Overview: The History of the Federal Reserve
1913 to today
David C. Wheelock, Federal Reserve Bank of St. Louis
The Federal Reserve System (“Fed”) is the central bank of the United States. This website serves as a gateway to the history of the Federal Reserve for educators, students, and the general public. The Fed has a complex structure and mission. The purpose of this site is to help demystify the Fed and its role in the economy, and to explain how the Fed and its mission have evolved over its more than 100-year history. The site is organized around eight time periods in the Fed’s history, with essays devoted to key events, policy actions, legislation, and the everyday work of Fed employees during each period. It also includes short biographies of Federal Reserve Board members and Reserve Bank presidents.
How It All Began
Founded by an act of Congress in 1913, the Federal Reserve System was established with several goals in mind. Perhaps most important was to make the American banking system more stable. Banking panics—events characterized by widespread bank runs and payments suspensions and, to a degree, outright bank failures—had occurred often throughout the 19th century. Such panics were widely blamed on the nation’s “inelastic currency.”
The national banking acts of the 1860s created an environment in which most of the nation’s currency consisted of notes issued by national banks (commercial banks with charters issued by the federal government) comprised most of the nation’s currency. The volume of notes that a national bank could issue was tied to the amount of U.S. government bonds the bank held. The supply of notes was largely unresponsive to changes in demand, especially when an unforeseen event or news caused bank customers to worry about the safety of their deposits and “run” to their banks to withdraw cash.
Reformers focused on ways to expand the supply of notes rapidly to meet the public’s demand for liquidity. The desire for an “elastic” currency was ultimately realized by the creation of the Federal Reserve and a new currency form—the Federal Reserve note. Federal Reserve notes are the predominant form of U.S. currency today and supplied in amounts needed to meet demand.
More broadly, the Federal Reserve System was established to improve the flow of money and credit throughout the United States in an effort to ensure that banks had the resources to meet the needs of their customers in all parts of the country.
Before the Fed
Although the problems with the U.S. banking system were widely recognized and studied throughout the 19th century, reforming the system was difficult because of competing interests and goals. The first of eight period essays on this website, “Before the Fed: The Historical Precedents of the Federal Reserve System,” delves into the evolution of the American banking system and efforts to manage the nation’s money supply before the Fed’s founding. The essay shows that the federal system of American government, which had its roots in the nation’s earliest history, shaped the American banking system. Before the Civil War, most banks were chartered by states. Notable, and controversial, exceptions were two banks chartered by the federal government. Shifts in the balance of power between politicians who favored a strong federal government, such as Alexander Hamilton, and those who tended to support states’ rights and limited federal power, such as Thomas Jefferson and Andrew Jackson, led first to the establishment and then demise of the two U.S. banks (both named Bank of the United States) in the early 19th century. As the essay describes, Jackson’s “war” with the second Bank of the United States eliminated a bank that performed some functions of a modern central bank.
In the mid-nineteenth century, the United States still had no central banking authority and dissatisfaction with the banking system had not improved. The nation’s next attempt at banking stabilization involved laws enacted during and shortly after the Civil War. These “National Banking” acts created a new federal banking charter. Banks chartered under these acts were much different than the two pre-Civil War national banks. Unlike the early banks, the new national banks were entirely privately owned and operated, restricted to a single office location, and subject to the supervision and regulation of the Office of the Comptroller of the Currency (a division of the U.S. Treasury established by the Banking Act of 1863 to issue charters to and supervise national banks).
One important feature of the post-Civil War banking landscape was the almost total absence of branch banking. Banks chartered by state governments were never permitted to branch into other states, which put them at a disadvantage relative to the two pre-Civil War U.S. banks which had extensive multi-state branching networks. Antipathy toward the U.S. banks and to large banks in general resulted in strong prohibitions on branching in federal banking law and in the laws of most states. Consequently, the U.S. banking system was characterized by thousands of small, one-office (or “unit”) banks scattered throughout the country. Unit banking contributed to instability by making it harder for banks to reach an efficient size or diversify their loan portfolios. The inherently fragile unit banking structure coupled with an inelastic currency was a recipe for a crisis prone system. Finding a political solution was difficult, however, because it pitted the interests of large city banks against those of banks in smaller cities and rural areas. It also stirred old conflicts over states’ rights and the power of the federal government to regulate the banking system. As the essay describes, a political solution was eventually found after the Panic of 1907, when in December 1913 Congress passed and President Woodrow Wilson signed the Federal Reserve Act.
The Early Years
The Federal Reserve Act attempted to deal with the “inelastic currency” problem by creating an entirely new currency—the Federal Reserve note—and a mechanism to get those notes quickly into circulation. The Act established a system of Reserve Banks with capital provided by the member commercial banks in their designated territories. National banks were required to purchase capital in their local Reserve Bank and thereby become members of the System with access to loans and other services provided by the Reserve Bank. Membership in the System was made optional for state-chartered banks. Although the Reserve Banks are technically private corporations with their own boards of directors, they are overseen by a board (today, the Board of Governors of the Federal Reserve System) comprised of government appointees, and the shareholder rights of the System’s member banks are limited and tightly regulated.
The Discount Window
The Federal Reserve Act required the Fed’s member banks to hold reserves in the form of Federal Reserve notes or deposit accounts with their local Reserve Bank. A member bank could obtain additional currency or reserve deposits by borrowing at the “Discount Window” of its Reserve Bank.1 A bank that wished to obtain funds in this way would provide some of its short-term commercial or agricultural loans as collateral for the loan. The Fed’s discount window was thus a mechanism for transforming illiquid bank loans quickly into cash and thus providing the nation’s money supply with the desired “elasticity.” An important function of central banks is to serve as lender of last resort to the banking system, and discount window lending has traditionally been a key part of how the Fed has performed that role.
The essay “The Fed’s Formative Years” describes in more detail the establishment of the discount window and other Federal Reserve operations in the Fed’s first years. The essay also discusses how cities were chosen for the locations of Reserve Banks and how Federal Reserve district boundaries were drawn. The Fed was just a few years old when the United States entered World War I, and the essay describes the Fed’s role in helping to finance the war effort as well as the effects of the war on the Fed and its policies.
The Payments System
The founding of the Fed had profound effects on the U.S. payments system, not only by creating a new currency, but also by making the processing of payments more efficient and rapid. The Reserve Banks provided check clearing services for their member banks, for example, which reduced the time and cost for banks of obtaining funds for checks that were deposited in their banks. An early innovation was the development of an electronic system for making long-distance payments using the telegraph which later became known as Fedwire.2
The Fed’s early years also saw the beginnings of monetary policy in the modern sense of the term. The Federal Reserve Act did not mention monetary policy. It also did not provide criteria for setting Reserve Bank discount rates. It did, however, require the Reserve Banks to maintain gold reserves equal to specific percentages of their outstanding note and deposit liabilities. Implicitly, this requirement was intended to limit the amount of currency and loans the Fed could issue and thus serve as a brake on inflation. Most of the Act concerned the Fed’s lending and other operations, however, and did not specify broad macroeconomic goals, such as price stability or maximum employment. Those goals—the so-called “dual mandate”—were not written into the Federal Reserve Act until the 1970s.
In the 1920s, the Fed began to adjust its discount rate and buy and sell U.S. government securities to achieve macroeconomic objectives. The Federal Reserve Act permitted the Reserve Banks to buy (and sell) U.S. government securities, mainly so the Banks would have interest income to cover their expenses. As the “Formative Years” essay describes, the Reserve Banks discovered that their purchases influenced short-term interest rates and credit conditions. Purchases of securities tended to lower rates and make credit more widely available while sales had the opposite effects. The Fed purchased securities in 1924 and 1927 when the economy slipped into recessions. By easing U.S. credit conditions, the purchases also helped in restoring the international gold standard which had been disrupted by World War I. In 1928, the Fed sold securities as policymakers sought tighter credit conditions to discourage stock market speculation. The Fed’s apparent success with adjusting the levers of monetary policy in the 1920s seemed to suggest that the new central bank could tame the business cycle and preserve price stability. However, it all went terribly wrong in the 1930s when the U.S. had the worst economic depression in its history.
The Great Depression
The bottom dropped out of the U.S. economy in the 1930s. Economic activity peaked in the summer of 1929 and began to fall precipitously after the stock market crashed in October. Total output of goods and services (GDP) fell by some 30 percent, prices fell sharply, and the unemployment rate soared to 25 percent by 1933. As the essay “The Great Depression” explains, many economists blame the depression on the Fed—specifically on the Fed’s limited response to banking panics and their disrupting effects on the economy. Economists and historians continue to debate why the Fed failed to prevent the Great Depression after apparently successfully steering the economy out of trouble during the 1920s.
Not surprisingly, the Great Depression brought many changes to the Fed. Various pieces of legislation altered the Fed’s structure, gave it some new powers but took away others, and fundamentally reshaped the structure and regulation of the American financial system. The Banking Acts of 1933 and 1935 shifted the balance of power within the Federal Reserve away from the 12 Reserve Banks to the Federal Reserve Board, which was renamed and reconstituted as the Board of Governors of the Federal Reserve System. The Board was given new authority over the setting of Reserve Bank discount rates and a majority of seats on the Fed’s open-market committee (the FOMC). Overall, however, the Fed’s power was reduced relative to the U.S. President and Treasury. Shortly after entering office, Congress gave President Franklin Roosevelt authority to revalue the dollar in terms of gold and to regulate the gold standard. The establishment of the Exchange Stabilization Fund, financed by a revaluation of gold transferred from the Fed to the Treasury, gave the Treasury a large pool of funds that it could use to manage the dollar. By the mid-1930s, the Treasury effectively had as much or more power than the Fed to determine the nation’s monetary policy.
The Great Depression also brought significant changes to the U.S. banking system and the establishment of several new government agencies focused on the financial system. For example, a federal deposit insurance system was introduced and operated by the Federal Deposit Insurance Corporation. The FDIC was given supervisory authority over all insured state-chartered banks that did not belong to the Federal Reserve System. The Fed retained its authority to supervise state member banks, while the Office of the Comptroller of the Currency continued to supervise national banks.
World War II and Beyond
The U.S. economy was still recovering from the Great Depression when the United States entered World War II in December 1941. Interest rates were already at low levels when the Fed agreed to prevent them from rising during the war. As the essay “From WWII to the Treasury-Fed Accord” explains, the Fed kept the yield on long-term U.S. government bonds from rising above 2.5 percent and pegged those on short-term term Treasury securities at lower levels throughout the war, thereby ensuring that the Treasury could borrow at low rates to finance the war effort. As it did during World War I, the Fed actively supported the war effort by promoting war bond sales to the public.
Large government deficits and the Fed’s policy of preventing the yields on government securities from rising caused the nation’s money supply to increase sharply. Wartime spending and armed forces mobilization brought full employment and rising household incomes which alongside highly expansionary fiscal and monetary policies put upward pressure on prices. To keep inflation in check, controls were put on wages and prices as well as on the growth of private credit. Wage and price controls were removed in summer of 1946, unleashing the suppressed inflation. As the essay describes, this triggered a debate between Fed and Treasury officials over whether to allow the yields on U.S. Treasury securities to rise. Fed officials pressed for higher interest rates to contain inflation, but the Treasury argued for holding the line on rates to keep down the government’s borrowing costs. Although Treasury officials eventually acquiesced to a small increase in short-term rates, they insisted that the yield on long-term government bonds not be allowed to rise above 2.5 percent. Ultimately, however, the situation became untenable. Inflation began to rise rapidly in 1950 as the Fed’s efforts to keep interest rates from rising pumped more money into the economy. The Fed and Treasury ultimately reached an agreement in March 1951, known as the Accord, which ended interest rate controls and freed the Fed to use its monetary tools to control inflation.
After the Treasury-Fed Accord
The Accord enabled the Fed to use monetary policy to achieve macroeconomic goals. As the essay “From the Treasury-Fed Accord to the Mid-1960s” explains, the Fed pulled back from broad support of the Treasury market and usually conducted its open-market operations in short-term Treasury bills. However, the Fed continued to assist the Treasury by agreeing to limit interest rate moves when the Treasury was issuing new debt and to intervene if needed to prevent Treasury auctions from failing.
The Accord also brought a change in leadership to the Fed. President Harry Truman nominated William McChesney Martin, Jr., to chair the Fed’s Board of Governors. Martin had negotiated the Accord for the Treasury Department and went on to be the Fed’s longest-serving chair, serving until 1970. Federal Reserve monetary policy evolved considerably under Martin’s tenure. The essay describes how the Fed’s policy goals changed over time under the influence of new economic thinking and pressure from the President and Congress. Whereas the Eisenhower administration had supported the Fed’s focus on price stability and mostly ignored the Fed, the Kennedy and, especially, Johnson administrations pressured the Fed to support faster economic growth and low interest rates. Martin, famous for his statements that the Fed’s job is to remove the punch bowl “just when the party [is] really warming up,”3 resisted political pressure but ultimately was unable to prevent inflation from increasing.
The Great Inflation
After an extended period of low and relatively stable inflation from the early 1950s through the mid-1960s, U.S. inflation began to rise and was unusually high and volatile from the late-1960s through the 1970s. As the essay, “The Great Inflation,” explains, by the 1960s many economists and policymakers had come to believe in the existence of a reliable and exploitable tradeoff between unemployment and inflation, known as the Phillips Curve. By accepting somewhat higher inflation, it seemed possible to drive the unemployment rate down significantly and, perhaps, permanently. Although many saw monetary policy as less effective than fiscal policy at taming the business cycle and stimulating growth, the Fed was encouraged to keep interest rates low to help promote full employment and hold down the government’s borrowing cost. To keep interest rates from rising the Fed pumped more and more money into the economy, and higher inflation was the result.
By the early 1970s, policymakers sought ways to contain inflation without tightening monetary policy and causing a recession. Fed chair Arthur Burns, who replace Martin in 1970, worked out an apparent solution with the Nixon Administration in the form of wage and price controls. Temporary controls on prices, it was thought, could squash inflation without having to raise interest rates or slow the growth of the money supply. Burns supported the move and agreed to chair a committee charged with encouraging voluntary restraints on interest rates and dividends.
Unfortunately, wage and price controls proved ineffective at controlling inflation for very long. As the essay explains, at the time, Burns and others publicly blamed inflation on a variety of causes, including government budget deficits, pricing power of firms and labor unions, and sharply rising prices of oil and other commodities. Economists also overestimated the economy’s potential growth rate, which led them to believe that an easier monetary policy could spur economic activity without generating higher inflation.
Burns was succeeded as Fed chair in 1978 by G. William Miller. Miller served as Fed chair for just a year when President Jimmy Carter named him Treasury Secretary and nominated Paul Volker, then President of the Federal Reserve Bank of New York, to be Fed chair. Volcker had previously been employed as a Fed economist and an official in the Treasury Department, as well as in the private sector. Soon after his appointment to the Board, Volcker convinced the FOMC to adopt new operating procedures to enhance control of the money supply and bring inflation under control. Under Volcker’s leadership, the Fed accepted responsibility for controlling inflation and persevered in its efforts to bring inflation down despite a significant “double-dip” recession in 1980-82.
The poor performance of the U.S. economy in the 1970s and early 1980s led to several pieces of legislation with a bearing on the Fed. Among them were:
- The Federal Reserve Reform Act of 1977, which requires the Fed to direct its policies toward achieving maximum employment and price stability and report regularly to Congress. The act also required Senate confirmation for the chair and vice chair of the Board of Governors while limiting their terms to four years.
- The Community Reinvestment Act of 1977, which requires the Fed and other bank regulators to evaluate banks on their performance in meeting the credit needs of low- and moderate-income communities in the markets they serve.
- The Full Employment and Balanced Growth Act of 1978, which amended the Employment Act of 1946 and makes more explicit the Fed’s “dual mandate” to support maximum sustainable employment and price stability.
- The Depository Institutions Deregulation and Monetary Control Act of 1980 which, among other things, granted access to Federal Reserve loans and payments services to banks and other depository institutions that are not members of the Federal Reserve System, and requires that the Fed charge fees for the services it provides. Further, the act sought to give the Fed greater control over the growth of the nation’s money supply by subjecting all banks to reserve requirements set by the Fed.
The Great Moderation
The Great Inflation was followed by a period of about 20 years commonly referred to as the Great Moderation. Compared with the Great Inflation era, inflation was low and stable, and fluctuations in economic activity were modest. The essay, “The Great Moderation,” explores possible reasons why the performance of the economy was so good during this period. It notes that “reducing inflation and establishing basic price stability laid the foundation for the Great Moderation.” The essay also points to structural changes in the economy and the absence of large shocks during the period. The Fed also began to communicate more information to the public about its monetary policy actions and approach. Since February 1994, the FOMC has issued a statement at the conclusion of each of its meetings followed by the release of meeting minutes a few weeks later. In 2007, the Committee began to release a quarterly summary of economic projections by FOMC members, and since 2011 the chair has regularly held press conferences following FOMC meetings to provide information about the deliberations and decisions made at the meeting. As the essay explains, greater transparency and communication might make policy more effective and perhaps contributed to economic stability during the Great Moderation period.
Significant legislation affecting the Fed and financial system during the Great Moderation era included:
- The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). Enacted in response to a large number of bank and savings institution failures in the 1980s, FDICIA aims to protect the federal deposit insurance system by requiring the Fed and other bank regulators to take “prompt corrective action” when banks become financially weak, and to resolve bank failures at the lowest cost to the insurance fund. The act also limits the Fed’s lending to troubled banks.
- The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which permits banks and bank holding companies to operate branches across state lines.
- The Gramm-Leach-Bliley Financial Services Modernization Act of 1999, which repealed large parts of the Glass-Steagall Act of 1933 (a section of the Banking Act of 1933 that prohibited the commingling of commercial and investment banks). Among other provisions, the act created the financial holding company charter with the Fed as the primary regulator of financial holding companies.
- The Check Clearing for the 21st Century Act of 2003 (Check 21), which permits electronic collection of most checks and makes paper copies of the front and back of a check legally the same as the original check. The act eliminated the need to physically transport checks between banks and thereby increased the speed and efficiency of check collection. The Fed subsequently consolidated its check processing operations and sharply reduced employment and resources devoted to check processing in Reserve Bank offices.
The Great Financial Crisis, Recession, and Aftermath
The Great Moderation ended, or perhaps was interrupted, when a major financial crisis triggered a serious recession. The essay, “The Great Recession and Its Aftermath,” explains that the financial crisis of 2007-08 began when firms and investors started to experience losses on home mortgage-related financial assets. As the crisis spread, several large firms experienced severe financial distress and turbulence rocked many financial markets.
The Fed took several actions to fight the crisis and lessen its impact on the broader economy. First it eased terms on discount window loans and created new programs to encourage banks to borrow funds to meet their own liquidity needs and those of their customers. Next the Fed used authorities under Section 13(3) of the Federal Reserve Act to create several programs intended to provide liquidity to specific financial markets and firms. Finally, the FOMC cut its target for the federal funds rate effectively to zero and then began a series of large scale purchases of U.S. Treasury and mortgage-backed securities (widely referred to a “quantitative easing” or QE) to stimulate economic activity. Despite the efforts of the Fed and Congress, the recession of 2007-09 was severe: Gross domestic product (GDP) fell by 4.5 percent and the unemployment rate doubled from under 5 percent to 10 percent. The recovery from the recession, especially the recovery of employment, was also slow. To support the recovery, the FOMC maintained a highly accommodative monetary policy, keeping its federal funds rate target at zero until December 2015.
As with previous crises, Congress responded to the Great Financial Crisis with sweeping financial legislation. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 called for tougher capital, risk management and other rules for bank holding companies and other firms whose failure could threaten the stability of the U.S. financial system, and gave the Fed more authority to scrutinize the activities of nonbank companies. In addition, the act established a Financial Stability Oversight Council, of which the Fed chair is a member, to monitor the financial system and identify financial firms that pose systemic risk. The act also established the Consumer Financial Protection Bureau, and it clipped the Fed’s ability to lend to nonbank firms in financial emergencies by requiring that all such lending be in programs that are broadly available to many borrowers, not just a single firm.
The COVID-19 Crisis and the Fed
The Federal Reserve and the nation were confronted with another crisis in 2020 by the COVID-19 pandemic. Financial market turmoil erupted in early March when the pandemic began to spread across the United States. The Fed acted swiftly. The FOMC reduced its federal funds rate target effectively to zero and began to purchase substantial quantities of U.S. Treasury and mortgage-backed securities to provide liquidity and ensure market functioning. Working with the U.S. Treasury, the Board of Governors established several programs to provide funding for specific financial markets, including programs that had previously been used during the Great Financial Crisis as well as new programs. The Fed’s aggressive response likely prevented a financial crisis and aided in the recovery from a severe but very short recession. Most of the programs were terminated at the end of 2020 or in early 2021 as financial market distress had largely abated. However, the FOMC retained its highly accommodative monetary policy into 2021 to encourage further recovery of the economy and as prescribed by a new policy framework that it introduced in mid-2020.
Written as of September 13, 2021. See disclaimer.
- 1 The Reserve Banks made loans on a discount basis, i.e., lending a sum that was less than the amount received from the member bank when the loan matured with the difference determined by the Reserve Bank’s discount rate.
- 2 Information on the history and evolution of Fedwire is available from the Federal Reserve Bank of New York.
- 3 Martin, William McChesney, Jr. Address before the New York Group of the Investment Bankers Association of America, October 19, 1955, via FRASER.