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The History and Purpose of the Federal Reserve Board

By Jerry Beyke, CFA®June 21, 2019Economy

As the New York Stock Exchange was ringing its opening bell at the start of a new trading day recently, CNBC showed a “countdown clock” in the bottom right corner of TV screens indicating that it was then 4 hours, 29 minutes, and 59 seconds until the Federal Reserve Board would announce an update on monetary policy from the scheduled meeting by the Federal Open Market Committee later that day. CNBC viewers could tick down every second, as if this were something truly momentous, akin to the lift-off of the Apollo 11 moon launch 50 years ago on July 16, 1969. When the actual Fed announcement came out, it was fairly predictable and unexciting; the Fed simply kept the current 2.5% target for the Fed Funds Rate unchanged for now. The S&P 500 nevertheless promptly traded higher to a new all-time high. Investors were reassured by the Fed’s suggestion that we are now approaching levels where it may be more appropriate to shift to an easier monetary policy by lowering interest rates in order to help sustain the current economic expansion.

What is the Federal Reserve Board, and what is their purpose? The birth of the Federal Reserve came on December 23, 1913, after The Federal Reserve Act was passed by the House of Representatives and the Senate and signed into law by President Woodrow Wilson.

During the 19th century and the early part of the 20th century, the US financial system suffered recurring financial crises in 1839, 1857, 1873, 1893, and 1907. Economic downturns in that earlier time period routinely led to financial crises as well, because access to money and credit often evaporated during downturns. The Federal Reserve Act was intended to be a solution to that problem, creating a Central Bank that could act as a “Lender of Last Resort” and inject much-needed liquidity into the financial system, thus keeping the door open for money and credit flows to help moderate economic downswings. The US experienced a very severe recession in 2007 to 2009, and the aggressive policy responses by the Federal Reserve helped to improve liquidity and boost confidence. This recession could have been far worse in terms of both the depth and duration of the decline in real GDP if not for the counter-cyclical efforts to boost the economy taken by the Federal Reserve.

In addition to taking actions to add liquidity and stabilize the banking system under periods of financial stress, the Federal Reserve also implements the nation’s monetary policy with a dual mandate of promoting full employment and maintaining stable inflation rates. When economic growth is weak and operating well below full employment, the Federal Reserve goal is to add stimulus through an easy monetary policy. During the later stages of the economic cycle, when the economy reaches the full employment stage, the Federal Reserve worries more about the risks of accelerating inflation. If inflation rates accelerate above the Federal Reserve targets, the Fed goal is to lean against that by tightening monetary policy (raising short-term interest rates) to keep the economy from overheating.

The overall goal of the Federal Reserve Board is to stabilize the banking system and obtain a more consistent long-term growth trend for the economy. Since the creation of the Federal Reserve in 1913 and Federal Deposit Insurance in 1933, the banking system has proven to be far more resilient and stable in withstanding down cycles. During the period, 1854-1912, before the Federal Reserve was created, there were 14 economic cycles during which the economy expanded for an average of 26 months followed by an average 23-month recession. During the most recent 75 years, after the Federal Reserve was created, there have been 12 economic cycles. These cycles have encompassed longer-lasting economic upswings, which now last 65 months on average (over 2x previous average) and shorter recessions that now average only 11 months on average (1/2 of the previous average).

At the same time, one can look around the world right now and observe $12.5 trillion in global government bonds worldwide that currently carry a negative yield, a phenomenon that probably wouldn’t even be possible without the aggressive artificial manipulation of interest rates by central banks all across the world. The challenge with central bank intervention on interest rates to try to stimulate economic growth is that it sometimes distorts markets and carries the potential to create asset bubbles.

The Federal Reserve Board also has its critics, such as the financial writer, James Grant, who worries that the Federal Reserve has at times distorted asset markets with overly easy money policies, which may have helped inflate the stock market bubble in 1998-2000 as well as the housing market bubble and subsequent Great Recession in 2007-2009:

“The Fed’s stated dual mandate is price stability and full employment. In fact, the Fed’s functional mandate is that of being both Arsonist and Fireman. Through its well-intended, but somewhat maladroit actions to manage and manipulate, the Fed creates those conditions that lead to financial turmoil. And as soon as the smoke begins rising from the marketplace, then you hear the clanging of fire trucks… and they wheel up, breathless and say, ‘We’re here and we’re now going to fix the fire that we started.’”

A realistic and balanced perspective on the role of central banks is that they usually have a stabilizing and reassuring effect on economies and markets, but financial market investors should maintain a watchful eye on how the Federal Reserve can also sometimes have a distorting effect on markets, and understand how it might affect their financial plan.

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