Even casual observers of financial news know that “Fed watching” is a serious activity in the financial and business communities. Currently, Janet Yellen is Chair of the Board of Governors of the Federal Reserve System, commonly known as the “Fed.” An understanding of the establishment of the Fed, its basic operation and powers, and its relationship with the Federal government and the banking community is especially important at a time when the direction of the economy is under constant scrutiny.
The United States was the only major industrial nation without a central bank until Congress established the Federal Reserve System in 1913. The economy had grown without any central control or coordination of banking activity, the direction of which had been left to local discretion. To establish the Fed, all member banks were required to make deposits into the new centralized system, thus creating a pool of reserves.
The Fed acquired two important powers as the system developed: first, the funds that banks are required to hold in reserve against customer deposits (reserve requirements) could be used to control the growth of banks; and second, decisions made by business leaders—and the business cycle itself—could be affected by the centralized control of the banking system.
In the years that followed, the Fed exercised increasing power over the American economy, leading it into occasional conflict with American business people, the president, and Congress.
At various times, critics viewed the Fed as too restrictive, not permitting the economy to grow rapidly enough. At other times, the Fed was cited for being too lenient, permitting demand to grow so rapidly that inflation threatened the economy. Such conflicts are a natural result of the Fed’s relationship with Congress and the president. Although the Fed is not an agency of the United States government, its policies may, at times, reflect the wishes of Congress and/or the president; however, it is not bound to do so. Instead, it is a corporation owned by banks that have purchased shares of stock. While only federally chartered banks are required to purchase stock and become members of the Federal Reserve System, all banks are subject to the Fed’s financial controls.
The Fed can manipulate the money supply in hopes of obtaining a desired effect over time. However, the Fed’s most effective short-range policy decisions used to manipulate the economy are those involving short-term interest rates. Consequently, the Fed can realistically have only one target—inflation.
If the Fed perceives that the prevailing forces of the economy will increase inflation, it will attempt to slow the economy by raising short-term interest rates—the assumption being that increases in the cost of borrowing money are likely to dampen both personal and business spending behavior. Conversely, if the Fed perceives that the economy has slowed too much, it will attempt to stimulate growth by lowering short-term interest rates—in other words, lowering the cost of borrowing in an attempt to stimulate personal and business spending.
In carrying out this balancing act, a very cautious Fed walks a fine line. If it does not tighten the reins soon enough (by raising interest rates), it runs the risk of inflation getting out of control. If it fails to loosen them soon enough (by lowering interest rates), it can plunge the economy into recession. Indeed, some individuals argue that the primary goal of the Fed is to keep inflation low enough that it is not a factor in business decisions.