Learning the job: a central bank evolves

Excerpt from Reflections from History:
The Minneapolis Federal Reserve Bank

Clarence W. Nelson
February 1973

The most vital aspect of the Minneapolis Bank's story is, to some, the attrition of early notions about the nature of a Reserve Bank, its functions and its control. Through a series of changes in practice and in law the Minneapolis Federal Reserve Bank was transformed from a presumably “autonomous regional reserve bank” into an integral part of the larger central bank of the United States.

It was a “quick” evolution. The three main elements of the System's initial architecture described earlier had been all but abandoned by the time the Minneapolis Bank moved into its new building in 1925. (These three original principles, you will recall, were (1) the autonomy of the Reserve Bank, (2) the private control of Reserve Bank policy through banker-elected directors, and (3) the automatic regulation of Reserve credit through the discounting of commercial paper by member banks.)

The decline of these concepts began very soon after the launching of the System. The first step, probably, was a 1916 Congressional amendment that drove an opening wedge between Reserve Bank credit on the one hand and self-liquidating commercial transactions (real bills) on the other; the amendment permitted Reserve Banks to make advances to member banks secured by U.S. government securities. Needless to say, the drama of abandonment of Original Doctrine was in large measure enacted upon a national stage. A few incidents from the history of the Minneapolis Bank, however, will help illustrate some of the change that occurred.

The reign of not-quite-autonomy (1914-1923)

The idea of autonomy was logically the first to go. For one thing, regional independence was compromised in the Act itself by the provision for a central supervisory body. For another, the Banks' managements recognized early that some form of “coordination” of policy was necessitated by the essentially national rather than regional character of money and credit markets.

Since centralized policy control would inevitably emphasize the position of the government-appointed Federal Reserve Board, while regional policy control would emphasize the position of the privately-elected majority of directors at the Reserve Banks, the matter of autonomy was closely linked to the matter of control. Prevailing opinion at the time of the Act, of course, tended to stress the private character of the individual Federal Reserve Banks. On this issue John Rich's views were somewhat unorthodox:

I personally prefer the wiping out of all of the paid-in capital. This is objected to on the theory that reserve banks would then be government banks. I had supposed that they are now, and have always been, government banks...

Direct coordination of System policy was attempted several times by the governors themselves. From the outset efforts to “organize” the statutory pluralism were made under the leadership of Governor Benjamin Strong of the Federal Reserve Bank of New York via the periodic Governors' Conferences. Such arrangements were consistently opposed by the Federal Reserve Board, partly because any combination of governors might seem a threat to the Board's supervisory authority, but also because any organization for unity of action conflicted with the still-official viewpoint disavowing all taint of centralization of policy-making.

The official position was clear: with the exception of setting up eligibility rules for commercial paper (which is reserved to the Board), policy initiative lay with the Federal Reserve Bank of Minneapolis and its sister banks, each operating within its own region. Emphasis on private control, obviously interwoven with the principle of regional autonomy, was also stressed.

A movement away from this early view of credit policy was to arise unexpectedly out of the exercise of powers granted to the individual Reserve Banks. From the beginning monetary policy prerogatives granted the Minneapolis Federal Reserve Bank were delegated to the executive committee, under the supervision and control of the board of directors. Four powers pertaining to credit control were tersely summarized in the Minneapolis Bank's by-laws as follows:

  1. To pass upon all commercial paper submitted for rediscount.
  2. To initiate and conduct open-market transactions.
  3. To fix the discount rate from time to time with the approval of a majority of the Board of Directors.
  4. To buy and sell securities...

The full significance of the above powers was not known to the banks at the time they were written, and indeed remained undiscovered until as late as 1922. During the first several years, the banks proceeded under these powers to apply the then limited concepts of monetary policy within the framework of regional independence. Powers (a) and (C) were considered the heart of the Bank's policy-making endeavors under the automatic regulatory mechanism of the Real Bills Doctrine.

Each Bank was empowered to conduct independent purchases and sales of trade acceptances and US government securities in the open market for its own account as indicated by (b) and (d), but these powers were initially rather unimportant. The Minneapolis “Fed” (like some of the other Reserve Banks) was especially concerned in the early years with the problem of earnings, and particularly with the problem of earning enough to cover dividends on the member banks' stockholdings. Holdings of government securities or other assets purchased at the Bank's initiative for its own portfolio were considered mainly a way to bolster earnings if and when rediscounts—the Bank's major source of earnings—were too low.

As John Rich explained the Minneapolis Bank's viewpoint to the Third Conference of Federal Reserve Agents in 1916, “... We do not want bonds for a permanent investment. The only incentive was to get some revenue...”

But out of these presumably minor provisions, (b) and (d), was to come the Federal Reserve's major policy instrument.

The Open Market episode and the era of vestigial autonomy (1923-1935)

In consequence of war finance programs, the Minneapolis Bank held some government securities during the period 1919-1921, and from these it secured some earnings. Rediscounts for member banks, however, formed the bulk of the Bank's earning assets. During the year 1920, for instance, the Minneapolis “Fed” averaged better than $80,000,000 in discounts outstanding, while its holdings of government securities averaged only about $8,000,000. From this portfolio the Minneapolis “Fed” derived earnings of $5,300,000, which was substantially more than its expenses of $1,000,000.

By late 1920, however, the postwar depression had begun to change the earnings picture greatly. Decline of agriculture and commerce coupled with continued gold inflow from Europe, caused a substantial reduction in credit pressures on commercial banks. This drop, in turn, was reflected in a rapid decline in rediscounts at the “Feds” from late 1920 through early 1922.

Discounts at the Minneapolis Bank had dropped by early 1922 to a mere third of their peak figure of late 1920. By the end of January 1922, it appeared that the Minneapolis Bank's monthly gross earnings soon might not cover current expenses. So, like some of the other “Feds,” the Minneapolis Bank decided to act on its own, specifically by adding to its holdings of US government securities in order to protect its earnings position. During the last week in February and the first week in March 1922, the Bank made its first large purchases—about $5,000,000 worth (thereby doubling its portfolio of government securities). Purchases continued through March and April, until the Minneapolis holdings rose to about $14,000,000. Other banks bought, too, and for the same reason. In all, between January and May 1922, hundreds of millions of dollars worth of securities were purchased. During this splurge of buying, in the competition for securities in the New York money market, individual Federal Reserve Banks even occasionally outbid the New York Federal Reserve Bank (which handled purchases for some of them) and the US Treasury Department.

The disruptive effects on the securities markets of these uncoordinated purchases by independently operating Federal Reserve Banks rang a warning bell. Moreover, it soon became apparent that efforts to bolster earnings via purchase of government securities tended to be self defeating.

This fact-of-life, all very logical in retrospect, was seemingly unforeseen in the early years. As the Federal Reserve Banks bought securities from private holders, the money paid for them was lodged by the sellers in commercial banks, which in turn took advantage of their improved reserve positions to pay off their debts to the “Feds.” So, as the Reserve Banks piled up securities in their collective portfolios, member banks paid down their rediscounts. This being so, Federal Reserve earnings were on a treadmill.

The earnings revelation was not nearly so important, however, as an unexpected finding that accompanied it—the discovery that such “open market operations” were a powerful force for easing or tightening of general credit conditions, a force that could be deliberately introduced into the central money markets, and would spread very quickly to all corners of the country.

At the Governors' Conference on May 6, 1922 the problem of coordinating purchases was discussed, and a special committee under the chairmanship of Governor Strong of New York was appointed, the “Committee on Centralized Execution of Purchases and Sales of Government Securities by Federal Reserve Banks.” While it did no more at that point than coordinate and channel purchases and sales of the separate Federal Reserve Banks through the single agency of the New York Federal Reserve Bank, it set the stage for an era of more centralized policy-making.

In October 1922 the special committee, after stressing to the Governors' Conference the power of Federal Reserve Bank investment policy on the money market, suggested that the committee ought to take on an “advisory”function. But the governors' initiative in moving to meet the now-recognized need for coordinated investment policy was soon brought under supervision by the Federal Reserve Board.

In March 1923 the Board dissolved the “committee-with- the-long-name” (much to the consternation of the governors) and set up, under the general supervision of the Federal Reserve Board, a new committee, the “Open Market Investment Committee for the Federal Reserve System.” The OMIC was designed to recommend plans for the purchase, sale, and distribution of securities for the System.

Note that these decisions, accomplished within roughly a year, effectively put an end to the idea of regional policy autonomy. In short, powers (b) and (d) referred to earlier were simply removed from the province of regional boards of directors.

Rediscount policy remained, of course, in the hands of the directors of the Reserve Banks. But its stature as an instrument of Federal Reserve credit policy was greatly reduced because the Real Bills Doctrine, on which its credibility rested, was also vitiated by the 1922-1923 revelations. It had become obvious from experience that extension of Reserve Bank credit based on rediscounting of commercial paper did not automatically produce the correct amount of commercial bank credit, guarantee its use in productive channels, or automatically cause its extinction as soon as legitimate commercial needs subsided. The realization that neither real bills nor the gold standard could function properly as a basis for Reserve credit was recorded in the Federal Reserve Board's Annual Report for 1923:

There are no automatic devices or detectors for determining, when credit is granted by a Federal Reserve Bank in response to a rediscount demand, whether the occasion of the rediscount was an extension of credit by the member bank for nonproductive use... A farmers' note may be offered for rediscount by a member bank when in fact the need for rediscounting has arisen because of extensions of credit by the member bank for speculative use...

In reference to the international gold standard, the Report stated:

...Under the present conditions, with gold embargoes in force in most foreign countries and the United States practically the only free gold market of the world, the movement of gold to this country does not reflect the relative position of the money markets nor does the movement give rise to corrective influences...

With this realization, “automaticity” was dead—to all practical effects—and the System entered a new policy era in which the key word was “judgment”:

... In its ultimate analysis credit administration is not a matter of mechanical rules, but is and must be a matter of judgment—of judgment concerning each specific credit situation at the particular moment of time when it has arisen or is developing.

Henceforth, if the “correct” amount of credit was to be supplied, the monetary authorities would have to (1) use judgment to determine credit conditions appropriate to each economic situation, and 12) actively employ their available policy implements to achieve the chosen degree of credit tightness or ease. Of the available policy implements, investment policy was easily the most direct and manageable. System investment policy became the primary instrument of credit control, while the setting of discount rates by the banks became, for the most part, a secondary technical adjustment dictated by Federal Reserve investment policy.

Thus, by April 9, 1923, when the Federal Reserve Bank of Minneapolis was laying the cornerstone for its permanent home, the Federal Reserve System almost simultaneously was laying the cornerstone for a modern monetary policy.

In the course of its first decade the Federal Reserve had (1) substantially replaced the original doctrine of regional autonomy; (2) correspondingly strengthened “public” control (represented by the Federal Reserve Board) over “private” control (represented by boards of directors of the banks); and (3) essentially scrapped the notion of automatic or passive credit regulation.

The broad pattern of the first decade, in a nutshell, was this: Out of the considered efforts to correct flaws of original design revealed through early experience, a central bank—in fact though not yet in form—was forced to evolve. The evolution would continue in the ensuing decades, yet the System would retain the stamp of its lineage. The central bank developed to serve the United States is unlike any other central bank and has drawn from the period of its founding a distinctive character that has perhaps supplied one of its greatest elements of strength: decision-making is centralized, but it is strongly and specifically tempered by regional representation.

Depression, crisis, depression, reform

The second ten years of the Federal Reserve Bank of Minneapolis were as fraught with economic difficulties as one could imagine. Most of the nation recovered from the collapse of the early twenties, and rode it out till 1929 in a faltering prosperity. But in the agriculture-dominated Ninth District the farm depression lingered on and on. In consequence, financial problems became especially intense in the Northwest. Bank failures mounted. During the period 1923-1927 more than 1,160 Ninth District banks failed, representing nearly a third of all bank suspensions in the entire United States during that period.

The district had never really climbed out of the trough of the twenties by the time the stock market crash of 1929 signaled the beginning of the most severe and prolonged depression of modern times, complete with financial panic and a “Bank Holiday.” Something had gone wrong, terribly wrong, and even the Federal Reserve System had been unable to prevent money panic under the conditions of 1933. Following the panic economic reform became the nation's number one item of business, including reform of the defects in the Federal Reserve. As a result, several important reform bills affecting the Federal Reserve were passed by Congress, beginning with emergency measures in the Glass-Steagall Act of 1932, continuing through a series of banking acts in 1933 and 1934, and culminating in the Banking Act of 1935.

The Banking Act of 1935: Congress redraws the blueprint

With the Banking Act of 1935, Congress formally cast aside the three elements of the original design. To summarize the accomplishments in brief, Congress

(1) centralized policy-making under the substantial control of a single System body, (2) clearly established public or governmental sponsorship of the central decision-making body, and (3) broke finally and completely with the Real Bills Doctrine by providing that Federal Reserve Banks could make advances to member banks secured by government securities, or, under emergency conditions, any paper—including stocks—“acceptable” to the Federal Reserve Bank.

Further, the International Gold Standard, which had been defunct as an arrangement between nations since World War I, was officially discarded by Congress for the domestic economy in 1934. Thus both features of the earlier notion of an automatic credit mechanism were formally scrapped.

Along with its redefined role, the Federal Reserve Board got a new name: it became the Board of Governors of the Federal Reserve System. Symbolic of this shift of statutory control, the title “governor” was no longer used to designate the operating executive at the individual Reserve Bank. The number of appointive governors on the Board was increased to seven from the previous six, all appointed by the President with Senate approval, while the two ex officio members (Secretary of the Treasury and Comptroller of Currency) were removed from the Board.

In addition, the Open Market Investment Committee, established in 1923 as a necessary outgrowth of Federal Reserve efforts to administer the original Act, but not mentioned in the Act, was given a statutory recognition through express creation of a Federal Open Market Committee. The FOMC was to be made up of twelve members: five heads of Federal Reserve Banks as before, plus the seven members of the Board of Governors, who thus formed a voting majority. Further, the Board of Governors was given additional power over discount rates by a provision requiring each bank to establish rates every fourteen days or oftener if deemed necessary by the Board (the original act left the timing of changes up to individual banks). The Board also received power to approve (or disapprove) appointment and salaries of executive heads of the individual Federal Reserve Banks. These and other policy powers placed in the hands of the Federal Reserve Board by Congress make it clear that the System had been officially redesigned before it was even twenty-five years old.

Reflections on a theme

We have seen that the Minneapolis Federal Reserve Bank, along with other Federal Reserve Banks, seemed very different at the outset from what it turned out to be. And most of the changes in the new direction took place during its first twenty-five years.

Now we can well ask: what is the Federal Reserve Bank of Minneapolis today? Obviously it is not an autonomous regional reserve bank, for if we have learned anything, it is that regional autonomy is a thing of the past. But to say that the Bank is simply a “branch” of the central bank would also be wrong, for it is something more than this. Perhaps the Federal Reserve Bank of Minneapolis is best viewed as one integral part of the nation's central bank. The Bank's president, in fact, participates in the System's highest monetary policy deliberations. In contributing a “regional voice” to the decision-making process, he draws upon information and views provided by the Bank's professional staff and its directors representing, in turn, member banks and the borrowing public.

Certainly the Minneapolis Bank's ability to serve the Ninth District has been strengthened by the centralization that has occurred. Yet it is probably also true that the Federal Reserve System's ability to serve the national economy has been strengthened by the traces of regionalism retained within its structure.