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Sunday, February 27, 2011

Federal Reserve System

Jay Mallin/Bloomberg News

Updated: Nov. 3, 2010

The Federal Reserve, through its power to raise and lower interest rates, has exercised more
influence over economic growth and the level of employment than any other government entity.
That unusual role dates from the 1970s, when the executive branch and Congress pulled back
from the use of fiscal tools -- vast New Deal-style spending and targeted tax cuts -- as the
primary means of regulating prosperity.
Instead, the Fed, as it is universally known, would pump up a sagging economy by using interest
rate cuts to in effect make money cheaper, or slow a boom down by ratcheting rates up -- a
process described by one Fed chairman as taking the punch bowl away just as the party's getting
going. That approach was credited with helping to moderate recessions.
But since the financial crisis began brewing in 2007, the Fed has been moving into uncharted
waters, aggressively intervening in deals to prop up or sell of failing institutions, making loans
available to banks in new ways and buying vast amounts of assets to help keep the global
economy afloat.
As the financial system moved to the brink of collapse in late 2008 and early 2009, the Fed
made up a whole new rule book, not only slashing interest rates virtually to zero, but pumping
well over a trillion dollars into the economy through purchases of securities and the creation of
new lending platforms. Most economists credit those actions, known as quantitative easing,
along with the stimulus bill and the federal bank bailout, with preventing a global depression.
But they also made the Fed the focus of unusual scrutiny and criticism, with critics pointing to
its failure to head off the real estate bubble and others denouncing what they saw as
unwarranted giveaways.
Despite that criticism, the Fed emerged as a big winner in the bill Congress passed in July 2010
to revamp the nation's financial regulatory system. Despite widespread agreement, even within

the Fed, that its regulatory record leading up to the 2008 credit crisis was poor, it was given
oversight of large financial institutions that are not banks, and a proposal to strip it of its
oversight of the nation's small banks was dropped. The bill also puts a new consumer protection
agency under its wing.
In the spring of 2010, Fed officials suggested that continued weakness in the labor market would
lead them to leave interest rates at very low levels for an extended period. But they also brought
to an end the single largest intervention to prop up the American economy, its $1.25 trillion
program to buy mortgage-backed securities.
But by the summer, a string of weak economic numbers altered the sentiment within the central
bank, leading Fed policy makers to stop worrying for the moment about the increasingly remote
prospect of inflation. Instead, they were increasingly focused on the potential for the economy to
slip into a deflationary spiral of declining demand, prices and wages and wondering whether to
make use again of their quantitative easing tools.
In late August 2010, Fed Chairman Ben S. Bernanke gave his strongest indication yet that he
was determined to prevent the economy from slipping into a cycle of falling prices. In
September, the Fed's policy making committee signaled or the first time that they were worried
that the slow-moving economic recovery could be undermined by very low rates of inflation, and
hinted strongly that it might resume buying vast amounts of government debt to spur the
recovery.
The Fed put off action during the runup to the Congressional elections. The day after the vote it
announced that it would buy $600 billion in government debt, calling the recovery
"disappointingly slow."
How the Federal Reserve Works
President Woodrow Wilson signed the Federal Reserve Act on Dec. 23, 1913, creating a sevenmember board of governors, including the Fed chairman, and 12 regional banks a structure
collectively known as the Federal Reserve System. The governors are appointed by the president
and approved by Congress; the regional bank presidents are selected by leaders of their
communities, particularly bankers.
Private banks controlled the flow of credit and thus interest rates in the late 19th and early 20th
centuries, and farmers, the backbone of the populist movement, complained that the big Eastern
banks often starved them of credit at critical moments. Populists called for direct access to
credit, without the banks as intermediaries. That did not happen.
The Federal Reserve System was a compromise. The banks would remain the lenders to the
public, but the Fed would control the supply of funds on which the banks depended to make
loans. Injecting more money into the banking system put downward pressure on interest rates,
while its opposite, restricting the supply of potential credit, pushed up rates. The regional banks
were intended to help make the flow of credit even across the country.
Through various refinements over the years, this open market operation, as it was called, has
been at the heart of the Feds power. The interest rate that results is called the federal funds rate.
In turn, the interest that banks and other lenders charge for mortgages and for various forms of
commercial and consumer credit fluctuate with the federal funds rate. As a supplement, to

assure an even flow of available credit, commercial banks in various parts of the country can
borrow directly from the Fed at the nearest regional bank, using the so-called discount window.
The discount rate is linked to the federal funds rate.
The federal funds rate is set by the Feds Open Market Committee, composed of the chairman,
the six other governors, and five of the 12 regional bank presidents, on a rotating basis. The
committee meets at Fed headquarters in Washington every six weeks or so.
The Feds chairman, currently Mr. Bernanke and before him Alan Greenspan and Paul A.
Volcker, dominates Open Market operations. Their main thrust has been to limit inflation, even
at the risk of a recession although they have cut rates when the nation seemed in danger of
one.
The Financial Crisis
With the American housing market on the verge of collapse, the Fed used its standard tool of
intervention. The central bank began an aggressive series of interest rate cuts beginning in
August 2007. The cuts were intended to counteract the tightening credit market and spur
growth. The Fed has since lowered interest rates to nearly zero. Analysts expect the central bank
to leave the target rate unchanged at the range of 0 to 0.25 percent.
When such cuts lose their impact, central banks turn to what economists call "quantitative
easing'' -- unorthodox methods of pumping money into an economy and working to lower
interest rates that central bankers do not usually control. Their effect is the same as printing
money in vast quantities, but without ever turning on the printing presses.
In November 2008, Mr. Bernanke, who has avoided the "quantitative easing'' term, outlined a
range of unorthodox new tools that the central bank can use to keep stimulating the economy
once the federal funds rate effectively reaches zero. Those techniques include buying vast
amounts of longer-term Treasury bonds, mortgage-backed securities issued by governmentsponsored companies like Fannie Mae and Freddie Mac and commercial debt issued by private
companies and consumer lenders.
The Federal Reserve introduced a slew of lending programs in its effort to revive corporate and
consumer lending. It had a hand in JPMorgan Chase's takeover of Bear Stearns, and the
government bailouts of Freddie Mac, Fannie Mae and American International Group.
Since September 2008, the Fed's balance sheet has ballooned from about $900 billion to more
than $2 trillion as the central bank has created new money and lent it out through all its new
programs. As soon as the Fed completes its plans to buy up mortgage-backed debt and
consumer debt, the balance sheet will be up to about $3 trillion.
More Power, More Controversy
Fed policy makers have traditionally made their decisions about interest rates behind closed
doors, communicating those decisions primarily through brief, cryptic statements that analysts
busily decode in the days that follow.
But that kind of distance has become impossible in the two years since the American economy
plunged into its worst financial crisis since the Great Depression. These days, Mr. Bernanke and

the Fed have been bailing out financial institutions, printing money in unheard-of volumes and
stepping in to fill the lending gap left by the crippled capital markets.
The Fed has never wielded as much power as it does right now, but the very expansion of its
mission has exposed it to more second-guessing and more challenges to its political
independence than ever before.
Republican lawmakers now portray the Fed as the embodiment of heavy-handed big
government, and have called for scaling back the central bank's regulatory powers. But liberal
Democrats have accused the Federal Reserve of caving in to demands by banks for huge
bailouts, for failing to protect consumers against dangerous financial products and for being too
secretive about its emergency rescue programs.
The ire at the central bank is sure to figure into the continuing debate over how to reform
financial regulations. The Obama administration has proposed consolidating regulatory powers
under the Fed, while some in Congress want to strip away its oversight authority.
Taking a step to normalize lending after holding interest rates to extraordinary lows for more
than a year to prop up the financial system, the Federal Reserve on Feb. 19, 2010, raised the
interest rate it charges on short-term loans to banks, to 0.75 percent from 0.50 percent.
The move was a clear sign to the markets, politicians in Washington and the country as a whole
that the era of extraordinarily cheap money necessitated by the crisis was drawing to a close.
On March 31, the Fed announced the end of its giant program of purchasing mortgage-backed
securities. The program was initially for $500 billion. The purchases began in January 2009,
and in March, the Fed raised the goal to $1.25 trillion. The purchases were to end by Dec. 31, but
in September, the Fed said the purchases would taper off more slowly, ending on March 31.
Reconsidering an Exit Strategy
Over the next few months, the Fed performed a turnabout. A series of newly worrying economic
indicators increased concern at the Fed about the pace of the recovery. Officials there shifted
from the more optimistic assessment of the spring that economic growth was sufficiently strong
to begin thinking about how to gradually return to normal monetary policy.
In June, the Open Market Committee downgraded its outlook and openly discussed the prospect
of deflation a declining spiral of demand, prices and wages but cautioned that it was only
likely to act if the situation took a serious turn for the worse. By August, the signs of a slowing
recovery were strong enough to lead the committee to announce that it would use use the
proceeds from its huge mortgage-bond portfolio to buy long-term Treasury securities, rather
than letting the bonds mature. The effect of the step would be to keep the Fed's giant balance
sheet from shrinking.
The measure fell short of the additional stimulus that some economists were hoping for, in the
form of new largescale asset purchases, the central bank left open the possibility that additional
easing of monetary policy could take place in the fall if the recovery were to continue to weaken.
The Fed bought $1.25 trillion in mortgage-backed securities, and another $200 billion in debts
owed by government-sponsored enterprises, primarily Fannie Mae and Freddie Mac, and

completed the purchases in March. The Fed had planned to allow the size of that portfolio to
shrink gradually over time as the debts matured or were prepaid. Instead, the Fed will reinvest
the principal payments in longer-term Treasury securities. The central bank said it would
continue to roll over its holdings of other Treasury securities as they mature.
By the fall the Fed's governors had reached a consensus that a new round of purchases was
needed to offset the drag on the economy caused by persistently high unemployment. Some
economists worried that big asset purchases would sow the seeds of new inflation; others
thought the $600 billion announced in November was not enough, or that pumping more
money into the system might have a limited effect when neither businesses or consumers were
in the mood for spending, no matter how available money becomes.