Open market operations, the principal tool of U.S. monetary policy,
was discovered accidentally and was the biggest development in terms
of the Fed's evolution from a passive to an active institution. (Monetary
policy consists of the actions taken by the Fed to influence the availability
and cost of money and credit.) That such an important responsibility
was stumbled upon during the Fed's early years is another indication
of the open-ended nature of the Federal Reserve Actthe idea that
the Federal Reserve System would evolve and adapt as needs arose.
Following World War I the country suffered from an economic slowdown
that had particular severity in agricultural regions. Because of
the slowdown, Federal Reserve district banks were transacting less
business with member banks and hence earning so little funds it
was feared that some banks would not meet their expenses. So, Fed
banks purchased government securities at a great pace through the
first half of 1922 to improve their earnings positions. The money
paid by the Fed banks for the securities was placed by the sellers
in commercial banks, swelling the reserves of banks across the nation.
Soon, Fed officials realized that by purchasing securities on the
open market, Federal Reserve Banks could affect general credit conditions
across the country. In other words, when the Fed bought securities it
increased commercial bank reserves and eased credit; the opposite applied
when the Fed sold securities. Open market operations, the Fed's primary
tool in implementing monetary policy, was born. By May 1922 a committee
was established to coordinate investment policy through a centralized
locationthe Federal Reserve Bank of New Yorkand by the following
year the Open Market Investment Committee for the Federal Reserve System
(OMIC) was formed.
The Banking Acts of 1933 and 1935 established the Federal Open Market
Committee (FOMC) to replace the OMIC, and the FOMC came to be the most
powerful policymaking body of the Federal Reserve System. Twelve voting
members make up the FOMC: five presidents of Federal Reserve Banks (members
rotate annually among the Reserve Banks, with the president of the New
York Fed retaining a permanent seat) and the seven members of the board
of governors, who make up a voting majority.
With the establishment of the FOMC less than 25 years after its own
formation, the Federal Reserve System had evolved beyond its founders'
furthest expectations: from its beginnings as essentially a "banker's
bank" to one of its most important functionsestablishing the nation's
monetary policy. In 1978 the board of governors was required under the
Humphrey-Hawkins Act to report to Congress twice a year on the objectives
and plans of the board and the FOMC with respect to monetary policy.
Those objectives were addressed in a broad sense, by Paul Volcker, chairman
of the Board of Governors, in a speech he gave in 1984:
Industrial nations, including our own, nowadays rely heavilysometimes
too heavilyon their central banks and on monetary policy to
achieve our economic goals: to promote growth and employment, to blunt
the forces of inflation, and to maintain financial stability. At times,
the pursuit of those objectives requires speed and flexibility in
decision-making, and that flexibility is one of the virtues of monetary
and credit policy. But through the necessary process of adaptation
and change runs another, more constant, threatthe need for a
sense of discipline. In the broadest sense, all of economics—I
am tempted to say all of lifeteaches us that our collective
desires always exceed the means to achieve them. And history has taught
us, again and again, that the creation of money is no substitute for
productivity, for savings, and for investment in enlarging our economic
welfare. Yet the temptation is always there to trywith the ultimate
result of destructive inflation that, in the end, only undermines
In addition to open market operations, the Federal Reserve can determine
monetary policy in two other ways: by changing reserve requirements
and through the discount rate level. Reserve requirements are the percentage
of deposits that financial institutions are required to maintain against
deposits. Changing reserve requirements is a hard-hitting measure and
is seldom used. In the past those reserve requirements only applied
to certain accounts in some commercial banks, but the Depository Institutions
Deregulation and Monetary Control Act of 1980 extended reserve requirements
to all depository institutions.
Finally, the third tool of monetary policy is the discount ratethe
rate the Fed charges to lend money to financial institutions. When a
Federal Reserve Bank lends money in its region there is an increase
in reserves. A change in the discount rate, which is approved by the
board of governors following recommendation by the district banks, is
sometimes used as an indication of monetary policy.
The Fed's involvement in monetary policy through the years has gradually
spawned its role as a center for economic research. Research departments
grew over the years at the board of governors and within each district
bank as a means to study the Fed's involvement in the economy and thereby
improve its performance, and also to examine other economic issues.
The research departments of district banks are generally representative,
ideologically, of the bank's current president. In other words, given
the interest of a particular president, a bank mad be led to research
certain theories or investigate certain problems. The notion of the
Fed as an active member of the economic research society is a recent
development in terms of the central bank's history and is becoming one
of the chief ways for district banks to develop their own personality.
The Federal Reserve System earns income, for
the most part, from holdings of U.S. government securities acquired
through open market operations, with the remainder coming from
holdings of foreign currencies, loans to depository institutions
and fees charged for services provided to depository financial
In 1987 the Fed returned $17.7 billion, or 91 percent of its
$19.4 billion gross earnings, to the United States government,
of which $285 million was contributed by the Minneapolis Fed.
The Fed paid $1.1 billion in operating expenses for the 12 Federal
Reserve Banks and their branches$62 million for the Minneapolis
Fed$82 million in expenses for the board of governors and
$171 million for the cost of currency.
Also, the Fed paid $117 million in six-percent dividends
to its member banks (required by law) and put $174 million
in its surplus account.
Minneapolis Fed President Gary Stern wrote in the bank's 1985 annual report of the unique
role of the Federal Reserve System as a policymaker.
"The situation of a U.S. policymaker is not easy in any year.
The Fed has a somewhat vague general objective of maximizing the
current and future welfare of society, which all public policy
institutions share. Congress has translated that into a few broad
operating goalsstable prices, high employment, and economic
growth, for examplebut these are not necessarily compatible
goals, the Fed has no direct control over them, and they are measured
"What's a policymaker to do? The Fed does what economic theory
says is best for a decision-maker in this situation: It uses all
the information available at each point in time to move as close
as possible to its broad goals. This means not targeting anything
except those goals...
"Targeting in this context means just what one might guess:
aiming to hit particular values..."