How the Federal Reserve Battles Recession

Historically, capitalistic societies have gone through boom and bust cycles on a regular basis. The economic good times are enjoyable for everyone involved, but sometimes the exuberance can lead to downturns which are often painful. The Federal Reserve was created to help moderate the effects of an economic contraction and was given some powerful tools to affect the money supply and keep the economy out of recession.

The establishment of a Central Bank went through many convolutions prior to becoming a non partisan guardian of monetary policy.   During the American Revolution, the Continental Congress printed the new nation's first paper money, known as "continentals”.  Later, at the urging of Treasury Secretary Alexander Hamilton, Congress established the First Bank of the United States, headquartered in Philadelphia, in 1791. By 1811, with a backlash toward the large banking establishment brewing, the bank's 20-year charter expired and Congress refused to renew it by one vote.

By 1816, Congress agreed to charter the Second Bank of the United

States, but Andrew Jackson, a central bank foe, was elected president in 1828 and

he was successful in allowing the charter to expire.  State-chartered banks and unchartered "free banks" took hold and began issuing their own notes, redeemable in gold. The New York Clearinghouse Association was established in 1853 to provide a way for the city's banks to exchange checks and settle accounts.

During the Civil War the National Banking Act of 1863 was passed, providing for nationally chartered banks, whose circulating notes had to be backed by U.S. government securities. Although the National Banking Act of 1863 established some measure of currency stability for the growing nation, bank runs and financial panics continued to plague the economy. In 1893 a banking panic triggered the worst depression the United States had ever seen, and the economy stabilized only after the intervention of financial mogul J.P. Morgan.

In 1907 a bout of speculation on Wall Street ended in failure, triggering a particularly severe banking panic. The Aldrich-Vreeland Act of 1908, passed as an immediate response to the panic of 1907, provided for emergency currency issues during crises. It also established the National Monetary Commission to search for a long-term solution to the nation's banking and financial problems. By December 23, 1913, when President Woodrow Wilson signed the Federal Reserve Act into law, it stood as a classic example of compromise -- a decentralized central bank that balanced the competing interests of private banks and populist sentiment.

Originally, the mandate of the Federal Reserve was not envisioned as an entity which would utilize an active monetary policy to stabilize the economy. The idea of using an economic stabilization policy only dates from the work of John Maynard Keynes in 1936. Instead, the founders viewed the Fed as a means of preventing the supplies of money and credit from drying up during economic contractions, as often happened prior to World War I.

The central bank’s function has changed since the days of the Great Depression, and the Fed now primarily manages the growth of bank reserves and money supply to help stabilize growth during expansions. In order to control the money supply, the Fed uses three main tools to change bank reserves.  These tools are a change in reserve requirements, a change in the either the discount rate or the federal funds rate, and the use of Open-market operations.

Changing the reserve ratio is a seldom used, but quite powerful tool at the Fed’s disposal. The reserve ratio is the percentage of reserves a bank is required to hold against deposits.  A decrease in the ratio will allow the bank to lend more, which will increase the supply of money. An increase in the ratio will have the opposite effect.

One of the principal ways in which the Fed provides insurance against financial panics is to act as the "lender of last resort", one of the tools used recently as the subprime mortgage debacle led to a credit crunch in the summer of 2007. When business prospects made commercial banks hesitant to extend credit, the Fed stepped in by lending money to the banks, thereby inducing banks to lend more money to their customers.  The Federal Reserve does this by lending at the discount window and changing the discount rate.

The federal funds rate is the interest rate that banks charge each other. The federal funds rate target is decided at Federal Open Market Committee (FOMC) meetings. Depending on their agenda and the economic conditions of the U.S., the FOMC members will either increase, decrease, or leave the rate unchanged. It is possible to infer the market expectations of the FOMC decisions at future meetings from the Chicago Board of Trade (CBOT) Fed Funds futures contracts, and these probabilities are widely reported in the financial media.

The Federal Reserve’s open-market operations consist of the buying and selling of government securities by the Fed. If the Fed buys back issued securities (such as Treasury bills) from large banks and securities dealers, it increases the money supply in the hands of the public. The Fed can decrease the supply of money when it sells a security.   The monetary expansion following an open-market operation involves adjustments by banks and the public. When the Fed buys securities from a member bank, the bank’s reserves increase, thereby encouraging it to lend .  When the bank makes an additional loan, the person receiving the loan gets a bank deposit.  These actions cause the money supply to increase by more than the amount of the open-market operation. This multiple expansion of the money supply is called the money multiplier.
 
Today, the Fed uses its tools to control the supply of money to help stabilize the economy. When the economy is slumping, the Fed increases the supply of money to spur growth. Conversely, when inflation is threatening, the Fed reduces the risk by shrinking the supply. While the Fed's mission of "lender of last resort" is still important, the Fed's role in managing the economy has expanded since its origin.  While the cyclical nature of the economy can't be denied, the actions of the Federal Reserve can soften economic downturns or exacerbate them.

John Kaighn is an Investment Advisor Representative with Jersey Benefits Advisors and writes articles about business and financial matters.  For more information, visit Jersey Benefits Group, Inc. or The Kaighn Report