The U.S. Federal Reserve: A stabilizing force

 

The U.S. Federal Reserve was initially established as a chaperone of sorts – one who could help the banking system get out of trouble after a series of financial panics that led to bank runs and defaults.

After a particularly disruptive panic in 1907, U.S. Congress decided the country needed a lender of last resort to provide liquidity and ensure a stable and reliable financial system.

“Financial stability concerns are very important in the United States and the Fed was set up to help stabilize interest rates, provide what they call an elastic currency,” said Angelo Melino, an economics professor with the University of Toronto.

Before the Fed became the U.S.’ central bank in 1913, the country had a network of individual banks, which didn’t have big enough reserves to stay afloat if customers panicked and pulled out their deposits. That meant those institutions were one big bank run away from going out of business.

Some banks would even find their customers making a run when they weren’t failing: Concern after a different bank’s failure was enough for people to take their savings home.

As a lender of last resort, the Fed would work to ensure banks stayed solvent by having enough reserves to handle a bank run, said Paul Shelestowsky, a senior wealth advisor with Meridian.

The Fed “mandated certain dollar percentages of reserve to ensure that if there was financial panic or run on the bank, (those reserves would) help protect the banks from going under,” he said.

New responsibilities

While the Fed’s main job hasn’t changed since inception, a lot of other responsibilities were eventually folded into its mandate.

In addition to acting as a lender of last resort, printing currency and working to stabilize the economy (by keeping inflation in check and ensuring maximum employment through interest rate adjustments), the Fed is now also in charge of regulating the banks and payment clearing, as well as consumer and fraud protection.

Regulation has become an increasingly important aspect of the Fed’s work since the 2008 financial crisis, most notably with the introduction of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010 aimed at protecting consumers from some of the credit and mortgage abuses that led to the downturn.

“That was this decade, so they’re still tweaking how the Fed operates to keep things stable,” Shelestowsky said.

Growing pains

Some aspects of the Fed’s evolution have been better received than others.

For instance, the central bank has worked to become more transparent, given how closely markets watch its decisions on rate changes.

“It used to be that the central banks worked very hard to keep things hidden; they were worried that the markets would be able to trade off of what the central bank wanted to do and they tried to hide their intentions and surprise markets and work behind the scenes,” said Melino.

“Now they’re very upfront about what they’re trying to achieve and what they think they need to do to achieve it.”

To Shelestowsky, however, that clarity isn’t always helpful.

“If everything that they’re saying is being predicted, then by the time the rate change actually happens it’s not as effective as it used to be, because it’s built-in,” he said.

There was also a lot of debate following the 2008 crisis about some of the tools the Fed used to manage the downturn, in particular its reliance on quantitative easing, a more aggressive approach to stimulating the economy that involves purchasing government securities, like U.S. Treasury Bills, while increasing the monetary base.

In 2019, concerns also arose about its ability to remain independent amid ongoing meddling by U.S. President Donald Trump, leading observers to question whether the Fed would be able to continue to do its job effectively and meet its objectives.

3 months ago