How the Federal Reserve Was Formed

The Federal Reserve is widely considered to be one of the most important financial institutions in the world. Its monetary policy decisions can send waves through not only the U.S. markets, but also the rest of the world.

In this article, we will look at the formation of the Federal Reserve and follow its history as it riled the market before sending it to new highs.

Key Takeaways

• Despite early attempts in the U.S. after the revolutionary war to form a central bank by Alexander Hamilton, these efforts failed due to political unfeasibility.
• After the panic of 1907, and at the urging of J.P. Morgan and other prominent financiers, Congress passed the Federal Reserve Act in 1913, establishing the Fed as America’s central bank.
• During World War II, the Federal Reserve aided the war effort by marketing war bonds and keeping interest rates low.
• After the war, the Fed established its independence from other arms of government via the Treasury-Fed Accord.

America Before the Federal Reserve

The United States was considerably more unstable before the creation of the Federal Reserve. Panics, seasonal cash crunches, and a high rate of bank failures made the U.S. economy a risky place for international and domestic investors to place their capital.

The lack of dependable credit stunted growth in many sectors, including agriculture and industry. Early Americans also did not want a central bank. They saw this as a model based on the British crown and the Bank of England. New America did not want to be made in the image of Britain, and it also favored a more decentralized state-by-state approach to its political economy.

Still, there were some early attempts. Alexander Hamilton, the first secretary of the Treasury, was instrumental in the formation of the first national bank in America, known as the First Bank of the United States. Located in Philadelphia within Independence National Historical Park, the structure was completed in 1797 and stands today as a National Historic Landmark. It was one of four major financial innovations at the time, including the U.S. government’s assumption of the state war debts, the establishment of a mint, and the imposition of a federal excise tax. Hamilton’s aim with these measures was to establish financial order, national credit, and resolve the issue of fiat currency.

However, this first attempt at an American central bank was short-lived, and its charter was not renewed (it was re-established later for another short period of years, as the second Bank of the United States, which was even shorter-lived). Hamilton proposed the Bank of the United States in 1790, and it opened in Philadelphia the following year. In April 1792, it opened a New York branch, Wall Street’s second bank. The charter of the First Bank of the United States was for 20 years (1791-1811).

J.P. Morgan and the Panic of 1907

After many decades of lacking a central bank, it was J.P. Morgan who ultimately forced the government into acting on the central banking plans it had been considering off and on for almost a century. During the Bank Panic of 1907, Wall Street turned to J.P. Morgan to steer the country through the crisis that was threatening to push the economy over the edge into a full crash and depression. Morgan was able to convene all the principal players at his mansion and command all their capital to flood the system, thus floating the banks that, in turn, helped to float the businesses until the panic passed.

The fact that the government owed its economic survival to a private banker forced the necessary legislation to create a central bank and the Federal Reserve.

Learning From Europe

In the years between 1907 and 1913, the top bankers and government officials in the U.S. formed the National Monetary Commission and traveled to Europe to see how the central banking was handled there. They came back with favorable impressions of the British and German systems, using them as the base and adding some improvements gleaned from other countries. Congress ultimately passed the 1913 Federal Reserve Act—legislation that created the current Federal Reserve System. Congress developed the Federal Reserve Act to establish economic stability in the United States by introducing a central bank to oversee monetary policy. The law sets out the purpose, structure, and function of the Federal Reserve System. Congress can amend the Federal Reserve Act and has done so several times.

The 1913 Federal Reserve Act, signed into law by President Woodrow Wilson, gave the 12 Federal Reserve banks the ability to print money to ensure economic stability. The Federal Reserve System created the dual mandate to maximize employment and keep inflation low. The Federal Reserve was thus given power over the money supply and, by extension, the economy. Although many forces within the public and government were calling for a central bank that printed money on demand, President Wilson was swayed by Wall Street arguments against a system that would cause rampant inflation. So the government created the Federal Reserve, but it was by no means under government control.

The Great Depression

The government soon came to regret the freedom it had granted the Federal Reserve as it stood by during the crash of 1929 and refused to prevent the Great Depression that followed.

Even now, it is hotly debated whether the Fed could have stopped the depression, but there is little doubt that it could have done more to soften and shorten it by providing lower interest rates to allow farmers to keep planting and businesses to keep producing. The high interest rates may even have been responsible for the unplanted fields that turned into dust bowls. By restricting the money supply at a bad time, the Fed starved out many individuals and businesses that might otherwise have survived.

2%

The target interest rate for the Federal Reserve’s monetary policy.

World War II and the Post-War Recovery

It was World War II, not the Federal Reserve, that lifted the economy out of the depression. The war benefited the Federal Reserve as well by expanding its power and the amount of capital it was called on to control for the Allies.

During the war, the Federal Reserve pledged to keep interest rates low to support the war effort. The Fed worked closely with the Treasury to market war bonds to the public and purchased government debt at 0.375%, a steep discount from the peacetime range of 2% to 4%.

Inflation soared after the war ended, and the Fed pivoted its priorities to raising interest rates. This caused political friction with the Treasury, which was more worried about maintaining bond prices. As inflation reached 21%, Truman summoned the entire Federal Open Market Committee to the White House and pressured them to maintain the wartime peg.

For the Fed, it was clear that monetary policy was at risk of becoming compromised by political considerations. After negotiations with the Treasury, the two agencies announced the Treasury-Fed Accord, which established the Federal Reserve as the primary authority on monetary policy while leaving fiscal policy to the Treasury. The accord also solidified the Fed as an independent agency rather than an arm of the presidency.

Inflation or Unemployment?

Over the following decades, the Fed continued to calibrate the economy using monetary policy, but its official mission remained the prevention of banking panics. Stagflation and unemployment hit the U.S. in the 1970s, highlighting the Fed’s importance in promoting economic growth.

The Federal Reserve Act of 1977 formally established the Fed’s dual mandate of lowering unemployment and preventing inflation. By controlling interest rates, the Fed can make corporate credit easy to obtain, thus encouraging business to expand and create jobs. Unfortunately, this increases inflation as well. On the flip side, the Fed can slow inflation by raising interest rates and slowing down the economy, causing unemployment. The history of the Fed is simply each chairperson’s answer to this central question.

When Was the Federal Reserve Created?

President Woodrow Wilson signed the Federal Reserve Act on Dec. 23, 1913, officially establishing the Fed as the country’s central bank. The founding of the Fed came in response to the financial panic of 1907, with advocacy from J.P. Morgan and other prominent financiers. Prior to this, the U.S. was the only major financial power in the world without a central bank.

What Is the Purpose of the Federal Reserve?

The Federal Reserve has a dual mandate of ensuring price stability (limiting inflation) and achieving maximum employment. It also regulates the activity of banks and aims to protect consumers.

Is the Federal Reserve Independent?

The Federal Reserve System operates under a mandate from the U.S. Congress. However, Congress granted autonomy to the Fed with the intention of allowing the central bank to carry out its mission in the absence of political pressure. Although this independence has been tested at times throughout history, the Fed’s three sections—the Federal Open Market Committee, the Board of Governors, and the Fed’s regional banks—maintain independence from the federal government as they fulfill their responsibilities.

The Bottom Line

Criticisms of the Federal Reserve continue. Boiled down, these arguments center on the image people have of the caretaker of the economy. You can either have a Fed that feeds the economy with ideal interest rates leading to low unemployment—possibly leading to future problems—or you can have a Fed that offers little help, ultimately forcing the economy to learn to help itself.

The ideal Fed would be willing to do both. Although there have been calls for the elimination of the Federal Reserve as the U.S. economy matures, it is very likely that the Fed will continue to guide the economy for many years to come.