The Federal Reserve Act: Law Explained

Understanding the complexities of central banking legislation can be challenging. However, most would agree that the Federal Reserve Act of 1913 marked a pivotal turn in US financial history.

In this post, I'll explain in simple terms what the Federal Reserve Act did, how it works, its key effects, and why it remains controversial over a century later.

You'll learn about the panic that spurred the Act's passage, the structure and tools of the Fed system it created, the Act's impact on monetary policy and financial crises, and the enduring debate over the Fed's independence.

Introduction to the Federal Reserve Act

The Federal Reserve Act, enacted in 1913, established the central banking system of the United States in response to a series of financial panics in the early 1900s.

The Panic of 1907: Catalyst for the Federal Reserve Act of 1913

The Panic of 1907 was a major financial crisis that highlighted the need for a central bank to help prevent and contain future panics. Major New York banks struggled to meet cash demands, the stock market plunged nearly 50%, and there was a nationwide run on banks. The crisis eventually ended when J.P. Morgan provided loans to troubled banks. However, the panic made clear the need for a more reliable lender of last resort.

Key Components of the Federal Reserve Act

To address the lack of central banking, the Federal Reserve Act created:

The Federal Reserve Board to oversee the system
12 regional Federal Reserve Banks to serve as the operating arms
The Federal Open Market Committee (FOMC) to implement monetary policy

The Act gave the Fed authority to issue currency, set reserve requirements, and provide loans to eligible banks through the discount window. This established the Fed's role as lender of last resort.

The Evolution of Central Banking: Amendments to the Federal Reserve Act

There have been several important amendments to expand the Fed's powers:

1933 Banking Act: Gave Fed more authority over banking sector
1935 Banking Act: Created modern Federal Open Market Committee
1978 Humphrey–Hawkins Act: Added goals for full employment and stable prices

These amendments have shaped the modern Federal Reserve System we have today.

What did the Federal Reserve Act do in simple terms?

The Federal Reserve Act of 1913 established the Federal Reserve System as the central banking system of the United States. In simple terms, it did a few key things:

Created the Federal Reserve System to oversee monetary policy and banking regulations. This includes the Federal Reserve Board of Governors and 12 regional Federal Reserve Banks.
Established a national currency system. Federal Reserve Notes, known as U.S. dollars, were established as the official currency. This provided a uniform currency across the country to support a national economy.
Provided tools for managing the money supply and interest rates. The Fed can adjust reserve requirements, lend to banks, and conduct open market operations to influence the money supply and credit conditions. This allows responding to economic stresses.
Provided liquidity to banks through the discount window and other programs. This lending function supports solvent banks facing temporary liquidity issues.
Created a more stable banking system. Through its regulatory powers, liquidity programs, and monetary policy tools, the Fed can moderate boom and bust cycles in the banking system.

In essence, the Act established a central bank to oversee banking and monetary policy across the country. This improved national coordination and economic stability. The Fed still plays these roles today over a century later.

How do you explain the Federal Reserve?

The Federal Reserve System, often referred to as "the Fed", is the central banking system of the United States. It was created in 1913 by the Federal Reserve Act to serve as the nation's central bank and provide the country with a safer, more flexible, and more stable monetary and financial system.

The key functions of the Federal Reserve include:

Conducting monetary policy - The Fed influences money and credit conditions in pursuit of full employment and stable prices. It does this primarily by adjusting the federal funds rate.
Supervising and regulating banks - The Fed oversees bank operations to ensure the safety and soundness of the banking system. This includes stress testing banks and enforcing consumer protection laws.
Maintaining stability of the financial system - The Fed monitors risks to overall financial stability and acts as the lender of last resort if banks face liquidity shortfalls.
Providing payment services to banks and the government - The Fed facilitates the electronic transfer of trillions of dollars each year through services like wire transfers and automated clearinghouse transactions.

The Federal Reserve System has evolved over the years, but its core purpose has remained the same - to foster a healthy economy by promoting price stability and maximum employment through effective monetary policy tools and robust oversight of the banking system. The Fed plays a vital role in ensuring financial and economic stability for the country.

What was the Federal Reserve Act provision?

The Federal Reserve Act, passed by Congress in 1913, had several key provisions to establish a central banking system in the United States. The main objectives outlined in the Act were:

To create a system of Federal Reserve banks to serve as the operating arms of the nation's central banking system. This established 12 regional Federal Reserve banks to carry out central banking functions.
To provide for an elastic currency that could expand and contract based on the needs of the economy. This was done by allowing Federal Reserve banks to issue Federal Reserve Notes that would serve as legal tender currency backed by commercial paper and government securities.
To set up a system to rediscount commercial paper, which enabled banks to borrow from Federal Reserve banks using business loans and other commercial paper as collateral. This provided liquidity to the banking system.
To establish more effective supervision of banks to ensure stability of the overall banking and monetary system. This was done through audits, examinations, and setting reserve requirements.
To make other provisions that facilitated the central banking functions of the Federal Reserve system with respect to issuing currency, facilitating check clearing, supervising banks, and acting as a lender of last resort when needed.

In summary, the key objectives of the Federal Reserve Act were to establish a elastic monetary system, provide liquidity through discounting of commercial paper, improve supervision of banks, and effectively carry out central banking functions for stability of the monetary and banking system.

What were the results of the Federal Reserve Act?

The Federal Reserve Act was passed by Congress and signed into law by President Woodrow Wilson in December 1913. This established the Federal Reserve System as the central banking system of the United States.

Specifically, the bill was approved by:

The United States House of Representatives in a 298-60 vote on December 22, 1913
The United States Senate in a 43-25 vote on December 23, 1913
Signed into law by President Woodrow Wilson on December 23, 1913

The passage of the Federal Reserve Act was considered a major legislative accomplishment at the time. It established crucial central banking functions for the U.S. financial system, including centralized control of the money supply, oversight of banks, and serving as a lender of last resort.

The Act laid the groundwork for the Federal Reserve System's structure, with features such as:

A national system of 12 regional Federal Reserve Banks
Oversight by the presidentially appointed Federal Reserve Board
The ability to issue Federal Reserve Notes as legal tender currency

Overall, the legislation was monumental in shaping the central banking framework that still governs the U.S. financial system today. Its passage marked a pivotal moment in the nation's financial history.

The Structure of the Federal Reserve System

The Federal Reserve Board of Governors: Oversight and Direction

The Federal Reserve Board of Governors is the oversight body of the Federal Reserve System. Located in Washington, D.C., the Board consists of seven members who are nominated by the President and confirmed by the Senate. The members of the Board serve 14-year terms.

The Board of Governors has several key responsibilities:

Setting monetary policy (along with the Federal Open Market Committee)
Overseeing the operations of the 12 Federal Reserve Banks
Regulating and supervising certain types of banks as mandated by Congress

In carrying out these responsibilities, the Board has significant influence over the U.S. economy. Decisions made by the Governors impact employment, prices, access to credit, and more.

The Federal Open Market Committee: Steering Monetary Policy

The Federal Open Market Committee (FOMC) is responsible for directing open market operations and setting key interest rates. This makes the FOMC the most influential decision-making body for U.S. monetary policy.

The voting membership of the FOMC consists of the seven Governors, the president of the Federal Reserve Bank of New York, and four of the remaining 11 Reserve Bank presidents, who serve one-year terms on a rotating basis.

The FOMC meets eight times per year to assess the outlook for the economy and potential risks. Based on this assessment, the Committee sets the target range for the federal funds rate. This rate influences broader financial conditions and the pace of economic growth.

By adjusting short-term interest rates and directing open market operations, the FOMC steers monetary policy to promote price stability and maximum employment.

The Role of Regional Federal Reserve Banks

There are 12 regional Federal Reserve Banks located throughout the U.S. that carry out important functions, including:

Supervising and regulating banks
Operating payment systems
Distributing currency and coin
Conducting economic research

Each Reserve Bank has its own president and board of directors. While the Reserve Banks have some autonomy, they ultimately operate under the oversight of the Board of Governors.

The Reserve Banks serve as the operating arms of the central bank. They provide important insights on regional economic conditions, which contributes to policymaking at the national level.

Federal Reserve Authorities and Tools

The Federal Reserve utilizes various monetary policy tools to manage the money supply and oversee the stability of the banking system. These core authorities empower the Fed to conduct open market operations, set reserve requirements, provide emergency lending, and supervise financial institutions.

Monetary Policy Instruments: Managing the Money Supply

The Fed influences money supply and credit conditions through:

Open market operations - The buying and selling of securities, typically Treasury bonds, in the open market. This impacts the level of bank reserves and broader monetary conditions.
Reserve requirements - The amount of liquid assets banks must hold against deposits. Lowering requirements injects reserves and expands money supply.
Discount window - The Fed lending directly to banks within the Federal Reserve system. By adjusting the borrowing rate and terms, it impacts bank liquidity and broader credit conditions.

These tools give the Federal Reserve considerable power to stimulate or tighten monetary policy as economic conditions warrant.

Bank Supervision and Regulation: Ensuring Stability

The Fed has regulatory authority over bank holding companies and certain state-chartered banks. Key aspects include:

Safety and soundness exams - Regular examination of balance sheets, risk management, corporate governance, and internal controls.
Stress testing - Assessing bank capital levels against simulated economic crisis scenarios.
Enforcement actions - Addressing unsafe practices with measures like fines or operational restrictions.

Through regulation and supervision, the Fed aims to maintain the stability of the banking system.

The Federal Reserve as Lender of Last Resort

As lender of last resort, the Fed can provide credit to financial institutions during liquidity crises when private markets fail to do so. This emergency lending function includes:

Discount window - Direct lending to banks within the Federal Reserve system.
Emergency credit facilities - Providing loans to certain non-bank entities critical to financial market functioning.

This authority aims to contain financial panic and preserve stability when unstable conditions emerge. The Fed's role as lender of last resort is seen as a core mandate.

The Impact and Legacy of the Federal Reserve Act

Establishing Modern Central Banking in the United States

The Federal Reserve Act of 1913 established the Federal Reserve System as the central banking system of the United States. This marked a major shift towards having a coordinated, centralized approach to managing the nation's monetary policy and financial system.

Prior to the Federal Reserve, the US lacked a unified central bank and instead had a fragmented system of national and state-chartered banks. The Fed Act brought much-needed structure by consolidating authority over monetary policy into the Federal Reserve System, comprised of 12 regional Federal Reserve Banks overseen by the Federal Reserve Board in Washington, D.C.

This centralization of authority enabled greater oversight and control over the money supply, lending capabilities, and the overall stability of the banking system. The Fed could now conduct open market operations, adjust reserve requirements, and act as a lender of last resort in times of financial panic or crisis.

Expanding the Federal Reserve's Monetary Policy Capabilities

Over the past century, the Federal Reserve Act has been amended to provide the central bank with an increasingly robust set of monetary policy tools.

For example, the Banking Act of 1935 gave the Fed greater control over reserve requirements and expanded the eligible collateral for borrowing from the Fed. The Federal Reserve-Treasury Department Accord of 1951 affirmed the Fed's independence in setting monetary policy. And amendments in the 1980s and 1990s enabled the Fed to more precisely target the federal funds rate.

Equipped with this arsenal of capabilities, the Federal Reserve can now conduct monetary policy operations aimed at maximum employment, stable prices, and moderate long-term interest rates as mandated by Congress. The Fed has a powerful mix of tools to influence money supply, credit conditions, and liquidity as needed to meet its dual mandate.

Strengthening Financial System Resiliency Through the Federal Reserve Act

A key intention of the Federal Reserve Act was providing stability to the banking system during periods of financial stress. By serving as the lender of last resort, the Fed can extend credit to solvent institutions facing liquidity problems.

This backstop has been activated during pivotal 20th century crises - from the Great Depression to the Global Financial Crisis of 2008. While painful, the crises highlighted how the Fed's emergency lending powers granted by the Federal Reserve Act help mitigate domino effects of bank failures impacting households and businesses.

The lender of last resort role has become an integral defense mechanism protecting the resilience and continuity of the US financial system through times of turbulence. And it remains an essential responsibility of the Federal Reserve to this day, over a century since the Fed Act established this safeguard.

The Federal Reserve Act and Its Effects on the Economy

The Federal Reserve Act of 1913 established the Federal Reserve System as the central banking system of the United States. The Act has had significant effects on monetary policy and the broader US economy over the past century.

The Federal Reserve Act Effect on Monetary Stability

The Federal Reserve Act helped promote greater monetary stability by creating the Federal Reserve System to oversee monetary policy. Key ways the Act impacted monetary stability include:

Establishing the Federal Reserve as the central bank to regulate money supply and credit. This gave the US a more elastic currency that could expand and contract as needed.
Creating 12 regional Federal Reserve Banks to decentralize banking reserves and resources. This improved liquidity management nationwide.
Providing tools like reserve requirements, the discount rate, and open market operations to manage money supply. This enabled responding to economic conditions.
Making the Fed the "lender of last resort" to supply liquidity during panics. This helped mitigate banking crises.

The Act brought much-needed oversight and coordination of monetary policy to promote stability after prior bank panics.

The Federal Reserve Act and Its Role in Economic Crises

The Fed's powers granted by the Federal Reserve Act equipped it to respond aggressively during major economic crises, including:

Great Depression

Lowered reserve requirements to release more capital into the banking system.
Conducted open market purchases on an unprecedented scale to provide liquidity.

2007-2009 Financial Crisis

Dropped federal funds rate to near zero to encourage lending.
Established emergency lending facilities to supply capital to financial institutions.
Engaged in quantitative easing through large-scale asset purchases.

While debate exists over the Fed's crisis responses, the Act gave it tools to take action. However, the Fed failed to prevent either crisis in the first place.

Assessing the Success of the Federal Reserve Act

The Federal Reserve Act has succeeded in:

Modernizing the US banking system from its fragmented 19th century form.
Providing coordination of monetary policy across US regions and economic sectors.
Equipping the Fed with an array of monetary policy tools to promote its dual mandate of maximum employment and stable prices.

However, the Act has also faced criticism for:

Failing to prevent major financial panics and economic recessions.
Allowing the oversupply of money leading to high inflation at times.
Lacking sufficient transparency and oversight in some Fed actions.

Overall the Act achieved major structural reforms, though ongoing debates question the Fed's performance of its mandated duties granted by the legislation.

Criticism and Opposition to the Federal Reserve Act

Historical Opposition to the Federal Reserve Act

The Federal Reserve Act faced significant opposition in its early days. Key figures like William Jennings Bryan, a progressive leader and three-time Democratic presidential nominee, were vocal critics. Bryan believed a central bank would put too much control over the nation's finances in the hands of private bankers rather than the public.

Other progressives also pushed back against the idea of a central bank, fearing it would favor Wall Street interests over average Americans. The debate highlighted a divide between those supporting more government oversight of the banking system versus those wanting less regulation.

Modern Critiques of the Federal Reserve System

In more recent decades, the Fed has continued to draw criticism from various camps. Some argue the Fed lacks sufficient transparency and accountability in its operations. The Fed's role in responding to the 2007-2008 financial crisis also sparked debates about its effectiveness as a lender of last resort.

The Fed's political independence has also come under scrutiny. Critics claim the Fed wields too much power over interest rates and the money supply without needing approval from the President or Congress. However, Fed advocates argue independence helps isolate key monetary policy decisions from partisan politics.

The Debate Over Federal Reserve Independence

The topic of the Fed's independence has been widely discussed by economists and policymakers. Complete autonomy allows the Fed to adjust interest rates and take unpopular steps to ensure price stability and maximum employment without political pressure.

However, critics counter that major Fed decisions impacting the economy should require some democratic checks and balances. Some argue the Fed serves private banker interests more than the public. Others want more Congressional oversight of Fed appointments and operations.

There are good-faith arguments on both sides. Ultimately, maintaining the Fed's credibility while ensuring appropriate transparency and accountability around monetary policy decisions remains an ongoing challenge.