Why do we need a central bank like the Fed when the laws of supply and demand will keep everything working perfectly?

December 1, 2004

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:

  1. Cash, check processing, and electronic transfer services,
  2. Banking regulation and supervision, and
  3. 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 instr
uctional 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!

Additional Reading

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.