The Federal Reserve voice - active or passive?

• Author: LaWare, John P.
• Position: Regulatory

The Federal Reserve voice - active or passive?

Let me build on a bit of history and personal experience. You will see that they will tie in with my theme of whether or not the Fed is active or passive in today's society - and whether or not it should be.

The Federal Reserve System was born out of the panic of 1907, when Congress determined that it was going to provide emergency liquidity to the banking system. Twelve banks were chartered, and the Federal Reserve Board was put in place in 1914.

The member banks set reserve requirements. They said that liquidity for the system required each bank to keep a certain amount of its deposits in the central bank. In a liquidity crisis, those reserves would be used to forestall a run on a bank. This was before deposit insurance.

Five or six years later, there were huge amounts of these reserves in the system. Banks in reserve cities, for example, were keeping as much as 20 percent of their deposits in this reserve pool. And the Fed could by law invest that money only in U.S. Treasury securities.

So an informal committee met once a month or so in New York and directed the New York Federal Reserve Bank to buy or sell Treasury securities for the accounts of the 12 individual banks. Gradually, the committee began to notice that after the orders coming out of these meetings were executed, the level of interest rates changed, and so did the whole government bond market. And because of the effect on the government bond market, there were implications for all the capital markets.

Suddenly, like a cartoon in which a light bulb goes on, somebody said: "Hey, this is another way that we can influence the economy." Thus began what is called open market operations as an instrument of monetary policy. The committee that makes these decisions today is called the Open Market Committee.

Let me now move from history to personal experience. The Open Market Committee consists in 1989 of the seven governors of the Federal Reserve Board and five of the 12 district bank presidents. The president of the New York bank is always a member because the New York bank is charged with the open market operations both in Treasury securities and in foreign exchange.

The committee meets every six weeks. Before each meeting, an enormous amount of data is gathered from all of the district banks and from the staff of 140 economists in Washington. Using various computer models, the data is analyzed and compiled in a report that is distributed to all members of the committee. Basically, these reports present the staff's opinion of what is going on in the economy and projections for the next 12 to 24 months.

At the committee meeting, each member sitting around the table is asked his opinion of the economy, the staff reports, and the projections. Then there is a strategic coffee break. Everybody has now heard how everybody else thinks, and each one begins to test his or her own ideas against what he or she heard around the table. So the 15 or 20 minutes in which the committee members are drinking coffee and eating donuts in the corridor outside is the period in which a consensus begins to develop.

After the coffee break, the chairman speaks first. He may start by saying: "Well, it looks to me like what is going on here is as follows." And in a few sentences, he will capsulize what he's heard. Then he might say: "In view...