The Federal Reserve is widely considered to be one of the most important financial institutions in the world. The Fed can either be your kindly grandmother or the mother-in-law from hell, and its character is usually a function of the Federal Reserve's board of governors. Its monetary policy decisions can send waves through not only the U.S. markets, but also the world.

In this article we will look at the formation of the Federal Reserve and follows its history as it riles the market and then turns it around and sends it to new highs.

Key Takeaways

  • Despite early attempts in the U.S. after the revolutionary war to form a central bank by Alexander Hamilton, these efforts failed due to political unfeasability.
  • The panic of 1907, and at the urging of J.P. Morgan and other prominent financiers, Congress eventually formed the Federal Reserve Act in 1913, establishing the Fed as America's central bank.
  • Since then, the Fed has played a crucial role in steering America's monetary policy and staving off economic challenges from the Great Depression to the 2008 financial crisis, through to the 2020 COVID-19 pandemic.

America Before the Federal Reserve

The United States was considerably more unstable financially before the creation of the Federal Reserve. Panics, seasonal cash crunches and a high rate of bank failures made the U.S. economy a riskier place for international and domestic investors to place their capital. The lack of dependable credit stunted growth in many sectors, including agriculture and industry. Americans early on, however, also did not want a central bank, as they saw this as a model based on the Royal Crown and its Bank of England. New America did not want to be made in the image of Britain, and also favored a more decentralized state-by-state approach to its political economy.

Still, there were some early attempts. Alexander Hamilton, the first Secretary of the Treasury, was instrumental in the formation of the first national bank in America, known as The Bank of the United States. Located in Philadelphia, Pennsylvania, within Independence National Historical Park, the structure was completed in 1797 and stands today as a National Historic Landmark. It was one of four major financial innovations at the time, including the U.S. government’s assumption of the state war debts, the establishment of a mint, and the imposition of a federal excise tax. Hamilton’s aim with these measures was to establish financial order, national credit, and resolve the issue of fiat currency.

However, this first attempt at an American central bank was short-lived, and its charter was not renewed (it was re-established later for another short period of years, as the second Bank of the United States, which was even shorter-lived). Hamilton proposed the Bank of the United States in 1790, and it opened in Philadelphia the following year. In April 1792, it opened a New York branch, Wall Street's second bank (then becoming the Bank of New York). These central banks lasted a total of eight years before being forced to close by congress.

J.P. Morgan and the Panic of 1907

After many decades of lacking a central bank, it was J.P. Morgan who ultimately forced the government into acting on the central banking plans it had been considering off and on for almost a century. During the Bank Panic of 1907, Wall Street turned to J.P. Morgan to steer the country through the crisis that was threatening to push the economy over the edge into a full crash and depression. Morgan was able to convene all the principal players at his mansion and command all their capital to flood the system, thus floating the banks that, in turn, helped to float the businesses until the panic passed.

The fact that the government owed its economic survival to a private banker forced the necessary legislation to create a central bank and the Federal Reserve.

Learning from Europe

In the years between 1907 and 1913, the top bankers and government officials in the U.S. formed the National Monetary Commission and traveled to Europe to see how the central banking was handled there. They came back with favorable impressions of the British and German systems, using them as the base and adding some improvements gleaned from other countries. Congress ultimately passed the The 1913 Federal Reserve Act is U.S. -- legislation that created the current Federal Reserve System. Congress developed the Federal Reserve Act to establish economic stability in the United States by introducing a central bank to oversee monetary policy. The law sets out the purpose, structure, and function of the Federal Reserve System. Congress can amend the Federal Reserve Act and has done so several times.

The 1913 Federal Reserve Act, signed into law by President Woodrow Wilson, gave the 12 Federal Reserve banks the ability to print money to ensure economic stability. The Federal Reserve System created the dual mandate to maximize employment and keep inflation low. The Federal Reserve was thus given power over the money supply and, by extension, the economy. Although many forces within the public and government were calling for a central bank that printed money on demand, President Wilson was swayed by Wall Street arguments against a system that would cause rampant inflation. So the government created the Federal Reserve, but it was by no means under government control.

The Great Depression

The government soon came to regret the freedom it had granted the Federal Reserve as it stood by during the crash of 1929 and refused to prevent the Great Depression that followed.

Even now, it is hotly debated whether the Fed could have stopped the depression, but there is little doubt that it could have done more to soften and shorten it by providing lower interest rates to allow farmers to keep planting and businesses to keep producing. The high interest rates may even have been responsible for the unplanted fields that turned into dust bowls. By restricting the money supply at a bad time, the Fed starved out many individuals and businesses that might otherwise have survived.

The Post-War Recovery

It was World War II, not the Federal Reserve, that lifted the economy out of the depression. The war benefited the Federal Reserve as well by expanding its power and the amount of capital it was called on to control for the Allies. After the war, the Fed was able to erase some of the bad memories from the depression by keeping interest rates low as the U.S. economy went on a bull run that was virtually uninterrupted until the '60s.

Inflation or Unemployment?

Stagflation and inflation hit the U.S. in the '70s, slapping the economy across the face, but hurting the public far more than business. The Nixon administration ended the nation's on and off again affair with the gold standard, making the Fed that much more important in controlling the value of the U.S. dollar. The big question for the Fed was whether the nation was better off with inflation or unemployment.

By controlling interest rates, the Fed can make corporate credit easy to obtain, thus encouraging business to expand and create jobs. Unfortunately, this increases inflation as well. On the flip side, the fed can slow inflation by raising interest rates and slowing down the economy, causing unemployment. The history of the Fed is simply each chairman's answer to this central question.

The Greenspan Years

Alan Greenspan took over the Federal Reserve a year before the infamous crash of 1987. When we think of crashes, many people consider the crash of 1987 more of a glitch than a true crash - a non-event nearer to a panic. This is true only because of the actions of Alan Greenspan and the Federal Reserve. Much like J.P. Morgan in 1907, Alan Greenspan collected all the necessary chiefs and kept the economy afloat.

Through the Fed, however, Greenspan used the additional weapon of low interest rates to carry business through the crisis. This marked the first time that the Fed had operated as its creators first envisioned 80 years before.

Following Greenspan, the Fed has had to navigate the 2008 financial crisis and the Great Recession under the stewardship of Ben Bernanke and Janet Yellen. Then, during the Trump presidency and the COVID-19 pandemic, Jerome Powell led the fed through a period defined by a lack of central bank independence and political cow-towing to lower rates and expand the Fed's balance sheet.

The Bottom Line

Criticisms of the Federal Reserve continue. Boiled down, these arguments center on the image people have of the caretaker of the economy. You can either have a Fed that feeds the economy with ideal interest rates leading to low unemployment - possibly leading to future problems - or you can have a Fed that offers little help, ultimately forcing the economy to learn to help itself. The ideal Fed would be willing to do both. Although there have been calls for the elimination of the Federal Reserve as the U.S. economy matures, it is very likely that the Fed will continue to guide the economy for many years to come.