One hundred years ago today President Wilson signed the Federal Reserve Act, thus creating the Federal Reserve System, our central bank. It wasn’t called the Bank of the United States, following the lead of the Bank of England, and it wasn’t called the Central Bank of the United States. Why such an odd name, the “Federal Reserve” System?
The Federal Reserve System was the result of a series of financial panics, most notably the Panic of 1907. Following that panic, a national monetary system was created to study the financial system and recommend measures to deal with such panics and provide stability to the banking system.
A primary cause of the banking problems was the practice of banks keeping their “reserve deposits” with other banks so that when they were withdrawn the other banks felt the shortage as well. In good old money and banking fashion, let’s assume that Bank A kept some deposits in Bank B, which kept some deposits in Bank C, and so on. If all the banks were substantially loaned up and one or more banks needed cash for some reason, their deposit withdrawals would trigger a need for other banks to withdraw deposits, and so on. Thus a reserve shortage, or just a need for more reserves, was a difficult matter. One bank could get reserve deposits back in cash, including gold, but only at the expense of other banks. The system worked when it worked, but any unusual, even seasonal, demand for cash would ripple through the system.
The authors of the Federal Reserve Act found a fairly simple solution. Instead of banks keeping what they regarded as their reserve deposits with each other, have them keep their reserve deposits with a central federal bank called Federal Reserve Banks. Thus the primary function of the new central bank was to consolidate the reserves of the banking system. When individual banks needed reserves, that need would not impact other banks. In fact, the Federal Reserve banks were given the authority to make very short-term liquid loans to commercial banks to make the reserves of the banking system more “elastic,” in that the total reserves of the banking system could expand under stress and then contract as the loans were paid off.
The primary way banks borrowed from the Federal Reserve Banks at first was to discount some of their own short-term commercial or agricultural paper. Since those were already called “discounts” they discounted the discounts at a rate called the “rediscount rate.” Later, as bank credit morphed away from discounts, the rediscount rate was shortened to the discount rate.
The Federal Reserve Banks could encourage or discourage commercial banks from using the “discount window” by lowering or raising the discount rate. Banks could still borrow from each other or from the Federal Reserve. When they borrowed from each other, no new reserves were created; they were just shifted from one bank to another in the system. But when banks borrowed from the Federal Reserve Banks, new reserves were created, and distinguished with the loans were repaid.
The above describes elasticity in the reserve base of the banking system. To the extent that the need to borrow resulted from cash withdrawals from some banks, the discount window borrowing provided elasticity to deposits and money as well. This elasticity meant that when the public needed more cash for seasonal or other reasons, it could be provided without causing a general shortage of bank reserves.
It was recognized that bank borrowing from the Fed increased the total of money and credit, but, since the borrowing was based on very short-term highly liquid commercial or agricultural paper, it was thought that the new money being created was matched by new goods being created. Therefore, it would not be inflationary. This was called the “commercial loan theory” or the “real bills doctrine.” If only real bills are discounted they are matched by real goods.
Anyway, I’m getting too far afield. My main point here is simply to explain the origins of the weird name given to our beloved central bank.
