How is the Fed’s structure, determined more than 100 years ago, helpful in tackling financial issues of today?
As appeared in the Cleveland Fed Digest’s Ask the Expert
When the Federal Reserve was set up after the banking panic of 1907, there were two things that drove its regional structure. First, the country was not thought of as a completely integrated economy or financial structure. The East Coast was industrial with large established banks, the Midwest was a rapidly developing industrial area, and the West was agricultural, and so part of the reason for the Fed’s being structured with 12 regional Reserve Banks was to account for differences in the regions. Regional Reserve Banks would know what was going on in their regions, and if banks wanted to borrow from the Fed, regional Reserve Banks would be better able to judge the creditworthiness of borrowers.
A lack of trust is the second factor that drove the Fed’s structure. The large eastern banks were financing the corporate mergers of the day by assisting companies with bond and stock sales. This exposed them to the stock market. The small, traditional, western banks viewed such activity as risky, and the larger, western banks were worried about government, hence political, involvement in banking. None wanted a structure dominated by any one stakeholder. Many worried if they had a system that was centralized, as opposed to the regional structure, the large eastern banks or political factions could dominate the system, practically speaking. People wanted the local, regional touch.
That said, people in both political parties, worried about the corporate consolidation and formation of large trust companies of the day, wanted more federal regulation, so that influenced the establishment in tandem of the Fed’s Board of Governors and having the president of the United States recommend governors that the Senate must approve.
The benefits of the Fed’s regional structure are as relevant today as they were decades ago.
Most standard economic data comes out with a lag: For example, you don’t know what the country’s gross domestic product (GDP) is until at least a month after a quarter is over. Economic information gathered regionally by the Reserve Banks gives the Fed a more real-time heads up about what’s going on. Bank leaders get out and talk with community constituents, and Banks also learn from their boards of directors, which are comprised of business and community leaders in the regions they serve. It’s anecdotal stuff, but if you get enough people telling you companies are laying people off, and it’s showing up in, say, the Fed’s Fifth District and its Twelfth District, you know something’s going on. The Banks bring this information to the Federal Open Market Committee (FOMC), which decides monetary policy such as interest rates.
Another reason the regional structure remains helpful is that the Reserve Banks compete for ideas. If the Fed were centralized and all its people worked in the same buildings and thought alike, you could have this monolithic structure, and in a monolithic structure it’s sometimes hard for new ideas to see the light of day. Across the Fed’s 12 Districts, new ideas can—and do—start in different places. For example, with the Great Inflation of the 1970s, the Cleveland Fed was one of the first banks to start talking about the Fed’s having a price-level target, aimed in the early 1980s at near zero-inflation. And the idea that a median price index could give a better measure of what inflation is doing because it removes certain price shocks also came from this Bank and ignited interest throughout the System. All regional Banks present ideas that either are rejected or accepted by the whole Federal Reserve System, and that’s a good thing.
Finally, if you have 12 Reserve Banks, it’s harder for a politician or a political movement to influence 12 regional, semiautonomous Banks. It’s easier to influence a monolithic structure. So to some extent, the regional banks reduce the chances of political influence over monetary policy decisions.