The Financial Panic of 1907 exposed a glaring weakness of the United States banking system. When the charter for the Second National Bank of the United States expired in 1837 there was no central bank to supervise the often excessive practices of individual banks. The next seventy years, known as the Free Banking Era, saw the country going through eighteen identifiable recessions. In 1907 the Knickerbocker Trust Company collapsed causing a severe monetary contraction. Without a central to step in to infuse funds into the economy, the salvation of the banking system came from J. Pierpont Morgan, an individual investor and founder of J. P. Morgan & Co. Finally, Congress recognized the absolute need to create a central banking authority to supervise banking activities throughout the country and, therefore, bringing to an end the Free Banking Era. In 1913 it enacted the Federal Reserve Act.
The Federal Reserve Act of 1913 did not stop at merely setting up a supervisory body, instead it granted special powers to engage in certain monetary practices to promote stability in the banking system and the economy. The granted powers consisted of the power to set the discount rate, the power to set bank reserve requirements and the power to participate in open market operations. The importance of participating in open market operations became apparent in the economic slowdown following World War I. Setting the discount rate and/or setting bank reserve requirements are effective monetary policy tools, however, there is an inherent time lag from the time the discount rate or reserve requirements are set to an observable change in the nation's money supply. As an alternative to the slow process of money 'creation', The Federal Reserve Bank decided to use the buying or selling of government securities in the open market as a means to pump immediate liquidity into the economy. Open market operations were exercised by several committees within the Federal Reserve Bank until the Banking Act of 1935 formally created the Federal Open Market Committee (FOMC) as a separate legal entity.
A mild recession occurred in 1945 as war time government spending subsided. Congress reacted to the slowdown and passed the Employment Act of 1946 to encourage the federal government, in cooperation with the private sector, to pursue policies of maximum employment, production and purchasing power. The Act fell short of specificity but continued to be the guide for monetary policy until high inflation and high unemployment began to creep into the economy in the 1970's. In 1978 Congress moved to correct the short comings of the 1946 Act by enacting the Full Employment and Balanced Growth Act (known as the Hawkins-Humphrey Act). The Act added robust new economic policy goals and the means by which to accomplish those goals. The Act drew heavily on Keynesian economic theory to accomplish the goals of full employment, growth in production, price stability and balance of trade. It also mandated the Federal Reserve Bank to develop a sound monetary policy by managing the amount and liquidity of the nation's money supply. The mandate reinforced the role of the FOMC.
Determination of the condition of the economy begins with data from the market participants…buyers, sellers, intermediaries, etc. That data, in the form of economic releases that we are all familiar with, is fed to a large core of economists in the Federal Reserve Bank where it is massaged, analyzed and reported to the policy makers in the FOMC. The twelve members of the committee (consisting of seven members from the Board of Governors, the president of the New York Federal Reserve Bank (a permanent seat on the committee) and four Reserve Bank presidents who serve on a rotating basis) meet eight times a year or as needed in the event of an emergency as occurred during the 2008-2009 financial meltdown. The deliberations result in an adoption of a monetary policy that will be transmitted to the appropriate functionaries within the Federal Reserve System for execution.
It is important to note that the transmission of monetary policy is not a static event that makes the financial headlines from time to time. Rather it is a constant and continuous activity to accommodate the need for liquidity in the normal operation of various sectors of the economy. For example, seasonal economic activities such as farming and retailing require large amounts of cash during the heights of their respective seasons. It is a function of the FOMC to meet those seasonal demands, and make other fine turning adjustments, by adding reserves to the banking system. Each week the Federal Reserve Bank releases an extensive report showing itemizing the factors affecting the reserve balances of depository institutions. The report is a snapshot of the current week, the prior week and a comparable year ago week. It includes U.S. Treasury securities, Federal Agency debt securities, and Mortgage-backed securities among other items. A reader interested in details can find the report by going to the Federal Reserve Bank website under the Statistical Release section.
Whether the FOMC goal is an ongoing routine adjustment to reserve balances or a reaction to a major
Money supply expansion is not always the goal of FOMC's policies. One only has to look back to 1980 when inflation had soared to just under 15 percent. Through an aggressive program of Treasury security sales, the then Chairman of the Federal Reserve Bank, Paul Volcker, pushed the 1981 federal funds rate to an eye-popping 20 percent. The process shown in the above chart was reversed. The Open Market Desk started a program of selling Treasury securities. Banks and other prospective buyers were more than happy to add high yielding government securities to their portfolios. The sales drained excess reserves from the banking system and effectively cut the oxygen supply to the runaway inflation that had built up during the '70's.
In 2007, one hundred years after the Financial Panic of 1907, the FOMC faced a new challenge…a devastating financial meltdown that threatened international financial security. The FOMB, in concert with the Secretary of the Treasury and Congress, reacted quickly to inject liquidity into the economy to stem the tide of rapidly failing financial institutions. The open market operations drove the federal funds rate from a peak of five and a quarter percent in late 2007 to near zero by the end of 2008. In the meantime, the economy fell into a deep recession that some considered to be as severe as the Great Recession of the 1930's. Despite near zero federal funds rates, the economy, and lending in particular, continued to stall and the FOMC drew upon the Japanese experience of earlier in the decade…quantitative easing …to inject additional liquidity into the economy. The sale of longer term treasury securities and mortgage backed securities constituted the bulk of the quantitative easing. Quantitative easing has helped the economy come out of its doldrums but has not yet resulted in a full bodied expansion.
It took the country one hundred years to get from one major crisis to another one. In retrospect, we are able to look at the 1907 crisis and the tools used to resolve the problem. Only time will tell if the FOMC met the current crisis with the right tools.