How the Federal Reserve Was Formed

The Federal Reserve is widely considered to be one of the most important financial institutions in the world. The Fed can either be a benign help or a cantankerous challenge, and its style is usually a function of the Federal Reserve's board of governors. Its monetary policy decisions can send waves through not only the U.S. markets, but also the world.

In this article, we will look at the formation of the Federal Reserve and follow its history as it riles the market and then turns it around and sends it to new highs.

America Before the Federal Reserve

The United States was considerably more unstable financially before the creation of the Federal Reserve. Panics, seasonal cash crunches, and a high rate of bank failures made the U.S. economy a riskier place for international and domestic investors to place their capital. The lack of dependable credit stunted growth in many sectors, including agriculture and industry. Americans early on, however, also did not want a central bank. They saw this as a model based on the Royal Crown and its 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.

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. After the war, the Fed was able to erase some of the bad memories from the depression by keeping interest rates low as the U.S. economy went on a bull run that was virtually uninterrupted until the 1960s.

Inflation or Unemployment?

Stagflation and inflation hit the U.S. in the 1970s, slapping the economy across the face but hurting the public far more than business. The Nixon administration ended the nation's on and off again affair with the gold standard, making the Fed that much more important in controlling the value of the U.S. dollar. The big question for the Fed was whether the nation was better off with inflation or unemployment.

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.

The Greenspan Years

Alan Greenspan took over the Federal Reserve two months before the infamous crash of 1987. When we think of crashes, many people consider the crash of 1987 more of a glitch than a true crash—a non-event nearer to a panic. This is true only because of the actions of Alan Greenspan and the Federal Reserve. Much like J.P. Morgan in 1907, Alan Greenspan collected all the necessary leaders and kept the economy afloat.

Through the Fed, however, Greenspan used the additional weapon of low interest rates to carry business through the crisis. This marked the first time that the Fed had operated as its creators first envisioned 80 years before.

Bernanke vs. the Great Recession

Much like Greenspan taking the helm right before a significant crash, Ben Bernanke stepped into the role of Fed chair in 2006, near the onset of a Global Financial Crisis and the Great Recession. Under Bernanke's leadership, the Fed tackled the crisis with a policy of quantitative easing (QE), buying mortgage-backed securities, government bonds, and other assets to stimulate the economy.

In addition to his role in helping navigate the Great Recession, Bernanke began holding press conferences to clarify the Fed's policy decisions and provided forecasts for short-term interest rates. The implementation of these policies during Bernanke's tenure, which lasted until 2014, helped improve the transparency of the central bank.

Yellen Oversees Period of Growth

Janet Yellen took over as chair in 2014, becoming the first woman in the history of the Federal Reserve to hold the top position. During her time as chair, the economy experienced strong growth in jobs and wages, benefiting from low interest rates. Yellen also supervised the Fed's sale of mortgage-backed securities and Treasuries that it had purchased to ease the Global Financial Crisis.

Powell Faces Pandemic and Inflation

Jerome Powell took the reins as chairman of the Federal Reserve Board in 2018. Powell began his tenure by reducing the Fed's balance sheet and increasing interest rates. These moves to tighten monetary policy drew criticism from President Trump, who had nominated Powell to the position, because of their potential to limit economic growth. Amid this political wrangling, questions surrounding central bank independence came to the forefront.

When the coronavirus pandemic sent shockwaves through the global economy in the beginning of 2020, Powell guided the Fed's strong response, which included purchasing corporate debt and offering loans to small businesses. Then, as the economy began to recover from the downturn induced by COVID-19, inflation rates skyrocketed, which required another forceful reaction from the Fed. Beginning in March 2022, Powell presided over 10 consecutive hikes in the federal funds rate aimed at tamping down the rate of price increases.

In the midst of the fight against inflation, turmoil struck the banking sector in March 2023, with the collapse of Silicon Valley Bank and Signature Bank. The aggressive interest rate hikes may have exacerbated issues at these financial institutions, contributing to declines in the value of fixed-income assets and inflicting damage on banks' balance sheets. It remains to be seen how Powell's Fed will navigate the new challenge of shoring up the banking system while continuing to reduce persistent inflation.

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.