Federal Reserve was not the first central bank of the U.S. Before the establishment of the Federal Reserve in 1913, the U.S. had two earlier central banks:

• The First Bank of the United States (1791 to 1811): The First Bank of the United States was established through the work of Alexander Hamilton, the first Secretary of the Treasury, as a part of his plan to stabilize and improve the nation’s credit and to improve how the financial business of the U.S. government was handled. Its charter was not renewed after 20 years because of opposition from those who said it favored creditors and commercial interests over farmers and laborers.24
• The Second Bank of the United States (1816 to 1836): After the financial difficulties of the War of 1812, the Second Bank of the United States was established. Like its predecessor, it was also chartered for 20 years, and it faced similar political and public opposition. The bank’s charter expired in 1836 following a struggle with President Andrew Jackson, who vehemently opposed the bank’s recharter.25

What Are the Major Legislative Changes that Have Affected the Fed?

Major legislative changes that impacted the Federal Reserve include the Glass-Steagall Act of 1933, which created the Federal Deposit Insurance Corporation and separated commercial and investment banking; the Employment Act of 1946, which set expectations for the Fed to promote maximum employment; and the Humphrey-Hawkins Act of 1978, which formally set the goals of maximum employment, stable prices, and moderate long-term interest rates as the Fed’s objectives.26 The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, enacted in response to the financial crisis of 2007-2008, brought significant changes to financial regulation in the United States. It increased the Federal Reserve’s regulatory responsibilities overseeing systemically important financial institutions.27

The Bottom Line

It is clear that the Fed has been instrumental in shaping the economic landscape of the U.S. From its early days responding to financial panics to its modern role as a guardian of economic stability, the Fed has evolved into one of the most influential institutions globally. It’s important to recall that the Federal Reserve’s influence extends beyond Wall Street and government policy. Its decisions on interest rates, inflation, and financial regulation have tangible effects on the lives of all Americans. From mortgage rates to savings accounts, from job markets to the price of goods, the Fed’s policies play a critical role in the economic well-being of individuals and communities across the U.S.

Source : Investopedia