The History Behind the Creation of the Fed

The Federal Reserve system is the central bank of the United States, created on December 23, 1913.

This happened after the Panic of 1907, also called the 1907 Bankers' Panic or Knickerbocker Crisis (see the image of Wall Street during the panic in October 1907), a financial crisis occurred in the United States when the New York Stock Exchange fell around 50 percent from its peak the previous year. The panic spread throughout the country during a time of economic recession, forcing many banks and businesses into bankruptcy.

The cause of the panic was a failed attempt to corner the market, a financial term meaning obtaining enough control of a particular commodity, stock, or any other asset to manipulate the market price. The goal was to gain enough control of the supply of the targeted commodity to set a specific price for it. This attempt was made on the stock of the United Copper Company.

When this attempt failed, the banks that had lent money to the cornering scheme suffered money runs, leading to the collapse of the Knickerbocker Trust Company, which was at the time New York City’s third-largest bank. The collapse of Knickerbocker spread fear throughout the city's trusts as regional banks withdrew reserves from New York City banks. The panic then extended across the nation as vast numbers of people withdrew deposits from their regional banks, causing the eighth-largest decline in U.S. stock market history.

However, intervention from the famous financier and investment banker J.P. Morgan, who pledged huge sums of his own money and convinced other bankers to do so, helped save the banking system. This financial crisis highlighted the limitations of the United States' Independent Treasury System, which had been created in 1846 to manage the money supply of the federal government independently of national banking and financial systems.

Although the system managed the nation's money supply, it was unable to inject liquidity back into the market. By November of the same year, a month after the incident, the crisis had ended. However, another crisis followed when a large brokerage firm used the stock of the Tennessee Coal, Iron and Railroad Company (TC&I)—a major American steel manufacturer at the time—as collateral. The price of the stock collapsed, and to contain the problem, then-President Theodore Roosevelt approved an emergency takeover by J.P. Morgan’s U.S. Steel Corporation.

These economic tribulations and instability led Senator Nelson W. Aldrich, the following year, to create and chair a commission to investigate the crisis and propose future solutions, ultimately leading to the creation of the Federal Reserve System in 1913 through the Federal Reserve Act, signed by President Woodrow Wilson.

What Does the Fed Do?

The main purpose of the Fed is conducting monetary policy by setting interest rates to control the money supply in the US economy. In addition to that the Fed aims to accomplish two key goals mandated by the US congress which are, promoting maximum employment (the highest level of employment or the lowest level of employment the economy can sustain while maintaining a stable inflation rate), and promoting stable prices for goods and services.

The Fed conducts monetary policy by raising or lowering its target range for the effective federal funds rate (EFFR) which refers to the interest rate that banks charge other institutions for lending excess cash to them from their reserve balances overnight, in simpler words the rate at which commercial banks borrow and lend their excess reserves to each other overnight. This rate is set based on the prevailing economic conditions, and it influences short term rates on consumer loans and credit cards, the rate is monitored by investors because it affects the stock market. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. The amount of money a bank must keep in its Fed account is known as the reserve requirement and is based on a percentage of the bank's total deposits. Financial institutions are required to maintain interest-bearing accounts at federal reserves banks to ensure they have enough money to cover depositors' withdrawals and other obligations. Any money in their reserve that exceeds the required level is available for lending to other banks that might have a shortfall.

Some key terms to know:

Rate cut the fed lowering EFFR to stimulate economic growth and prevent unemployment from rising, lowering the rate encourages individuals and businesses to borrow money cheaply, which stimulates spending and investment, which is what the fed did during the covid 19 pandemic by lowering the rate to 0.05 percent as of April 2020 to stimulate growth in the economy, Rate Hike the fed raising interest rate to cool down an overheating economy or curb inflation which makes borrowing more expensive for everyone and encourages saving, which is what the fed did after the passing of the covid 19 pandemic by raising the rate to 5.33 percent as of July 2023 to cool down consumer spending. The EFFR has a tremendous effect on many sectors and industries across the whole economy. such as the foreign exchange market where rate changes can affect the value of the US dollar relative to other currencies impacting international trade and investments. Another affected sector is financial markets where changes in the rate can affect stock prices since its effect on corporate profits and investor behaviour, moreover government finances too are affected by the fed funds rate because it influences the cost of government borrowing and influences budget deficits.