Episode 55: The Federal Reserve

On today's lesson: What is the Federal Reserve? How important is it? What tools does the Fed use to manage the U.S economy, and why is it organized differently than other government agencies? Our guest is Louise Sheiner, policy director at the Brookings Institution's Hutchins Center on Fiscal and Monetary Policy. 

Have a civics question you want answered? Let us know in the form below and we'll try to answer it!


[Virginia Prescott] There was no central bank at the founding of the Republic, so when did the Federal Reserve come to be?

[Juliette Kayyem] The United States and so in fact the US has had central banks in the past. It didn't have one at the founding of the republic but it did had one shortly after that was actually designed by Alexander Hamilton. That bank failed. And another one after it also failed mostly because of a lack of political support. And I think the reason that there has been this difficulty with central banks in the United States is that there's really been a tradition of distrust and discomfort with the idea of a strong federal government. So for a long time there was no central bank in United States and you come to the early 1900s and the banking system was just extremely dysfunctional and it was wholly unsuited to the needs of the U.S. economy which by then had been industrialized and quite sophisticated and without a national banking system without a central bank. You had problems like there would be cash shortages in one part of the country and leading to bank runs and spikes in interest rates and recessions and these happen quite frequently. And then in 1987 there was a huge financial panic followed by a severe recession and it made it clear that something had to be done some type of central bank was needed to manage the peaks and valleys of the economy and to smooth out developments in different areas of the economy. And so the result was the Federal Reserve Act of 1913 which established the Federal Reserve system.

[VP] So it was established in the progressive era. How was it set up to appease those who didn't mistrust the idea of a central bank?

[JK] Yes so in order to get the political support for the central bank there were a lot of compromises that were made and those compromises actually are still reflected in the organisation of the Fed today. So in particular the Federal Reserve is not the strong federal central bank it is actually called the Federal Reserve System and it consists of the different parts. One is the Board of Governors and thats located in Washington and the members of the Board of Governors are appointed by the president. But it also has 12 regional Federal Reserve banks which are scattered across the country and who have presidents that are appointed not by Washington but by bankers and private citizens. So the system was created to balance all the competing worries and interests. Some partisan the federal government in Washington some part is controlled by government. Some part is controlled by private citizens and bankers and there is also regional coverage so that the interests of different people in different areas of the country are represented within this de-centralized central banking system what does the Fed actually do. OK so the Fed has a number of responsibilities. So most importantly conducts monetary policy meaning that it uses its capacity to affect interest rates and the money supply to try to fulfill its mandate which is to keep both inflation and unemployment low so formerly the mandate calls for maximum employment and stable prices but it's interpreted as basically saying we shouldn't have inflation too high and we shouldn't have unemployment too high either.

[VP] We periodically hear that the Fed is going to raise interest rates are lower than or maintain benchmark interest rates. How were those decisions made and what does that do to the economy in order to fulfill its mandate.

[JK] The Fed has to be constantly monitoring the state of the economy to decide whether it's getting too strong meaning that inflation is going to be right around the corner or too weak. Me that employment is going to increase. And so it sort of decides what the economy needs to try to keep on that steady keel and then it decides what interest rate should be in order to effect the change that it thinks is necessary. So when the Fed changes interest rates it can change how fast the economy is growing. So when it raises interest rates borrowing becomes more expensive so people will cut back on new home purchases. Credit card boring or other types spending and that can keep the economy from getting out of whack growing too fast and causing inflation. On the other hand when the economy is weak or is in a recession the Fed can lower interest rates to try to help spur investment and increase spending and get the economy out of its bad situation and lower unemployment.

[VP] So how about regulating banks. Does the Fed have a role in overseeing what goes on in the banking system in general.

[JK] Yes. The Fed has a very important role in regulating banks and also just in promoting the stability of a financial system as a whole. So it kind of does us in two ways. One it makes sure that the banks under its supervision which are most large banks are in good financial shape and aren't taking on too much risk. So that's kind of like trying to prevent a financial crisis from happening and two, it also has a role of stepping in if and when a financial crisis does occur. To try to take steps to try to stabilize the financial system.

[VP]  I do definitely want to get to the role of the Fed in the financial crisis. The most recent one the great recession which began 2008. But who oversees or regulate the Fed.

[JK] So the Fed is an independent agency but it is accountable it is part of government so it is accountable to Congress and to the American people. So it is overseen by Congress but it is independent in a way that many other agencies are not members of the Board of Governors are appointed for staggered 14 year terms and the board chair is appointed for a four year term. Unlike other executive agencies and new president or a new Congress cannot come in and just change the membership of the Fed.

[VP] So Janet Yellen for example shes now chair of the Fed. Her tenure set to expire in 2018.

[JK] Exactly in January of 2018 and then the president can appoint the next person but he Trump couldn't have come in and just said I dont like Janet were going to change it. And on top of that it's also true that the Fed is not actually funded by congressional appropriations. So although there is congressional oversight they cant control the Fed by determining its budget. So the Fed has a lot more independence and other agencies. So how is it funded. Its funded actually by the lending that it does it lends money to banks and pay interest and from that interest it funds itself and then what they dont use to fund itself goes back to the Treasury then how much can an administration actually influence Fed policy. The reason the Fed is an independent agency in the sense that I already described is that there is a view that independence is very important for central banks that it is important that monetary policy decisions not be subject to political short term political considerations. There is a worry that if the administration had a lot of influence on the Fed then you know when an election is coming up and you want the economy to be juiced up you would try to put pressure on the Fed to lower interest rates and that would be bad for the long term health of the economy. It would be bad for the credibility of the Fed. It would make it much harder for the Fed to say we're going to not let inflation get very high because people will say Yes yes what you say but come election. You know you might be talking differently. And so the reason it was set up as independent is because it's been recognized here and abroad its very standard that the Central Bank is independent in the sense that the Congress sets the mandate. Right so the Congress says here's what you need to do. But then it's left to the technical experts at the Fed to figure out how best to do that. So it has both the technical expertise to figure out how to do that. You know the Fed employs many many Ph.D. economists and also tries to insulate it from political pressure that would make it try to do things in the short run that might not be in the long run interest of the economy.

[VP] So that sounds like a net positive keeping the Fed separate or distinct from politics in some way. Are there cons are there any downsides to that kind of independence from working with an administration.

[JK] So I think the downsides are that it does seem a little less democratic in a way to have technocrats have so much control over something that's so important. So you know fiscal policy you know taxes and spending is also very important for the economy. But those go through Congress and are definitely in the political realm. Somehow monetary policy has managed to stay outside of that. I think one of the things that happened though is that when the Fed takes steps that are unpopular then this idea that it's kind of separate and secret in a way it's viewed as sort of secret what it does makes people very wary. And so I think people then say well why is this agency have this ability to do whatever it wants. You know when they are not elected officials not accountable necessary to be accountable but not in the same way that you know well you're going to like it if we don't like what Janet Yellen does then we're going to vote her out. Right. So it's it doesn't have that or the president will say I don't like how she's doing it so we'll you know we'll dismiss her. All right. So you know once you want Janet Yellen is there. She's there for four years and sort of there's no recourse sort of like the Supreme Court for example even though that lasts forever. But it is an agency that you know the power is given by the president because the president does do the appointing. But then once the person is appointed they sort of have a lot of political a lot of power.

[VP] Let's get to the great recession or the financial crisis that began in 2008 because the Fed was criticized for failing to see the magnitude of the problem or worse in some cases blamed for the crisis. I know there are opinions on many sides of what do you think the Fed role was in that crisis.

[JK] Well so I do think there are opinions on many sides there's some still some dispute in the economics literature about whether the Fed should have eased earlier. It's clear that the Fed did not see what was coming. And you know what I'll say I was at the Fed at the time as you know. Neither did the rest of the economics profession. So I don't know if this is a knock on the Fed or a knock on an x profession or in some sense maybe neither. It may be just these things are very difficult to know. So I think most economists agree that if the Fed hadn't acted the way it did in the recession the recession would have lasted much longer and would have been even worse than it was and that's through two of its tools so one of the things that did was do what it normally does which is to adjust monetary policy to try to stimulate the economy. And the Fed lowered interest rates from five and a quarter percent in September 2007 to near zero and kept them there for about nine years. The Fed also did other things to try to stimulate the economy. Very importantly the Fed also used its powers to try to stabilize the financial system so as everybody knows it made loans to help prevent the collapse of two very important firms. Bear Stearns and AIG because it believed that if these firms collapse it could greatly increase the financial panic and really damage the economy. So as bad as the recession was then it was bad without the Fed intervening. A lot of people think it would have been another great depression. The Fed also created a bunch of new lending programs that would make loans to banks and other bank like institutions. And that was really to fulfill its role of lender of last resort and to pretty much say look there doesn't need to be a panic. We are here to lend money if you need it and to basically calm the markets and prevent the system from guy kind of going into sort of chaos.

[VP] So Louise since this is the terms that the Fed deals with what is the long term outlook for the Fed both economic and political.

[JK] I think you know I'm hoping that the Fed has a very healthy long term outlook and has weathered political storms in the past right from the beginning it's always been an institution that is not typically all that popular and it manages or survive. And I hope it still does. I think it faces two challenges going forward. One of them of course is this political challenge as we've mentioned. You know there still is a lot of anger about the Great Recession and the Fed's role in it and also the Fed sort of bailing out Wall Street firms even though you know we would say it was the right thing to do. It still is something that angers people. And now as the Fed is starting to raise interest rates you know it might become a scapegoat for people who say oh the economy would be growing faster except for the Fed. And so I think there is this worry about the independents as there always is. But I think particularly at this time there is a great worry about whether or not the Fed can maintain its independence on the economic front. I think one the things that economists worry about is that you know nine years into the recovery interest rates are still really really low. And if we're hit by a recession and you know in the next few years and interest rates are really low the Fed won't be able to lower interest rates like it did in the last recession. Can't go much below zero. And so we have other tools. The Fed has other tools that it can use to help stimulate the economy but those aren't as time tested. And so I think that's another worry is that interest rates are very low now. And you know there's some decent probability that another recession will be on us in the next few years.

[VP] Louise thank you very much for speaking with us.

[JK] Oh my pleasure.



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