–– Knut Wicksell, 1935

THE Federal Reserve began operations in 1914 as a peculiar hybrid, a partly public, partly private institution, intended to be independent of political influence, with principal officers of the Government on its supervisory board, endowed with central banking functions, but not a central bank.

Each of the 12 semi- autonomous reserve banks set its own discount rates, subject to the approval of the Federal Reserve Board in Washington, made its own policy decisions, and set its own standards for what was eligible for discounting. Even branches of reserve banks initially had some independent powers.

The new system had two principal monetary powers. It could buy and sell gold, thereby changing interest rates and money, and it could set the rate at which member banks discounted eligible paper. Other activities and responsibilities included centralising the country’s gold reserve, developing a domestic market for bills of exchange, acting as lender of last resort in a crisis, and eliminating large seasonal increases in interest rates during the autumn, when the agricultural harvest moved through the commodity markets.

The Federal Reserve had little discretion. The founders intended the gold standard to work automatically. Discounting was at the discretion of the member banks. The Federal Reserve could decide the timing of discount rate changes, but the rules of the gold standard limited the range within which it could set the discount rate. It could set the rate at which it bought acceptances, but despite its efforts, the acceptance market did not become large and active.

The original structure, organisation and methods of operation did not survive. Establishment of the Federal Reserve helped to create a national financial market that undermined the system of separate discount rates. Banks used the correspondent banking system to borrow in markets with lower rates. By the early 1920s, the system had moved toward more uniform discount rates; although differences between districts continued, they were smaller, and rate schedules became more uniform.

Wars, the growing role of the Federal Government, and other external forces contributed to the major changes in structure. Flaws in the original plan and different conceptions about the roles and responsibilities of the Board and the reserve banks combined with these external events to force changes. Different beliefs about the roles of the reserve banks and the Board, and rivalry over power and influence, worked to delay change and disperse power.

By 1951 the Federal Reserve System had become a central bank with its headquarters in Washington. The accord with the Treasury in March of that year released the Federal Reserve from Treasury control and began the evolution toward the modern Federal Reserve. Although struggles over power and influence continued, the Board of Governors had final control over decisions.

The semi-autonomous regional banks were now part of a unified system. The Federal Open Market Committee (FOMC) made binding portfolio decisions for the reserve banks. Open market purchases and sales of government securities replaced discounting as the principal means of implementing policy. The discount rate had a minor role.

The system’s founders would not have liked or even recognised the Federal Reserve that existed in 1951. Gold no longer had an important role. Activist policies, based on collective judgment, determined money interest rates and prices. A small, mostly passive institution had become the most important central bank in the world.

The Federal Reserve’s founders wanted to base currency or note issue on discounts of commercial paper to free currency from dependence on government securities. They believed that the new arrangement would permit currency and money to expand and contract with the needs of trade and the public’s demand.

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