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Historical Perspective
Until the establishment by Congress in 1913 of the Federal Reserve System, the United States was the only major industrial nation without a central bank. The economy had grown without any central control or coordination of banking activity, the direction of which had been left to local discretion. To establish the Fed, all member banks were required to make deposits into the new centralized system, thus creating a pool of reserves.

As the system developed, the Fed discovered two important powers: First, the capital reserve requirement could be used to control the growth of banks; and second, decisions made by business leaders and the business cycle itself could be affected by the centralized control of the banking system. In the years ahead, the Fed exercised increasing power over the American economy, leading it into occasional conflict with American businessmen, the president, and Congress.

At various times, critics viewed the Fed as too restrictive, not permitting the economy to grow rapidly enough. At other times, the Fed was cited for being too lenient, permitting demand to grow so rapidly that inflation threatened the economy. Such conflicts are a natural result of the Fed’s relationship with Congress and the president. It is not an agency of the United States government, and its policies may, at times, reflect the wishes of Congress and/or the president, but is not bound to do so. Instead, it is a corporation owned by banks, which have purchased shares of stock. While only federally chartered banks are required to purchase stock and become members of the Federal Reserve System, all banks are subject to the Fed’s financial controls.

How the Fed Does It
The Fed can manipulate the money supply in hopes of obtaining a desired effect over time. However, the Fed’s most effective short-range policy decision with which to manipulate the economy are short-term interest rates. Consequently, the Fed can realistically have only one target—inflation. If the Fed perceives that the prevailing forces will increase inflation, it will attempt to slow the economy by raising short-term interest rates (the assumption is that the increases in the cost of borrowing money are likely to dampen both personal and business spending behavior).

Conversely, if the Fed perceives that the economy has slowed too much, it will attempt to stimulate growth by lowering short-term interest rates (i.e., lowering the cost of borrowing).

In carrying out this balancing act, a very cautious Fed walks a fine line. If it doesn’t tighten the reins soon enough (by raising interest rates), it runs the risk of inflation getting out of control. If it fails to loosen soon enough (by lowering interest rates), it can plunge the economy into recession. Indeed, some experts argue that the primary (only?) goal of the Fed is to keep inflation low enough so that it is not a factor in business decisions.

Copyright 2000 Liberty Publishing, Inc. All rights reserved.



Last Updated: 9/23/2012 10:05:00 PM