MBF Homework 5:

Structure of the Federal Reserve

The Federal Reserve Act (12 U.S.C. 221 et seq.) created the Fed as the nation’s central bank in 1913. The Fed is
composed of 12 regional Federal Reserve banks overseen by a Board of Governors in Washington, DC. Figure 1
illustrates the city in which each bank is headquartered and the area of each bank’s jurisdiction. The board is
composed of seven governors nominated by the President and confirmed by the Senate. The President selects (and
the Senate confirms) a chair and two vice chairs from among the governors; one vice chair is responsible for
supervision. The governors serve nonrenewable 14-year terms, but the chair and vice chairs serve renewable 4-year
terms. Jerome Powell’s term as Chair began February 5, 2018. Board members are chosen without regard to political
affiliation. Regional bank presidents are chosen by their boards, not by the President, with the approval of the Board
of Governors

Generally, policy is formulated by the board and carried out by the regional banks. Monetary policy decisions,
however, are made by the Federal Open Market Committee (FOMC), which is composed of the seven governors, the
president of the New York Fed, and four other regional bank presidents. Representation for these four seats rotates
among the other 11 regional banks. The FOMC meets at least every six weeks to review the stance of monetary
policy.

The Fed’s budget is not subject to congressional appropriations or authorizations. The Fed is funded by fees and the
income generated by securities it owns. Its income exceeds its expenses, and it remits most of its net income to the
Treasury, where it is used to reduce the federal debt.

The Fed’s capital consists of stock and a surplus. The Fed’s surplus is capped at $10 billion by law. Private banks
regulated by the Fed buy stock in the Fed to become member banks. Membership is mandatory for national banks,
but optional for state banks. The stock pays dividends of 6% for banks with less than $10 billion in assets and the
lower of 6% or the 10-year Treasury yield for banks with more than $10 billion in assets. Stockholders choose two-
thirds of the board at the regional Fed banks.

Responsibilities of the Federal Reserve

The Fed’s responsibilities fall into four main categories: monetary policy, lender of last resort, prudential
supervision of certain banks and other financial firms, and provision and oversight of payment systems.

Monetary Policy. The Fed’s primary monetary policy instrument is the federal funds rate (the overnight bank
lending rate). The Fed influences interest rates to affect interest-sensitive spending on capital investment, consumer
durables, and housing. Interest rates also indirectly influence the value of the dollar and, therefore, spending on
exports and imports. The Fed reduces rates to stimulate economic activity and raises rates to slow activity. Monetary
policy is considered a blunt instrument that cannot be targeted to affect specific regions, certain industries, or the
income distribution.

The Fed targets the federal funds rate through open market operations—the purchase and sale of U.S. Treasury
securities mainly from primary dealers (who specialize in trading government securities) in the secondary market.
Often, these transactions are made on a temporary basis using repurchase agreements, known as repos. The Fed sets
reserve requirements and the interest rate it pays banks to hold reserves. In addition, monetary policy can involve
foreign exchange operations, although these are rare. Open market and foreign exchange operations are conducted
by the New York Fed per the board’s directives. The Fed influences the size of the money supply through its control
over the amount of bank reserves and currency (Federal Reserve notes) in circulation.

The Fed conducted large-scale asset purchases of Treasury- and mortgage-backed securities from 2008 to 2014—
known as quantitative easing—that increased the size of its balance sheet. Since then, the Fed has begun to
normalize monetary policy. In December 2015, the Fed raised the federal funds rate above zero, where it had been
since December 2008. In September 2017, the Fed began gradually winding down its balance sheet. Quantitative
easing has boosted the Fed’s remittances to the Treasury in recent years, but normalization is likely to reduce
remittances.

Lender of Last Resort. Despite their name, Federal Reserve banks do not carry out any banking activities, with one
limited exception. The Fed traditionally acts as lender of last resort by making short-term, collateralized loans to
banks through its discount window. The Fed generally sets the discount rate charged for these loans above market
rates. In normal market conditions, the Fed’s lending operations are minimal. In the 2007-2009 financial crisis, it
created a number of temporary emergency facilities to provide assistance to the broader financial system.

Regulation. The Fed regulates bank holding companies (including the largest banks), some foreign banks, and some
state banks. The Fed’s regulatory responsibilities overlap with those of other regulators. Responsibility for
regulating banks is divided among the Fed, the Consumer Financial Protection Bureau (CFPB), the Federal Deposit
Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC). The Fed shares
responsibility for maintaining financial stability with the Financial Stability Oversight Council (FSOC) and its
members. FSOC is a council of regulators, including the Fed, headed by the Treasury Secretary. The Fed
participates in intergovernmental forums, such as the Financial Stability Board and the Basel Committee on Banking
Supervision, with other U.S. agencies.

Payment Systems. The Fed operates key payment systems, including those for check clearing and interbank
transfers, and oversees other payment systems. It also acts as the federal government’s fiscal agent—federal receipts
and payments flow through Treasury’s accounts at the Fed.

Policy Issues

Congressional Oversight. Congress has delegated monetary policy to the Fed but conducts oversight to ensure the
Fed meets its statutory mandate of “maximum employment, stable prices, and moderate long-term interest rates.”
The Fed has defined stable prices as a longer-run goal of 2% inflation.

The Fed is more independent from Congress and the Administration than most agencies. Economists have justified
the Fed’s independence on the grounds that monetary policy decisions that are insulated from short- term political
pressures result in better economic outcomes. There is an inherent tradeoff between independence and
accountability, however.

The Fed is statutorily required to testify semiannually before and present a written report to the House Financial
Services Committee and the Senate Banking, Housing, and Urban Affairs Committee. Congress has debated whether
the Fed should report to it more frequently and in more detail. Congress has also debated what types of information
the Fed should publicly disclose. Disclosure helps Congress and the public to better understand the Fed’s actions.
Up to a point, this makes monetary and regulatory policy more effective, but too much disclosure could make both
less effective because they rely on market-sensitive and confidential information. The Dodd-Frank Act (P.L. 111-
203) required the Fed to release information with a lag on the identities of all borrowers and the terms of borrowing.

GAO Audits. To enhance oversight, Congress has considered removing statutory restrictions on Government
Accountability Office (GAO) audits of the Fed. Contrary to popular belief, GAO already audits the Fed upon
congressional request, but it is prohibited by law from conducting economic analyses of monetary or lender-of- last-
resort activities. The Dodd-Frank Act broadened GAO’s audit authority and required two one-time audits of the Fed.
Although removing GAO audit restrictions may increase accountability, Fed leaders oppose such a change, arguing
that it would undermine the Fed’s independence from Congress and politicize monetary policy.

Balance Sheet. Congress has conducted oversight of the gradual wind down of the Fed’s large balance sheet. The
Fed is expected to reach a decision on the ultimate size of the balance sheet and bank reserves and to what extent it
will rely on interest on bank reserves for conducting monetary policy when policy normalization is completed.
Congress has also reduced the Fed’s financial surplus as a budgetary “pay for” in recent unrelated acts (P.L. 114-94,
P.L. 115-123, P.L. 115-174).

Regulation. Congress granted large and small banks regulatory relief from Fed regulation in P.L. 115-174. Finding
the optimal tradeoff between the benefits and costs of financial regulation continues to be debated. Congress has
also been concerned about whether the Fed is susceptible to regulatory capture, the concept that regulated entities
have undue influence over regulation.

Emergency Lending. The Fed’s use of its emergency authority (Section 13(3) of the Federal Reserve Act) during the
financial crisis—notably, to prevent AIG and Bear Stearns from failing—was controversial. The Dodd-Frank Act
modified Section 13(3) to restrict future intervention on behalf of a failing firm. Congress has debated whether to
place additional restrictions on the use of Section 13(3). The Fed would like its emergency authority to be broad
given the unpredictable nature of financial instability, but open-ended authority could potentially be used in ways
that Congress did not intend, as the crisis illustrated.

Governance. Congress has debated changes to the Fed’s governance structure. Proposals include changing the
voting balance between Fed governors and presidents on the FOMC; making the New York Fed president a
presidential appointee; and changing how the regional bank directors and presidents are selected. Some Members of
Congress have also expressed concern over a lack of diversity at the Fed. The Dodd-Frank Act created Offices of
Minority and Women Inclusion throughout the Federal Reserve System.

What Is a Central Bank? 

A central bank is a financial institution given privileged control over the
production and distribution of money and credit for a nation or a group of nations.
In modern economies, the central bank is usually responsible for the formulation
of monetary policy and the regulation of member banks.

Central banks are inherently non-market-based or even anti-competitive

institutions. Although some are nationalized, many central banks are not
government agencies, and so are often touted as being politically independent.
However, even if a central bank is not legally owned by the government, its
privileges are established and protected by law.

The critical feature of a central bank—distinguishing it from other banks—is

its legal monopoly status, which gives it the privilege to issue banknotes and
cash. Private commercial banks are only permitted to issue demand liabilities,
such as checking deposits.

What Is the Federal Reserve System (FRS)? 

The Federal Reserve System (FRS) is the central bank of the U.S. The Fed, as it
is commonly known, regulates the U.S. monetary and financial system. The
Federal Reserve System is composed of a central governmental agency in
Washington, D.C., the Board of Governors, and 12 regional Federal Reserve
Banks in major cities throughout the U.S.

What does it mean that the Federal Reserve is "independent within the
government"?
The Federal Reserve, like many other central banks, is an independent government agency but also
one that is ultimately accountable to the public and the Congress. The Chair and other staff testify
before Congress, and the Board submits an extensive report—the Monetary Policy Report—on
recent economic developments and its plans for monetary policy twice a year. The Board also
makes public the System's independently audited financial statements, along with minutes from the
FOMC meetings.
The Federal Reserve does not receive funding through the congressional budgetary process. The
Fed's income comes primarily from the interest on government securities that it has acquired through
open market operations. After paying its expenses, the Federal Reserve turns the rest of its earnings
over to the U.S. Treasury.
The Congress established maximum employment and stable prices as the key macroeconomic
objectives for the Federal Reserve in its conduct of monetary policy. The Congress also structured
the Federal Reserve to ensure that its monetary policy decisions focus on achieving these long-run
goals and do not become subject to political pressures that could lead to undesirable outcomes. So,
members of the Board of Governors are appointed for staggered 14-year terms, and the Board Chair
is appointed for a four-year term. Elected officials and members of the Administration are not
allowed to serve on the Board.

The one factor that is sure to move the currency markets is interest rates.

Interest rates give international investors a reason to shift money from one
country to another in search of the highest and safest yields.

The growing interest rate spread between countries have been the main focus of
professional investors, but what most individual traders do not know is that
the absolute value of interest rates is not what's important – what really matters
are the expectations of where interest rates are headed in the future.
Familiarizing yourself with what makes a central bank tick will give you a leg up
when it comes to predicting their next moves, as well as the future direction of a
given currency pair. ( For more see our tutorial: Popular Forex Currencies)
1775-1791: U.S. Currency

To finance the American Revolution, the Continental Congress printed the new
nation's first paper money. Known as "continentals," the fiat money notes were
issued in such quantity they led to inflation, which, though mild at first, rapidly
accelerated as the war progressed. Eventually, people lost faith in the notes, and
the phrase "Not worth a continental" came to mean "utterly worthless."

1791-1811: First Attempt at Central Banking

At the urging of then Treasury Secretary Alexander Hamilton, Congress established

the First Bank of the United States, headquartered in Philadelphia, in 1791. It was
the largest corporation in the country and was dominated by big banking and
money interests. Many agrarian minded Americans uncomfortable with the idea of
a large and powerful bank opposed it. When the bank’s 20-year charter expired in
1811 Congress refused to renew it by one vote. 

1816-1836: A Second Try Fails

By 1816, the political climate was once again inclined toward the idea of a central
bank; by a narrow margin, Congress agreed to charter the Second Bank of the
United States. But when Andrew Jackson, a central bank foe, was elected president
in 1828, he vowed to kill it. His attack on its banker-controlled power touched a
popular nerve with Americans, and when the Second Bank’s charter expired in
1836, it was not renewed. 
1836-1865: The Free Banking Era
State-chartered banks and unchartered “free banks” took hold during this period,
issuing their own notes, redeemable in gold or specie. Banks also began offering
demand deposits to enhance commerce. In response to a rising volume of check
transactions, the New York Clearinghouse Association was established in 1853 to
provide a way for the city’s banks to exchange checks and settle accounts.

1863: National Banking Act

During the Civil War, the National Banking Act of 1863 was passed, providing for
nationally chartered banks, whose circulating notes had to be backed by U.S.
government securities. An amendment to the act required taxation on state bank
notes but not national bank notes, effectively creating a uniform currency for the
nation. Despite taxation on their notes, state banks continued to flourish due to the
growing popularity of demand deposits, which had taken hold during the Free
Banking Era. 

1873-1907: Financial Panics Prevail

Although the National Banking Act of 1863 established some measure of currency
stability for the growing nation, bank runs and financial panics continued to plague
the economy. In 1893, a banking panic triggered the worst depression the United
States had ever seen, and the economy stabilized only after the intervention of
financial mogul J.P. Morgan. It was clear that the nation’s banking and financial
system needed serious attention. 

1907: A Very Bad Year

In 1907, a bout of speculation on Wall Street ended in failure, triggering a
particularly severe banking panic. J.P. Morgan was again called upon to avert
disaster. By this time, most Americans were calling for reform of the banking
system, but the structure of that reform was cause for deep division among the
country’s citizens. Conservatives and powerful “money trusts” in the big eastern
cities were vehemently opposed by “progressives.” But there was a growing
consensus among all Americans that a central banking authority was needed to
ensure a healthy banking system and provide for an elastic currency. 
1908-1912: The Stage is Set for Decentralized Central Bank

The Aldrich-Vreeland Act of 1908, passed as an immediate response to the panic of

1907, provided for emergency currency issue during crises. It also established the
national Monetary Commission to search for a long-term solution to the nation’s
banking and financial problems. Under the leadership of Senator Nelson Aldrich,
the commission developed a banker-controlled plan. William Jennings Bryan and
other progressives fiercely attacked the plan; they wanted a central bank under
public, not banker, control. The 1912 election of Democrat Woodrow Wilson killed
the Republican Aldrich plan, but the stage was set for the emergence of a
decentralized central bank. 

1912: Woodrow Wilson as Financial Reformer

Though not personally knowledgeable about banking and financial issues,

Woodrow Wilson solicited expert advice from Virginia Representative Carter Glass,
soon to become the chairman of the House Committee on Banking and Finance,
and from the Committee’s expert advisor, H. Parker Willis, formerly a professor of
economics at Washington and Lee University. Throughout most of 1912, Glass and
Willis labored over a central bank proposal, and by December 1912, they presented
Wilson with what would become, with some modifications, the Federal Reserve Act.
1913: The Federal Reserve System is Born

From December 1912 to December 1913, the Glass-Willis proposal was hotly
debated, molded and reshaped. By December 23, 1913, when President Woodrow
Wilson signed the Federal Reserve Act into law, it stood as a classic example of
compromise—a decentralized central bank that balanced the competing interests
of private banks and populist sentiment.

1914: Open for Business

Before the new central bank could begin operations, the Reserve Bank Operating
Committee, comprised of Treasury Secretary William McAdoo, Secretary of
Agriculture David Houston, and Comptroller of the Currency John Skelton Williams,
had the arduous task of building a working institution around the bare bones of the
new law. But, by November 16, 1914, the 12 cities chosen as sites for regional
Reserve Banks were open for business, just as hostilities in Europe erupted into
World War I. 

1914-1919: Fed Policy During the War

When World War I broke out in mid-1914, U.S. banks continued to operate
normally, thanks to the emergency currency issued under the Aldrich-Vreeland Act
of 1908. But the greater impact in the United States came from the Reserve Banks’
ability to discount bankers acceptances. Through this mechanism, the United States
aided the flow of trade goods to Europe, indirectly helping to finance the war until
1917, when the United States officially declared war on Germany and financing our
own war effort became paramount. 
1920s: The Beginning of Open Market Operations

Following World War I, Benjamin Strong, head of the New York Fed from 1914 to his
death in 1928, recognized that gold no longer served as the central factor in
controlling credit. Strong’s aggressive action to stem a recession in 1923 through a
large purchase of government securities gave clear evidence of the power of open
market operations to influence the availability of credit in the banking system.
During the 1920s, the Fed began using open market operations as a monetary
policy tool. During his tenure, Strong also elevated the stature of the Fed by
promoting relations with other central banks, especially the Bank of England. 

1929-1933: The Market Crash and the Great Depression

During the 1920s, Virginia Representative Carter Glass warned that stock market
speculation would lead to dire consequences. In October 1929, his predictions
seemed to be realized when the stock market crashed, and the nation fell into the
worst depression in its history. From 1930 to 1933, nearly 10,000 banks failed, and
by March 1933, newly inaugurated President Franklin Delano Roosevelt declared a
bank holiday, while government officials grappled with ways to remedy the nation’s
economic woes. Many people blamed the Fed for failing to stem speculative lending
that led to the crash, and some also argued that inadequate understanding of
monetary economics kept the Fed from pursuing policies that could have lessened
the depth of the Depression. 

1933: The Depression Aftermath

In reaction to the Great Depression, Congress passed the Banking Act of 1933,
better known as the Glass-Steagall Act, calling for the separation of commercial and
investment banking and requiring use of government securities as collateral for
Federal Reserve notes. The Act also established the Federal Deposit Insurance
Corporation (FDIC), placed open market operations under the Fed and required
bank holding companies to be examined by the Fed, a practice that was to have
profound future implications, as holding companies became a prevalent structure
for banks over time. Also, as part of the massive reforms taking place, Roosevelt
recalled all gold and silver certificates, effectively ending the gold and any other
metallic standard.

1935: More Changes to Come

The Banking Act of 1935 called for further changes in the Fed’s structure, including
the creation of the Federal Open Market Committee (FOMC) as a separate legal
entity, removal of the Treasury Secretary and the Comptroller of the Currency from
the Fed’s governing board and establishment of the members’ terms at 14 years.
Following World War II, the Employment Act added the goal of promising maximum
employment to the list of the Fed’s responsibilities. In 1956 the Bank Holding
Company Act named the Fed as the regulator of bank holding companies owning
more than one bank, and in 1978 the Humphrey-Hawkins Act required the Fed
chairman to report to Congress twice annually on monetary policy goals and
objectives.

1951: The Treasury Accord

The Federal Reserve System formally committed to maintaining a low interest rate
peg on government bonds in 1942 after the United States entered World War II. It
did so at the request of the Treasury to allow the federal government to engage in
cheaper debt financing of the war. To maintain the pegged rate, the Fed was forced
to give up control of the size of its portfolio as well as the money stock. Conflict
between the Treasury and the Fed came to the fore when the Treasury directed the
central bank to maintain the peg after the start of the Korean War in 1950.
President Harry Truman and Secretary of the Treasury John Snyder were both
strong supporters of the low interest rate peg. The President felt that it was his duty
to protect patriotic citizens by not lowering the value of the bonds that they had
purchased during the war. Unlike Truman and Snyder, the Federal Reserve was
focused on the need to contain inflationary pressures in the economy caused by
the intensification of the Korean War. Many on the Board of Governors, including
Marriner Eccles, understood that the forced obligation to maintain the low peg on
interest rates produced an excessive monetary expansion that caused inflation.
After a fierce debate between the Fed and the Treasury for control over interest
rates and U.S. monetary policy, their dispute was settled resulting in an agreement
known as the Treasury-Fed Accord. This eliminated the obligation of the Fed to
monetize the debt of the Treasury at a fixed rate and became essential to the
independence of central banking and how monetary policy is pursued by the
Federal Reserve today

1970s-1980s: Inflation and Deflation

The 1970s saw inflation skyrocket as producer and consumer prices rose, oil prices
soared and the federal deficit more than doubled. By August 1979, when Paul
Volcker was sworn in as Fed chairman, drastic action was needed to break
inflation’s stranglehold on the U.S. economy. Volcker’s leadership as Fed chairman
during the 1980s, though painful in the short term, was successful overall in
bringing double-digit inflation under control.

1980 Setting the Stage for Financial Modernization

The Monetary Control Act of 1980 required the Fed to price its financial services
competitively against private sector providers and to establish reserve
requirements for all eligible financial institutions. The act marks the beginning of a
period of modern banking industry reforms. Following its passage, interstate
banking proliferated, and banks began offering interest-paying accounts and
instruments to attract customers from brokerage firms. Barriers to insurance
activities, however, proved more difficult to circumvent. Nonetheless, momentum
for change was steady, and by 1999 the Gramm-Leach-Bliley Act was passed, in
essence, overturning the Glass-Steagall Act of 1933 and allowing banks to offer a
menu of financial services, including investment banking and insurance. 
1990s: The Longest Economic Expansion

Two months after Alan Greenspan took office as the Fed chairman, the stock
market crashed on October 19, 1987. In response, he ordered the Fed to issue a
one-sentence statement before the start of trading on October 20: “The Federal
Reserve, consistent with its responsibilities as the nation’s central bank, affirmed
today its readiness to serve as a source of liquidity to support the economic and
financial system.” The 10-year economic expansion of the 1990s came to a close in
March 2001 and was followed by a short, shallow recession ending in November
2001. In response to the bursting of the 1990s stock market bubble in the early
years of the decade, the Fed lowered interest rates rapidly. Throughout the 1990s,
the Fed used monetary policy on a number of occasions including the credit crunch
of the early 1990s and the Russian default on government securities to keep
potential financial problems from adversely affecting the real economy. The decade
was marked by generally declining inflation and the longest peacetime economic
expansion in our country’s history. 

September 11, 2001

The effectiveness of the Federal Reserve as a central bank was put to the test on
September 11, 2001 as the terrorist attacks on New York, Washington and
Pennsylvania disrupted U.S. financial markets. The Fed issued a short statement
reminiscent of its announcement in 1987: “The Federal Reserve System is open and
operating. The discount window is available to meet liquidity needs.” In the days
that followed, the Fed lowered interest rates and loaned more than $45 billion to
financial institutions in order to provide stability to the U.S. economy. By the end of
September, Fed lending had returned to pre-September 11 levels and a potential
liquidity crunch had been averted. The Fed played the pivotal role in dampening the
effects of the September 11 attacks on U.S. financial markets.

January 2003: Discount Window Operation Changes

In 2003, the Federal Reserve changed its discount window operations so as to have
rates at the window set above the prevailing Fed Funds rate and provide rationing
of loans to banks through interest rates. 

2006 and Beyond: Financial Crisis and Response

During the early 2000s, low mortgage rates and expanded access to credit made
homeownership possible for more people, increasing the demand for housing and
driving up house prices. The housing boom got a boost from increased
securitization of mortgages—a process in which mortgages were bundled together
into securities that were traded in financial markets. Securitization of riskier
mortgages expanded rapidly, including subprime mortgages made to borrowers
with poor credit records.

Summary
The 2007-2009 financial crisis led the Federal Reserve (Fed) to revive an obscure provision found in
Section 13(3) of the Federal Reserve Act (12 U.S.C. 344) to extend credit to nonbank financial firms for
the first time since the 1930s. Section 13(3) provides the Fed with greater flexibility than its normal
lending authority. Using this authority, the Fed created six broadly based facilities (of which only five
were used) to provide liquidity to “primary dealers” (certain large investment firms) and to revive demand
for commercial paper and asset-backed securities. More controversially, the Fed provided special, tailored
assistance exclusively to four firms that the Fed considered “too big to fail”—AIG, Bear Stearns,
Citigroup, and Bank of America.

In response to the financial turmoil caused by the coronavirus disease 2019 (COVID-19), the Fed
reopened four of these broadly-based programs and created two new ones in 2020. Treasury pledged $50
billion of assets from the Exchange Stabilization Fund (ESF) to protect the Fed against losses in most of
these programs. H.R. 748, referred to by some as the “third coronavirus stimulus” bill, was passed by the
Senate on March 25, 2020. The bill would provide between $454 billion and $500 billion to support Fed
liquidity facilities. The bill states that applicable requirements of Section 13(3) shall apply to these
facilities.

Credit outstanding (extended in the form of cash or securities) authorized by Section 13(3) peaked at
$710 billion in November 2008. All credit extended under Section 13(3) during the financial crisis was
repaid with interest. Contrary to popular belief, the Fed earned profits of more than $30 billion and did
not suffer any losses on transactions authorized by Section 13(3). These transactions exposed the taxpayer
to greater risks than traditional discount window lending to banks, however, because in some cases the
terms of the programs had fewer safeguards.

The Fed’s use of Section 13(3) in the 2007-2009 crisis raised fundamental policy issues: Should the Fed
be lender of last resort to banks only, or to all parts of the financial system? Should the Fed lend to firms
that it does not supervise? How much discretion does the Fed need to be able respond to unpredictable
financial crises? How can Congress ensure that taxpayers are not exposed to losses? Do the benefits of
emergency lending outweigh the costs, including moral hazard? How can Congress ensure that Section
13(3) is not used to “bail out” failing firms? Should the Fed tell Congress and the public to whom it has
lent?

The restrictions in Section 13(3) placed few limits on the Fed’s actions in 2008. However, in 2010, the
Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203) added more restrictions to
Section 13(3), attempting to ban future assistance to failing firms while maintaining the Fed’s ability to
create broadly based facilities. The Dodd-Frank Act also required records for actions taken under Section
13(3) to be publicly released with a lag and required the Government Accountability Office (GAO) to
audit those programs. Although Section 13(3) must be used “for the purpose of providing liquidity to the
financial system,” some Members of Congress have expressed interest in—while others have expressed
opposition to—the Fed using Section 13(3) to assist financially struggling entities, including states,
municipalities, and territories of the United States.

Jeb Hensarling, former Chairman of the House Financial Services Committee, contends that “Dodd-Frank
tried but failed to rein in the Fed’s emergency lending authority.” Legislation was passed by the House in
th th
the 114 Congress (H.R. 3189) and 115 Congress (H.R. 10) that would have further limited the Fed’s
authority under Section 13(3). Then-Federal Reserve Chair Janet Yellen contended that such restrictions
would “essentially repeal the Federal Reserve’s remaining ability to act in a crisis.” Current Fed
Chairman Jerome Powell opposed further reducing the Fed’s discretion under Section 13(3) on the
grounds that the Fed needs “to be able to respond flexibly and nimbly” to threats to financial stability.

The financial crisis that began nearly three years ago has caused great hardship for people in many
parts of the world and represented the most profound challenge to central banks since the Great
Depression. Faced with unprecedented financial stresses and sharp contractions in economic
activity, many central banks, including the Federal Reserve, responded with extraordinary measures.
In the United States, we lowered the federal funds rate target to a range of 0 to 1/4 percent to help
mitigate the economic downturn; we expanded the scale, scope, and maturity of our lending to
provide needed liquidity to financial institutions and to address dislocations in financial markets; we
jointly established currency swap lines with foreign central banks (including the Bank of Japan) to
ensure the global availability of dollar funding; and we purchased a large quantity of longer-term
securities to help improve the functioning of financial markets and support economic
recovery.1 Looking to the future, central banks around the world are working with their governments
to prevent future crises by strengthening frameworks for financial regulation and supervision.
In undertaking financial reforms, it is important that we maintain and protect the aspects of central
banking that proved to be strengths during the crisis and that will remain essential to the future
stability and prosperity of the global economy. Chief among these aspects has been the ability of
central banks to make monetary policy decisions based on what is good for the economy in the
longer run, independent of short-term political considerations. Central bankers must be fully
accountable to the public for their decisions, but both theory and experience strongly support the
proposition that insulating monetary policy from short-term political pressures helps foster desirable
macroeconomic outcomes and financial stability.
In my remarks today, I will outline the general case for central bank independence and review the
evolution of the independence of the Federal Reserve and other major central banks. I will also
discuss the requirements of transparency and accountability that must accompany this
independence.
The Case for Central Bank Independence
A broad consensus has emerged among policymakers, academics, and other informed observers
around the world that the goals of monetary policy should be established by the political authorities,
but that the conduct of monetary policy in pursuit of those goals should be free from political
control.2 This conclusion is a consequence of the time frames over which monetary policy has its
effects. To achieve both price stability and maximum sustainable employment, monetary
policymakers must attempt to guide the economy over time toward a growth rate consistent with the
expansion in its underlying productive capacity. Because monetary policy works with lags that can
be substantial, achieving this objective requires that monetary policymakers take a longer-term
perspective when making their decisions. Policymakers in an independent central bank, with a
mandate to achieve the best possible economic outcomes in the longer term, are best able to take
such a perspective.
In contrast, policymakers in a central bank subject to short-term political influence may face
pressures to overstimulate the economy to achieve short-term output and employment gains that
exceed the economy's underlying potential. Such gains may be popular at first, and thus helpful in
an election campaign, but they are not sustainable and soon evaporate, leaving behind only
inflationary pressures that worsen the economy's longer-term prospects. Thus, political interference
in monetary policy can generate undesirable boom-bust cycles that ultimately lead to both a less
stable economy and higher inflation.
Undue political influence on monetary policy decisions can also impair the inflation-fighting credibility
of the central bank, resulting in higher average inflation and, consequently, a less-productive
economy. Central banks regularly commit to maintain low inflation in the longer term; if such a
promise is viewed as credible by the public, then it will tend to be self-fulfilling, as inflation
expectations will be low and households and firms will temper their demands for higher wages and
prices. However, a central bank subject to short-term political influences would likely not be credible
when it promised low inflation, as the public would recognize the risk that monetary policymakers
could be pressured to pursue short-run expansionary policies that would be inconsistent with long-
run price stability. When the central bank is not credible, the public will expect high inflation and,
accordingly, demand more-rapid increases in nominal wages and in prices. Thus, lack of
independence of the central bank can lead to higher inflation and inflation expectations in the longer
run, with no offsetting benefits in terms of greater output or employment. 3 
Additionally, in some situations, a government that controls the central bank may face a strong
temptation to abuse the central bank's money-printing powers to help finance its budget deficit.
Nearly two centuries ago, the economist David Ricardo argued: "It is said that Government could not
be safely entrusted with the power of issuing paper money; that it would most certainly abuse it.…
There would, I confess, be great danger of this, if Government--that is to say, the ministers--were
themselves to be entrusted with the power of issuing paper money." 4 Abuse by the government of
the power to issue money as a means of financing its spending inevitably leads to high inflation and
interest rates and a volatile economy.
These concerns about the effects of political interference on monetary policy are far from being
purely theoretical, having been validated by the experiences of central banks around the world and
throughout history. In particular, careful empirical studies support the view that more-independent
central banks tend to deliver better inflation outcomes than less-independent central banks, without
compromising economic growth.5 In light of all these considerations, it is no mystery why so many
observers have come to see central bank independence as a critical component of a sound
macroeconomic framework, and economists have studied a variety of approaches to enhance the
independence and credibility of monetary policymakers. 6 
To be clear, I am by no means advocating unconditional independence for central banks. First, for its
policy independence to be democratically legitimate, the central bank must be accountable to the
public for its actions. As I have already mentioned, the goals of policy should be set by the
government, not by the central bank itself; and the central bank must regularly demonstrate that it is
appropriately pursuing its mandated goals. Demonstrating its fidelity to its mandate in turn requires
that the central bank be transparent about its economic outlook and policy strategy, as I will discuss
further in a moment. Second, the independence afforded central banks for the making of monetary
policy should not be presumed to extend without qualification to its nonmonetary functions. For
example, many central banks, including the Federal Reserve, have significant responsibilities for
oversight of the banking system. To be effective, bank regulators and supervisors also require an
appropriate degree of independence; in particular, the public must be confident that regulators'
decisions about the soundness of specific institutions are not unduly influenced by political pressures
or lobbying. But for a number of reasons, the nature and scope of the independence granted
regulatory agencies is likely to be somewhat different than that afforded monetary policy. In the
conduct of its regulatory and supervisory activities, the central bank should enjoy a degree of
independence that is no greater and no less than that of other agencies engaged in the same
activities; there should be no "spillover" from monetary policy independence to independence in
other spheres of activity. In practice, the Federal Reserve engages cooperatively with other agencies
of the U.S. government on a wide range of financial and supervisory issues without compromising
the independence of monetary policy.
The case for independence also requires clarity about the range of central bank activities deemed to
fall under the heading of monetary policy. Conventional monetary policy, which involves setting
targets for short-term interest rates or the growth rates of monetary aggregates, clearly qualifies. I
would also include under the heading of monetary policy the central bank's discount-window and
lender-of-last-resort activities. These activities involve the provision of short-term, fully collateralized
loans to the financial system as a means of meeting temporary liquidity needs, reducing market
dysfunctions, or calming financial panics. As has been demonstrated during financial panics for
literally hundreds of years, the ability of central banks to independently undertake such lending
allows for a more rapid and effective response in a crisis. On the other hand, as fiscal decisions are
the province of the executive and the legislature, the case for independent lender-of-last-resort
authority is strongest when the associated fiscal risks are minimal. Requiring that central bank
lending be fully secured, as is the case in the United States, helps to limit its fiscal implications.
Looking forward, the Federal Reserve supports measures that help further clarify the dividing line
between monetary and fiscal responsibilities. Notably, the development of a new statutory
framework for the resolution of failing, systemically important firms is not only highly desirable as a
means of reducing systemic risk, but it will also be useful in establishing the appropriate roles of the
Federal Reserve and other agencies in such resolutions.
The issue of the fiscal-monetary distinction may also arise in the case of the nonconventional policy
known as quantitative easing, in which the central bank provides additional support for the economy
and the financial system by expanding the monetary base, for example, through the purchase of
long-term securities. Rarely employed outside of Japan before the crisis, central banks in a number
of advanced economies have undertaken variants of quantitative easing in recent years as
conventional policies have reached their limits. In the United States, the Federal Reserve has
purchased both Treasury securities and securities guaranteed by government-sponsored
enterprises.
Although quantitative easing, like conventional monetary policy, works by affecting broad financial
conditions, it can have fiscal side effects: increased income, or seigniorage, for the government
when longer-term securities are purchased, and possible capital gains or losses when securities are
sold. Nevertheless, I think there is a good case for granting the central bank independence in
making quantitative easing decisions, just as with other monetary policies. Because the effects of
quantitative easing on growth and inflation are qualitatively similar to those of more conventional
monetary policies, the same concerns about the potentially adverse effects of short-term political
influence on these decisions apply. Indeed, the costs of undue government influence on the central
bank's quantitative easing decisions could be especially large, since such influence might be
tantamount to giving the government the ability to demand the monetization of its debt, an outcome
that should be avoided at all costs.
The Historical Evolution of Central Bank Independence
Support for the idea of central bank independence has evolved over time. In the United States and
many other countries, the historically high and volatile inflation rates in the 1970s and early 1980s
prompted a reexamination of monetary policies and central bank practices. Since that time, we have
observed the confluence of two global trends: the widespread adoption of improved monetary policy
practices and the virtual elimination of high inflation rates. The improved policy practices prominently
include a broad strengthening of central bank independence, increased transparency on the part of
monetary policy committees, and the affirmation of price stability as a mandated goal for monetary
policy. Inflation targeting, in which the government sets a numerical target for inflation but assigns
responsibility for achieving that target to the central bank, has become a widely used framework
embodying these principles, but other similar monetary frameworks have also proved effective.
In recent years, the number of central banks with a relatively high degree of independence has
steadily increased, and the experience of some major central banks testifies to the importance of
that independence. The Bank of England, one of the oldest central banks in the world, was
essentially an agent of the British Treasury for a substantial part of the 20th century. When the
government announced on May 6, 1997, that the Bank of England would be reborn as an
independent central bank, U.K. Treasury bond yields fell sharply at longer maturities, likely reflecting
a substantial decline in investors' inflation expectations and their perceptions of inflation risk.
Moreover, several studies have shown that U.K. inflation expectations exhibited significantly greater
stability in the years following independence. 7 
Prior to the creation of the European Central Bank (ECB) in June1998, independence was seen as
such a crucial element that it was enshrined in the Maastricht Treaty, an international agreement that
can only be changed by unanimous consent of its signatories. The independence of the ECB has
helped to keep euro-area inflation expectations firmly anchored. 8 
The importance of central bank independence also motivated a 1997 revision to Japanese law that
gave the Bank of Japan operational independence. 9 This revision significantly diminished the scope
for the Ministry of Finance to influence central bank decisions, thus strengthening the Bank of
Japan's autonomy in setting monetary policy.
Although the Federal Reserve was established as an independent central bank in 1913, its effective
degree of independence has gradually increased over time. Initially, the Secretary of the Treasury
and the Comptroller of the Currency sat on the Board; they were removed when the current structure
of the Federal Open Market Committee (FOMC) was introduced with the Banking Act of 1935. The
act also extended the terms of Board members from 10 years to 14 years; the long, staggered terms
of Board members have also served as a brake on political influence.
During World War II, the Federal Reserve agreed to peg Treasury yields at low levels to reduce the
cost of financing wartime deficits. After the war, the Fed sought to resume an independent monetary
policy, fearing the inflationary consequences of continued political control, but the Treasury was still
intent on containing the cost of servicing the debt. The conflict was resolved in 1951 through the
negotiation of the Treasury-Federal Reserve Accord, as it came to be known. The accord
reestablished the Federal Reserve's ability to freely set interest rates, but with active consultation
between the Fed and Treasury. It was only by the amendment of the Federal Reserve Act in 1977
that the Fed's current objectives of maximum employment and stable prices were specified by the
Congress.10 A clear mandate of this kind is a key pillar of central bank independence.
Over the years, a consensus developed among U.S. political leaders that the Federal Reserve's
independence in making monetary policy is critical to the nation's prosperity and economic stability.
In 1978, the Congress formally recognized this principle by approving a provision that exempts
monetary policy, discount window operations, and the Fed's interactions with other central banks
from Government Accountability Office policy reviews. In 1979, President Carter appointed Paul
Volcker chairman of the Federal Reserve with the expectation that Volcker would strengthen the
central bank's inflation-fighting credibility, even though those steps would likely involve short-term
economic and political costs. Subsequently, President Reagan's support for Volcker's politically
unpopular disinflationary policies and for the principle of Federal Reserve independence proved
crucial to the ultimate victory over inflation, a victory that set the stage for sustained
growth.11Presidents and other U.S. political leaders have since then regularly testified to the benefits
of an independent Federal Reserve. For instance, President Clinton said in 2000, "[O]ne of the
hallmarks of our economic strategy has been a respect for the independence and the integrity of the
Federal Reserve."12 President Bush noted in 2005, "It's this independence of the Fed that gives
people not only here in America[,] but the world, confidence." 13 And President Obama said in August
2009, "We will continue to maintain a strong and independent Federal Reserve." 14 
Transparency and Accountability
Central bank independence is essential, but, as I have noted, it cannot be unconditional. Democratic
principles demand that, as an agent of the government, a central bank must be accountable in the
pursuit of its mandated goals, responsive to the public and its elected representatives, and
transparent in its policies. Transparency regarding monetary policy in particular not only helps make
central banks more accountable, it also increases the effectiveness of policy. Clarity about the aims
of future policy and about how the central bank likely would react under various economic
circumstances reduces uncertainty and--by helping households and firms anticipate central bank
actions--amplifies the effect of monetary policy on longer-term interest rates. The greater clarity and
reduced uncertainty, in turn, increase the ability of policymakers to influence economic growth and
inflation.15 
Over the years, the Federal Reserve--like many central banks around the world--has taken
significant steps to improve its transparency and accountability. Policymakers give frequent
speeches and testimonies before the Congress on the economic situation and on the prospects for
policy, and the Federal Reserve submits an extensive report to the Congress twice each year on the
economy and monetary policy.16 The FOMC, the Fed's monetary policymaking arm, releases a
statement after each of its meetings that explains the Committee's policy decision and reports the
vote on that decision. The FOMC also publishes the minutes of each meeting just three weeks after
the meeting occurs and provides, with a lag, full meeting transcripts. In addition, the FOMC has
begun providing the public a quarterly summary of Committee participants' forecasts of key
economic variables and, more recently, their assessments of the longer-run values to which these
variables would be expected to converge over time. 17 The information released by the FOMC
provides substantial grist for the activities of legions of "Fed watchers" who analyze all aspects of
monetary policy in great detail.
Apart from traditional monetary policy, the Federal Reserve's response to the financial crisis has
involved a range of new policy measures, about which the Fed has provided extensive information.
For example, the Board has regularly published detailed information about the Federal Reserve's
balance sheet and the special liquidity facilities that were introduced. We created a section on our
website devoted to these issues and initiated a regular monthly report as well. 18 And we are
committed to exploring new ways to enhance the Federal Reserve's transparency without
compromising our mandated monetary policy and financial stability objectives. 19 
Conclusion
As a result of the crisis, countries around the world are implementing significant financial and
regulatory reforms. Such reforms that reduce the chance of a future crisis and that mitigate the
effects of any crisis that does occur are worthy of our full support. As we move along the path of
reform, however, it is crucial that we maintain the ability of central banks to make monetary policy
independently of short-term political influence. In exchange for this independence, central banks
must meet their responsibilities for transparency and accountability. At the Federal Reserve, we will
continue to work to facilitate public understanding of both our monetary policy decisions and our
actions to ensure the soundness of the financial system.