 Ask
Dr. Econ
December 2004
Why do we need a central bank like the Fed when the laws
of supply and demand will keep everything working perfectly?
Yours is a question I wish more people would ask! As the U.S. central
bank, the Fed plays several important roles in the U.S. economy that
are not always visible to the public, though they directly and indirectly
affect participants in many financial transactions—which means
everyone at some point or another! Occasionally, however, the roles of
the Fed become more obvious. Although such events occur rarely, the Fed’s
actions have played a very important role stabilizing the economic and
financial system following various shocks to the economy:
- After the failure of Continental Illinois National Bank,
one of the country’s biggest banks, in 1984, the Fed prevented
smaller banks with deposits at the large institution from being jeopardized
by
temporarily loaning $5 billion to Continental Illinois.
- During the stock market crash of 1987, when the market
plunged more than 20 percent, the Fed provided liquidity to help stabilize
financial markets.
- Following the default of the Russian ruble in 1998, which
caused the Russian government to halt payments on its foreign debt,
the Fed lowered
short-term interest rates to help alleviate turbulence caused to
the U.S. and international economies.
More recently, the financial system as a whole faced significant disruptions
after the September 11, 2001, terrorist attacks in New York and Washington
D.C. While this tragic day remains poignant in our memories for reasons
beyond economics, the impact on the financial system serves to illustrate
the Federal Reserve’s critical role keeping the U.S. financial
and economic systems open and operating.
In the beginning
When the Fed was created by Congress in 1913, its primary purpose was
to ensure and safeguard against bank “panics,” episodes
when depositors raced to their banks to withdraw their funds because
they feared that the bank might become insolvent. One of the responsibilities
of the new central bank was to act as “lender of last resort” to
banks during difficult financial times and/or problems with liquidity,
or availability of money. The Fed’s responsibilities have since
broadened to fostering a sound banking and economic system through
the avenues of:
- Cash, check processing, and electronic transfer services,
- Banking regulation and supervision, and
- Monetary policy.
As you pointed out, the U.S. economy relies on market forces to provide
price signals that help producers and consumers adjust the supply and
demand for goods and services. Ultimately, we believe this process leads
to the efficient allocation of resources—they are directed to where
they are most highly valued. The United States is fortunate to have a
relatively well functioning and stable economic and financial system.
However, when rare market disturbances or financial shocks occur, this
stability may no longer be taken for granted and the importance of a
central bank that can respond to the situation becomes very apparent.
Market disturbances
To see how a so-called “market disturbance” could affect
you directly, try asking yourself: What would happen if you weren’t
able to access the cash in your banking account? What if you could not
access your funds through a local ATM, or you couldn’t cash a check
because the bank was short of funds? How would that affect you and your
family, especially if you needed to purchase food or other necessities
right away? How would businesses respond if they were unable to access
their funds to pay for supplies or to receive payments from their customers?
Now imagine what would happen if such an event affected a significant
part of the U.S. economy and how it might disrupt commerce and the financial
system.
Fed actions to support the financial system
On September 11, the Federal Reserve took action to retain public confidence
in the financial system when it issued a statement that the Fed was “open
and operating”—given the magnitude of the disruptions it
is uncertain whether a system without a flexible central bank would
have been able to respond to the extent that the U.S. economy did.
The Fed acted within its three primary functions:
- Keeping the Payments System running. For example, nationally,
the Fed ensured the check-processing system was operational by continuing
to
make payments to banks receiving funds, even though the Fed was
unable to collect from the banks making the payments because the air
transport
system used to move checks was shut down. Locally, in New York
City the Fed delivered more than 425 million dollars in cash to banks
located
near the attacks so that they would have funds in the event that
they faced increased precautionary demand for cash.
- Acting within its Banking Supervision and Regulation role.
The Fed made it easier for banks to obtain overnight loans through
its discount window,
and thus have enough cash on hand for their customers. It accomplished
this by lending a record 46 billion dollars to banks through the
discount window on September 12 (compared to a 2001 daily average of
only 54 million!).
- Using Monetary Policy and the target federal funds interest
rate to provide liquidity to the banking system:
- The Federal Open Market Committee (FOMC) held an emergency
meeting on September 17 to lower the overnight fed funds rate one-half
of a percentage point, to provide liquidity to the banking system
and
avoid
shortages
or liquidity problems that could disrupt commerce.
- The Fed pumped cash into the financial system. The Fed bought
$38 billion, 70 billion, and 81 billion in U.S. Treasury securities
on September
12,
13, and 14, respectively, infusing the economy with cash—on
a normal day in 2001, Fed purchases of Treasury securities
ranged from only $2
to 8 billion.
Liquidity was critical
In short, the Fed ensured the economy had ample liquidity to keep the
economic system moving and to minimize financial disturbances created
by the disrupted operations of some New York banks and closure of the
transportation system for clearing checks across the country.
The Fed’s actions helped maintain the confidence of financial
institutions and their customers that banks would continue to operate
despite the disruptions. Financial markets were fully functional when
they reopened on September 17, after a four-day closure, yielding the
largest trading volume ever on the New York Stock Exchange in a single
day—this could not have been achieved without the liquidity provided
by the Federal Reserve.
Open and operating
How the Fed used its central bank functions to stabilize the financial
system and the economy during and after the events of September 11
is an important concept to both the Fed and its constituents—so
important, in fact, that the Federal Reserve Bank of San Francisco
developed an instructional video on this topic entitled, Open
and Operating: The Federal Reserve Responds to September 11.
Open and Operating features interviews
with Federal Reserve executives who provide first-hand accounts
of the events of that day, and explores
what the Fed did to ensure that cash was available to consumers who
needed it and checks were processed even though no planes were allowed
to fly.
The video also looks at how the Fed worked with commercial banks that
wanted to borrow from the Fed’s discount window. Lastly, it traces
and explains the monetary policy decisions the FOMC made in response
to the events of September 11.
The Open and Operating video and full classroom curriculum
is available now—check the “Fed Educational Resources” page
for additional details. In the meantime, kudos for asking this
question—we hope
this shows the important role a central bank can play in stabilizing
the financial system, and ultimately the economy, in an extreme event!
For other examples of when the Fed stepped in to
help avert financial crises, see, “The
Federal Reserve Responds to Crises: September 11th Was Not the First,” by
Christopher J. Neely, Federal Reserve Bank of St. Louis Review (March/April
2004)
McAndrews, James J. and Potter, Simon M. (2002). “Liquidity
Effects of the Events of September 11, 2001.” Federal Reserve
Bank of New York, Economic Policy Review Executive Summary, November
2002.
Neely, Christopher J. (2002). “The
Federal Reserve’s Response
To the September 11 Attacks.” Federal Reserve Bank of St.
Louis, Regional Economist, January 2002.
Parry, Robert T. (2001). “The
U.S. Economy after September 11.”
Federal Reserve Bank of San Francisco, Economic Letter, December 2001.
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