A History of the Federal Reserve; Chapter 3: In the Beginning, 1913-21

The Federal Reserve Act passed on December 28, 1913. Almost a year later, in November 1914, Federal Reserve banks opened for business. The Act was a compromise that bundled together those who wanted a central bank, those who feared control of credit and money by bankers and "Wall Street", and those who wanted government control of money and credit. The compromise created 12 semi-autonomous banks and a supervisory board in Washington. From the beginning the compromise produced conflict over control that persisted until the 1930s. The initial conception was passive. The gold standard was expected to keep prices stable in the long-run. The real bills (commercial loan) theory ceded responsibility for deciding on the volume of borrowing to the banks. The discount rate was a penalty rate, set at a premium to the market rates. The intention, or hope, was that a bankers acceptance market would develop, like the market in London, so that the Federal Reserve could operate as the Bank of England did by buying acceptances. Wartime finance, postwar inflation and deflation ended this plan. The Federal Reserve helped to finance World War I by increasing the money stock and by lending to banks to enable them to profitably carry government bonds. For a year after the war, the System remained subservient to the Treasury. Then, faced with rising inflation, it contracted sharply. The recession of 1920-21 provides a test of alternative explanations of recovery. It is the only recession in which long-term interest rates are higher at the trough than at the preceding peak. Prices fell, so real interest rates rose above nominal rates. Falling prices raised the value of real balances, and gold inflows--attracted by real returns--increased the nominal and real money stock, increasing aggregate spending and bringing the recession to an end. The experience during inflation and deflation convinced the Federal Reserve that its conception was flawed. The gold inflow and rising gold reserve ratio signalled lower discount rates despite large portfolios of Treasury securities (non real bills) and at a time when the penalty discount rate had not been restored. The real bills doctrine called for a higher discount rate; the gold reserve rate signalled the opposite. Political considerations tipped the balance toward lower rates. Farmers and small merchants were highly critical of Federal Reserve policy, particularly the rise in interest rates and reliance on so-called progressive discount rates. To many in the south and west, the Federal Reserve had done what they feared most--raised interest rates to help Wall Street and bankers at the expense of farmers and merchants. This experience convinced the Federal Reserve that the original policy conception was flawed. The Bank of England policy arrangement could not be transplanted unchanged to the United States. This conclusion was based more on conjecture than on careful analysis, the conclusion itself as much political as economic. In addition, some within the system realized that the real bills doctrine provided no effective limitation to the total stocks of money and credit. One of these was Benjamin Strong, Governor of the New York Federal Reserve bank. Strong and others began work that became the effective operating procedure for the rest of the decade and beyond.