Chapter 19 Organization of the Fed

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Chapter 19 Organization of the Fed
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Creation of the Fed

• The Fed was established by the Federal Reserve
  Act of 1913.
• Two prime motives for its founding
• To serve as a lender of last resort along the
  lines of the Bank of England
• To break the power of the large NYC banks

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Lender of Last Resort

• After the 1907 banking crisis, a commission was
  created to make recommendations to Congress.
• It proposed a lender of last resort like the Bank
  of England, which had developed methods for
  preventing liquidity crises.
• Most of the Commission favored a single central
  bank in New York City.

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New York City Banks

• Large NYC banks were central to the financial
  system
• They served as correspondent banks for many other
  banks.
• They served Wall Street and many major
  corporations.
• They were tightly connected with large foreign
  banks and international financiers.
• William Jennings Bryan argued that peoples
  banks should be established to take their place
  as correspondent banks.
• He wanted 50 Federal Reserve Banks with branches
  in every major crossroad.

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Compromise

• Congress attempted to combine the two concepts in
  a single piece of legislation.
• It established a Federal Reserve System
  comprising 12 Federal Reserve Banks spread across
  the country as Bryan had urged.
• It gave the Banks powers that would enable them
  to jointly serve as a lender of last resort if
  they chose to do so.

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Aftermath

• The large NYC banks remained as powerful as ever,
  reflecting the economic fundamentals of the US
  economy.
• The Fed failed to serve as a lender of last
  resort in the liquidity crisis of 1930-1933
  because its fragmentation led to intense
  political infighting rather than action.
• Important lesson In designing new institutions,
  it is important to think through how they will
  function.

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Twelve Federal Reserve Banks

• A, 1. Boston
• B, 2. New York City
• C, 3. Philadelphia
• D, 4. Cleveland
• E, 5. Richmond
• F, 6. Atlanta

• G, 7. Chicago
• H, 8. St. Louis
• I, 9. Minneapolis
• J, 10. Kansas City
• K, 11. Dallas
• L, 12. San Francisco

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Figure 19.1 Federal Reserve Districts and Banks
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Federal Reserve Banks

• They serve multi-state districts surrounding
  them.
• Pork-barrel and political considerations
  determined their number and locations.
• Riots broke out in Baltimore and New Orleans
  because Richmond and Dallas were sites.
• Richmond was favored because the Chair of the
  House Banking Committee came from Virginia.
• Similar considerations led to the selection of
  Dallas and Kansas City.

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Key Functions of Fed Banks

• Clearing checks
• Putting currency into circulation and replacing
  it when worn or damaged
• Discount lending to the banks in their districts
• Examining, supervising and regulating state
  member banks
• Collecting district data and making them
  available
• Performing research on monetary policy and other
  topics

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Membership in the Fed

• All national banks are required to be member
  banks of the Federal Reserve System.
• State banks are permitted to join if they wish.
• Only 1/7 exercise this option, typically only the
  largest ones.

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A Major Structural Change

• The 1933 and 1935 Banking Acts centralized
  authority in Washington.
• Authority passed from the previously
  semi-autonomous Banks to the Board of Governors.
• The Board comprises seven Governors who serve
  nonrenewable staggered terms of 14 years.
• The President appoints a new Governor every 2
  years to replace the Governor whose term has just
  expired.
• The Federal Open Market Committee (FOMC) was also
  created.
• FOMC has evolved into the decision-making body
  that controls US monetary policy.

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Structure of FOMC

• FOMC consists of
• 7 Governors from the Board
• The President of the New York Fed
• The Presidents of the Chicago and Cleveland Banks
  in alternate years
• The other 9 Presidents of Fed Banks in three
  rotations that bring each to FOMC once every
  third year

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1. Monetary Policy

• FOMC has eight scheduled meetings a year.
• Economists at the Board (the Board Staff) put the
  national forecasts together and distribute them
  in the Green Book.
• Economists at the Fed Banks distribute data and
  forecasts for their districts in the Beige Book.
• FOMC plus the other seven Presidents review and
  discuss forecasts over the next year.
• All 19 participants can voice their views on the
  forecasts and on what the Fed should do.

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2. Monetary Policy

• A vote is taken of the 12 FOMC members near the
  end of the meeting, and the majority rules.
• Most votes are unanimous since consensus is
  typically widespread.
• The FOMC then drafts
• A directive to the Open Market Trading Desk at
  the NY Fed, specifying the federal-funds-rate
  target
• A public statement, stating FOMCs rationale for
  its action and describing what the majority
  perceive as the balance of risks in the US
  economy at the time

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Power on FOMC

• FOMCs structure suggests equal power for all
  participants. Wrong!
• The Chairman of the Board is extremely powerful.
• The Board Staff, which has no vote at all, is
  also powerful since it generates the Green Book.
• Others can make a difference only if they can
  make a compelling factual case that the Board
  Staff has overlooked relevant considerations.

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Board Staff

• It consists of professional economists.
• Governors besides the Chairman can easily have
  the Board Staff research their ideas.
• The Presidents have their own staffs of
  professional economists.
• So disagreement is rare in practice and mistakes
  are quickly detected and rectified.

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FOMCs Decision-Making

• Evolutionary changes over the postwar period have
  gradually improved FOMCs system for making
  decisions.
• In earlier periods, the Chairmans central
  position enabled serious mistakes to persist,
  especially from the mid-1960s until 1979.
• It would be much harder for such persistent
  mistakes to be made now.

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Independence of the Fed

• The Fed is formally independent of the rest of
  the government.
• Several features of its governance make this
  independence real rather than merely formal
• Long staggered terms for Governors
• Nonrenewable terms for Governors
• The Fed determines its own budget independent of
  the President and Congress.
• The Banks are nominally private, owned by the
  member banks, and their Presidents are selected
  by a process outside politics.

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Is Independence Desirable? Con

• Independence of the Fed in 1930-1933 was
  disastrous.
• Being a direct agency of the Treasury would no
  doubt have worked better.
• Conclusion Independence for a disfunctional and
  irresponsible central bank is a bad idea.

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Is Independence Desirable? Pro

• The Fed is now highly responsive to society.
• It has adopted effective procedures for making
  monetary policy.
• Insulation from political currents is necessary
  for a well-functioning central bank because
• Monetary policy should be largely oriented toward
  long-term outcomes (the average inflation rate)
• Politicians are largely oriented toward
  short-term outcomes (their reelection)

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Evidence

• Alberto Alesina and Larry Summers examined the
  performance of central banks from 1955-1988,
  finding that greater independence led to
• A lower average inflation rate
• Greater stability in the inflation rate
• No difference in either the average growth rate
  of real GDP or its variance
• The next page illustrates their findings.

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A Recent Trend

• Since 1990 many central banks have been made
  independent e.g. in UK, Canada, New Zealand,
  Australia, Sweden, Japan, and Euroland.
• This trend has reflected the strong consensus
  among economists favoring independence.
• Independence has paid off the UK, Australia, New
  Zealand, Sweden and Canada have brought down
  inflation and increased stability.

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Cautionary Note

• The European Central Bank (ECB) is not only
  independent but also fragmented in much the same
  way as the early Fed.
• It also lacks many of the institutions that have
  evolved within the Fed to systematize the
  formulation of monetary policy.
• Only time will tell whether the ECB evolves into
  a well-functioning central bank or devolves into
  a disfunctional collection of warring factions,
  should a large shock hit the EC.