Understanding the Federal Reserve, Part Two: The History

David Frost // Blog


March 7  

This is part two of a series on the Federal Reserve, starting with the history of the Federal Reserve and the Federal Reserve Act. Click here for part one.

Congress created the Federal Reserve in 1913 via the Federal Reserve Act, which then-President Woodrow Wilson signed into law in December 1913. The Fed is actually the third attempt at setting up a central bank in the U.S. The First Bank of the United States and the Second Bank of the United States each lasted 20 years, and their charters were not renewed. 

Before the Federal Reserve

One of the big issues with the first two central banks was the way control was handled. The federal government was required to buy 20% of the shares and appoint 20% of the directors of each of the first two central banks. However, wealthy investors bought the other 80% of the banks’ shares, putting them firmly in control of the nation’s central bank. 

State-chartered banks opposed the first two central banks, viewing them as huge competitors. Many individuals also opposed the banks because of the way wealthy investors had control over them. President Andrew Jackson vetoed legislation that would have renewed the charter of the Second Bank of the United States, essentially saying that all Americans should be equally represented in the nation’s banking system. 

Years after the charter of the Second Bank of the United States ended, the National Currency Act was passed to help pay for the Civil War. The period between the Second Bank and the Federal Reserve is generally known as the Free Banking Era. During this time, the National Currency Act created a system of national banks which all could issue standardized national bank notes based on government bonds. A year later in 1864, the law was revised and became the National Banking Act. It created the Office of the Comptroller of the Currency, which still exists today. 

Before the National Reserve was created, U.S. banks had a habit of lending more money than what their assets could cover. As a result, there were several major bank panics. Whenever there were rumors that a bank was having problems, people would panic and pull their money out. Thus, the need for a central banking system became more and more apparent. 

Before the Panic of 1907, lawmakers created the National Monetary Commission by passing the Aldrich-Vreeland Act. The act created one commission to study the U.S. monetary system and another commission to study Europe’s central banks. Nelson Aldrich, who oversaw the National Monetary Commission, came to appreciate central banking systems after studying Germany’s system.

The Federal Reserve Act

It wasn’t until after much political negotiating in 1913 that the Federal Reserve Act was passed. The Panic of 1907 served as a major catalyst in convincing most Americans that something needed to be done about the nation’s banking system. One major issue at the time was whether the central bank would be controlled by the private sector or the government sector. The Federal Reserve Act represented a compromise between these two extremes. 

Under the Federal Reserve Act, 12 regional Federal Reserve Banks were created and tasked with managing the nation’s money, overseeing banks and making loans to them, and acting as the lender of last resort. The law also created the Federal Reserve Board of Governors to oversee the central bank. The president appoints the members of the board, and the Senate confirms them before they take office. 

Because the Federal Reserve Act was a compromise between calls for public and private control over the central bank, the system it created included both public and private entities. The 12 regional Federal Reserve Banks were private and controlled by a board.  The Federal Reserve Act also created a Federal Advisory Committee, which was made up of 12 members, and the Federal Reserve Note, which became the nation’s only currency. The monetary system created by the law was designed to respond the stress within the nation’s banking system and to stabilize the financial system. 

Nationally chartered banks were required to join the Federal Reserve System as part of the Federal Reserve Act. Member banks also had to buy non-transferable shares of their regional Federal Reserve Bank and set aside a set amount of non-interest-bearing reserves. Member banks are also eligible to receive some services from the Federal Reserves, such as discounted loans.

Another amendment later tasked the Fed with effectively promoting “the goals of maximum employment, stable prices, and moderate long-term interest rates.” 

The Federal Open Market Committee

An amendment in 1933 created the Federal Open Market Committee (FOMC) to oversee the Fed’s open market operations. These operations include the sale and purchase of Treasury securities. The FOMC makes important decisions about interest rates and the state of the money supply in the U.S. The Federal Reserve Act originally authorized each one of the regional Federal Reserve banks to buy and sell Treasuries in the open market, which pitted them against each other in the bidding for the securities. The creation of the FOMC prevented the regional Federal Reserve banks from bidding against each other. 

The FOMC sets monetary policy by setting the short-term goal for the Fed’s open market operations. This usually includes a target for the federal funds rate, which is the interest rate commercial banks charge each other for overnight loans. The FOMC also oversees the Fed’s operations in foreign exchange markets in coordination with the U.S. Treasury. 

The committee consists of the Federal Reserve Board’s seven members, the president of the New York Federal Reserve Bank, and the presidents four of the other 11 regional Fed banks. Each of the other presidents serve one-year terms on a rotating basis. The FOMC is required to meet at least four times per year.

The Fed responds to financial crises

Over the years, various laws and amendments affecting the Fed have been passed. One example is the Federal Deposit Insurance Corporation Improvement Act of 1991, which was passed during the savings and loan crisis. The law made the Federal Deposit Insurance Corporation stronger by enabling it to borrow directly from the Treasury. 

The Federal Reserve Reform Act of 1977 made the Fed more accountable for the actions it makes on fiscal and monetary policy. It stated that the Fed must “promote maximum employment, production and price stability.” In fact, it was the first time that price stability became a goal of national policy. 

A more recent law affecting the Fed was the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in 2010. The law followed the 2007-2008 financial crisis and overhauled almost the entire financial services industry in the U.S. 

Future articles in this series will cover other aspects and powers of the Fed.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost