January | 2017 | Dens Triple D

The Fed has a long history dating back to the 1791; it lasted until 1811. There had to be a system of currency, so the Fed set up a system of money creation. They created money out of thin air, so there would be a away to buy and sell products efficiently. That was successful, as it was difficult to exchange furs for food, for example.
In 1813 the first federal bank (Feds) was created to to finance the American Revolution, the Continental Congress printed the new nation’s first paper money. Known as “continentals,” the fiat money notes were issued in such quantity they led to inflation, which, though mild at first, rapidly accelerated as the war progressed. Eventually, people lost faith in the notes, and the phrase “Not worth a continental” came to mean “utterly worthless. They also needed a way to handle the flow of money. In order to get dollars one had to buy them with gold – we call that gold backed dollars. If you wanted your gold back, you only had to turn in your dollars for your gold. Unlike later it was legal to have gold.

1816-1836: A Second Try Fails

By 1816, the political climate was once again inclined toward the idea of a central bank; by a narrow margin, Congress agreed to charter the Second Bank of the United States. But when Andrew Jackson, a central bank foe, was elected president in 1828, he vowed to kill it. His attack on its banker-controlled power touched a popular nerve with Americans, and when the Second Bank’s charter expired in 1836i, it was not renewed.

History of the Federal Reserve

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1775-1791: U.S. Currency

To finance the American Revolution, the Continental Congress printed the new nation’s first paper money. Known as “continentals,” the fiat money notes were issued in such quantity they led to inflation, which, though mild at first, rapidly accelerated as the war progressed. Eventually, people lost faith in the notes, and the phrase “Not worth a continental” came to mean “utterly worthless.”

1791-1811: First Attempt at Central Banking

At the urging of then Treasury Secretary Alexander Hamilton, Congress established the First Bank of the United States, headquartered in Philadelphia, in 1791. It was the largest corporation in the country and was dominated by big banking and money interests. Many agrarian minded Americans uncomfortable with the idea of a large and powerful bank opposed it. When the bank’s 20-year charter expired in 1811 Congress refused to renew it by one vote.

1816-1836: A Second Try Fails

1836-1865: The Free Banking Era

State-chartered banks and unchartered “free banks” took hold during this period, issuing their own notes, redeemable in gold or specie. Banks also began offering demand deposits to enhance commerce. In response to a rising volume of check transactions, the New York Clearinghouse Association was established in 1853 to provide a way for the city’s banks to exchange checks and settle accounts.

1863: National Banking Act

During the Civil War, the National Banking Act of 1863 was passed, providing for nationally chartered banks, whose circulating notes had to be backed by U.S. government securities. An amendment to the act required taxation on state bank notes but not national bank notes, effectively creating a uniform currency for the nation. Despite taxation on their notes, state banks continued to flourish due to the growing popularity of demand deposits, which had taken hold during the Free Banking Era.

1873-1907: Financial Panics Prevail

Although the National Banking Act of 1863 established some measure of currency stability for the growing nation, bank runs and financial panics continued to plague the economy. In 1893, a banking panic triggered the worst depression the United States had ever seen, and the economy stabilized only after the intervention of financial mogul J.P. Morgan. It was clear that the nation’s banking and financial system needed serious attention.

1907: A Very Bad Year

In 1907, a bout of speculation on Wall Street ended in failure, triggering a particularly severe banking panic. J.P. Morgan was again called upon to avert disaster. By this time, most Americans were calling for reform of the banking system, but the structure of that reform was cause for deep division among the country’s citizens. Conservatives and powerful “money trusts” in the big eastern cities were vehemently opposed by “progressives.” But there was a growing consensus among all Americans that a central banking authority was needed to ensure a healthy banking system and provide for an elastic currency.

1908-1912: The Stage is Set for Decentralized Central Bank

The Aldrich-Vreeland Act of 1908, passed as an immediate response to the panic of 1907, provided for emergency currency issue during crises. It also established the national Monetary Commission to search for a long-term solution to the nation’s banking and financial problems. Under the leadership of Senator Nelson Aldrich, the commission developed a banker-controlled plan. William Jennings Bryan and other progressives fiercely attacked the plan; they wanted a central bank under public, not banker, control. The 1912 election of Democrat Woodrow Wilson killed the Republican Aldrich plan, but the stage was set for the emergence of a decentralized central bank.

1912: Woodrow Wilson as Financial Reformer

Though not personally knowledgeable about banking and financial issues, Woodrow Wilson solicited expert advice from Virginia Representative Carter Glass, soon to become the chairman of the House Committee on Banking and Finance, and from the Committee’s expert advisor, H. Parker Willis, formerly a professor of economics at Washington and Lee University. Throughout most of 1912, Glass and Willis labored over a central bank proposal, and by December 1912, they presented Wilson with what would become, with some modifications, the Federal Reserve Act.

1913: The Federal Reserve System is Born

From December 1912 to December 1913, the Glass-Willis proposal was hotly debated, molded and reshaped. By December 23, 1913, when President Woodrow Wilson signed the Federal Reserve Act into law, it stood as a classic example of compromise—a decentralized central bank that balanced the competing interests of private banks and populist sentiment.

1914: Open for Business

Before the new central bank could begin operations, the Reserve Bank Operating Committee, comprised of Treasury Secretary William McAdoo, Secretary of Agriculture David Houston, and Comptroller of the Currency John Skelton Williams, had the arduous task of building a working institution around the bare bones of the new law. But, by November 16, 1914, the 12 cities chosen as sites for regional Reserve Banks were open for business, just as hostilities in Europe erupted into World War I.

1914-1919: Fed Policy During the War

When World War I broke out in mid-1914, U.S. banks continued to operate normally, thanks to the emergency currency issued under the Aldrich-Vreeland Act of 1908. But the greater impact in the United States came from the Reserve Banks’ ability to discount bankers acceptances. Through this mechanism, the United States aided the flow of trade goods to Europe, indirectly helping to finance the war until 1917, when the United States officially declared war on Germany and financing our own war effort became paramount.

1920s: The Beginning of Open Market Operations

Following World War I, Benjamin Strong, head of the New York Fed from 1914 to his death in 1928, recognized that gold no longer served as the central factor in controlling credit. Strong’s aggressive action to stem a recession in 1923 through a large purchase of government securities gave clear evidence of the power of open market operations to influence the availability of credit in the banking system. During the 1920s, the Fed began using open market operations as a monetary policy tool. During his tenure, Strong also elevated the stature of the Fed by promoting relations with other central banks, especially the Bank of England.

1929-1933: The Market Crash and the Great Depression

During the 1920s, Virginia Representative Carter Glass warned that stock market speculation would lead to dire consequences. In October 1929, his predictions seemed to be realized when the stock market crashed, and the nation fell into the worst depression in its history. From 1930 to 1933, nearly 10,000 banks failed, and by March 1933, newly inaugurated President Franklin Delano Roosevelt declared a bank holiday, while government officials grappled with ways to remedy the nation’s economic woes. Many people blamed the Fed for failing to stem speculative lending that led to the crash, and some also argued that inadequate understanding of monetary economics kept the Fed from pursuing policies that could have lessened the depth of the Depression.

1933: The Depression Aftermath

In reaction to the Great Depression, Congress passed the Banking Act of 1933, better known as the Glass-Steagall Act, calling for the separation of commercial and investment banking and requiring use of government securities as collateral for Federal Reserve notes. The Act also established the Federal Deposit Insurance Corporation (FDIC), placed open market operations under the Fed and required bank holding companies to be examined by the Fed, a practice that was to have profound future implications, as holding companies became a prevalent structure for banks over time. Also, as part of the massive reforms taking place, Roosevelt recalled all gold and silver certificates, effectively ending the gold and any other metallic standard.

1935: More Changes to Come

The Banking Act of 1935 called for further changes in the Fed’s structure, including the creation of the Federal Open Market Committee (FOMC) as a separate legal entity, removal of the Treasury Secretary and the Comptroller of the Currency from the Fed’s governing board and establishment of the members’ terms at 14 years. Following World War II, the Employment Act added the goal of promising maximum employment to the list of the Fed’s responsibilities. In 1956 the Bank Holding Company Act named the Fed as the regulator of bank holding companies owning more than one bank, and in 1978 the Humphrey-Hawkins Act required the Fed chairman to report to Congress twice annually on monetary policy goals and objectives.

1951: The Treasury Accord

The Federal Reserve System formally committed to maintaining a low interest rate peg on government bonds in 1942 after the United States entered World War II. It did so at the request of the Treasury to allow the federal government to engage in cheaper debt financing of the war. To maintain the pegged rate, the Fed was forced to give up control of the size of its portfolio as well as the money stock. Conflict between the Treasury and the Fed came to the fore when the Treasury directed the central bank to maintain the peg after the start of the Korean War in 1950.

President Harry Truman and Secretary of the Treasury John Snyder were both strong supporters of the low interest rate peg. The President felt that it was his duty to protect patriotic citizens by not lowering the value of the bonds that they had purchased during the war. Unlike Truman and Snyder, the Federal Reserve was focused on the need to contain inflationary pressures in the economy caused by the intensification of the Korean War. Many on the Board of Governors, including Marriner Eccles, understood that the forced obligation to maintain the low peg on interest rates produced an excessive monetary expansion that caused inflation. After a fierce debate between the Fed and the Treasury for control over interest rates and U.S. monetary policy, their dispute was settled resulting in an agreement known as the Treasury-Fed Accord. This eliminated the obligation of the Fed to monetize the debt of the Treasury at a fixed rate and became essential to the independence of central banking and how monetary policy is pursued by the Federal Reserve today.

1970s-1980s: Inflation and Deflation

The 1970s saw inflation skyrocket as producer and consumer prices rose, oil prices soared and the federal deficit more than doubled. By August 1979, when Paul Volcker was sworn in as Fed chairman, drastic action was needed to break inflation’s stranglehold on the U.S. economy. Volcker’s leadership as Fed chairman during the 1980s, though painful in the short term, was successful overall in bringing double-digit inflation under control.

1980 Setting the Stage for Financial Modernization

The Monetary Control Act of 1980 required the Fed to price its financial services competitively against private sector providers and to establish reserve requirements for all eligible financial institutions. The act marks the beginning of a period of modern banking industry reforms. Following its passage, interstate banking proliferated, and banks began offering interest-paying accounts and instruments to attract customers from brokerage firms. Barriers to insurance activities, however, proved more difficult to circumvent. Nonetheless, momentum for change was steady, and by 1999 the Gramm-Leach-Bliley Act was passed, in essence, overturning the Glass-Steagall Act of 1933 and allowing banks to offer a menu of financial services, including investment banking and insurance.

1990s: The Longest Economic Expansion

Two months after Alan Greenspan took office as the Fed chairman, the stock market crashed on October 19, 1987. In response, he ordered the Fed to issue a one-sentence statement before the start of trading on October 20: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” The 10-year economic expansion of the 1990s came to a close in March 2001 and was followed by a short, shallow recession ending in November 2001. In response to the bursting of the 1990s stock market bubble in the early years of the decade, the Fed lowered interest rates rapidly. Throughout the 1990s, the Fed used monetary policy on a number of occasions including the credit crunch of the early 1990s and the Russian default on government securities to keep potential financial problems from adversely affecting the real economy. The decade was marked by generally declining inflation and the longest peacetime economic expansion in our country’s history.

September 11, 2001

The effectiveness of the Federal Reserve as a central bank was put to the test on September 11, 2001 as the terrorist attacks on New York, Washington and Pennsylvania disrupted U.S. financial markets. The Fed issued a short statement reminiscent of its announcement in 1987: “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.” In the days that followed, the Fed lowered interest rates and loaned more than $45 billion to financial institutions in order to provide stability to the U.S. economy. By the end of September, Fed lending had returned to pre-September 11 levels and a potential liquidity crunch had been averted. The Fed played the pivotal role in dampening the effects of the September 11 attacks on U.S. financial markets.

January 2003: Discount Window Operation Changes

In 2003, the Federal Reserve changed its discount window operations so as to have rates at the window set above the prevailing Fed Funds rate and provide rationing of loans to banks through interest rates.

2006 and Beyond: Financial Crisis and Response

During the early 2000s

During the early 2000s, low mortgage rates and expanded access to credit made homeownership possible for more people, increasing the demand for housing and driving up house prices. The housing boom got a boost from increased securitization of mortgages—a process in which mortgages were bundled together into securities that were traded in financial markets. Securitization of riskier mortgages expanded rapidly, including subprime mortgages made to borrowers with poor credit records. House prices faltered in early 2006 and then started a steep slide, along with home sales and construction. Falling house prices meant that some homeowners owed more on their mortgages than their homes were worth. Starting with subprime mortgages, more and more homeowners fell behind on their payments. Eventually, this spread to prime mortgages as well. The rising number of delinquencies on subprime mortgages was a wake-up call to lenders and investors that many residential mortgages were not nearly as safe as once believed. As the mortgage meltdown intensified, the magnitude of expected losses rose dramatically. Because millions of U.S. mortgages were repackaged as securities, losses spread across the globe. It became very difficult to determine the value of many loans and mortgage-related securities. In addition, the widespread use of complex and exotic financial instruments made it even harder to figure out the vulnerability of financial institutions to losses. Institutions became increasingly reluctant to lend to each other.

The situation reached a crisis point in 2007 when these fears about the financial health of other firms led to massive disruptions in the wholesale bank lending market. As a result, rates on short-term loans rose sharply relative to the overnight federal funds rate. In the fall of 2008, two large financial institutions failed: the investment bank Lehman Brothers and the savings and loan Washington Mutual. The extensive web of connections among major financial institutions meant that the failure of one could start a cascade of losses throughout the financial system, threatening many other institutions. Confidence in the financial sector collapsed and stock prices of financial institutions around the world plummeted. Banks were unable to sell most types of loans to investors because securitization markets had stopped working. As a result, banks and investors clamped down on many types of loans by tightening standards and demanding higher interest rates—a classic credit crunch. Tight credit weakened spending on big-ticket items financed by borrowing: houses, cars, and business investment. The hit to household wealth was another factor causing people to cut back on spending as they struggled to rebuild depleted savings. With demand weakening, businesses canceled expansion plans and laid off workers. The U.S. economy entered a recession, a period in which the level of economic activity was shrinking, in December 2007. The recession had been relatively mild until the fall of 2008 when financial panic intensified, causing job losses to soar.

As short-term markets froze, the Federal Reserve expanded its own collateralized lending to financial institutions to ensure that they had access to the critical funding needed for day-to-day operations. In March 2008, the Federal Reserve created two programs to provide short-term secured loans to primary dealers similar to discount-window loans provided to banks. Conditions in these markets improved considerably in 2009. The possible failure of the investment bank Bear Stearns early in 2008 carried the risk of a domino effect that would have severely disrupted financial markets. In order to contain the damage, the Federal Reserve provided non-recourse loans to the bank JP Morgan Chase to facilitate its purchase of certain Bear Stearns assets. Following the collapse of the investment bank Lehman Brothers, financial panic threatened to spread to several other key financial institutions, potentially leading to a cascade of failures and a meltdown of the global financial system. The Federal Reserve provided secured loans to the giant insurance company American International Group (AIG) because of its central role guaranteeing financial instruments.

In normal times, banks borrow from each other for terms ranging from overnight to several months. Starting in August 2007, banks became increasingly reluctant to make short-term loans to each other. In response, the Federal Reserve increased the availability of one- and three-month discount-window loans to banks through the creation of the Term Auction Facility. It also created swap lines with foreign central banks to increase the availability of dollar-denominated loans to banks in other countries. In the spring of 2009, the Federal Reserve, in conjunction with other federal regulatory agencies, conducted an exhaustive and unprecedented review of the financial condition of the 19 largest U.S. banks. This included a “stress test” that measured how well these banks could weather a bad economy over the next two years. Banks that didn’t have enough of a capital cushion to protect them from loan losses under the most adverse economic scenario were required to raise new money from the private sector or accept federal government funds from the Troubled Asset Relief Program.

In response to the economic crisis, the Federal Reserve’s policy making body, the Federal Open Market Committee, slashed its target for the federal funds rate over the course of more than a year, bringing it nearly to zero by December 2008. This is the lowest level for federal funds in over 50 years and effectively is as low as this key rate can go. Cutting the federal funds rate helped lower the cost of borrowing for households and businesses on mortgages and other loans. To stimulate the economy and further lower borrowing costs, the Federal Reserve turned to unconventional policy tools. It purchased $300 billion in longer-term Treasury securities, which are used as benchmarks for a variety of longer-term interest rates, such as corporate bonds and fixed-rate mortgages. To support the housing market, the Federal Reserve authorized the purchase of $1.25 trillion in mortgage-backed securities guaranteed by agencies such as Freddie Mac and Fannie Mae and about $175 billion of mortgage agency longer-term debt. These Federal Reserve purchases have reduced mortgage interest rates, making home purchases more affordable.

Dens Triple D

Month: January 2017

The Feds