Fed Operating Mechanisms

Michael Kendall August 20, 2016 2 Comments

Despite its present day seeming omnipotent power, the Fed still retains only one significant economic lever.¹  This has been true since the Fed’s creation in 1913.  The Fed can create base money or remove it.  The Fed has complete, total control over the formation and removal of base money.  Base money is cash and reserves, the non-interest bearing debt of the U.S., and the foundation upon which the pyramid of credit—contracts denominated in dollars—is built.  Base money can be thought of as the lubricant for the economic machinery that runs the economy—contracts, production, services, investment, etc.  Too much lubricant and the machinery runs too fast and begins to overheat; too little lubricant and the machinery begins to grind at less efficiency.  The Fed creates base money out of thin air with an accounting ledger and when it removes base money, the accounting disappears.  Over time with advances in population, innovation, technology, and productivity, base money must expand to meet the needs of economic growth.  In the interim the requirement for base money fluctuates constantly.

Congress created the Fed in 1913 and gave it monopoly power to manage the dollar.  This ended the U.S. era of free banking where individual banks issued dollar currency backed by gold.  At the Fed’s creation in 1913, the dollar was still defined at the specific weight of $20.67 per ounce of gold.  The U.S. remained on a gold standard established by Hamilton in 1789.  A gold standard is nothing more than an automatic means to regulate the creation and removal of base money, economy’s lubricant, at the precise level demanded by a constantly changing market.  In concept it operates the same as a currency board, except the standard is gold rather than another currency.  Gold’s unique properties define gold as the monetary reference.  Its value has remained stable for centuries so any currency linked to gold retains the same stable value—“as good as gold”.

The Fed tightened or loosened monetary policy by adjusting the supply of base money to meet demand at the fixed price of $20.67/oz gold.  This was an automatic process as long as the Fed adhered to the principle of a gold standard—maintaining the stability of currency at the defined weight of gold.  Base money was a residual used to maintain the link of $20.67 to one ounce of gold.  If the price of gold (POG) rose above $20.67, this indicated that the Fed’s supply of base money exceeded demand.  The Fed’s operating mechanism would then “tighten” by extinguishing base money until the fixed dollar price of gold was regained.  If the POG fell below $20.67, then demand for base money was greater than supply.  The Fed’s operating mechanism would “loosen”, create new base money, until the POG rose back to $20.67.

The Fed has four operating mechanisms to regulate the flow of base money into the system.  1) Open market purchases or sales of securities.  2) Open market purchases or sales of foreign exchange.  3) Increases or decreases in the discount rate.  4) Raising or lowering reserve requirements.  When the Fed properly manages a gold standard, any or all of these methods achieve the same result.  The chosen Fed mechanism regulates base money to maintain the parity price of the dollar with gold.  

From its founding in 1913  through the onset of the Great Depression, the Fed primarily regulated the flow of base money through the discount window, accepting only high quality eligible collateral under rigid rules.  The Glass-Steagall Act of 1932 centralized Fed open market purchases of government securities within the FOMC. By 1932 open market purchases became the primary means the Fed used to regulate base money.  Open market purchases allow the Fed to monetize debt by permitting government securities to serve as collateral for Federal Reserve Note issues.

With the gold exchange standard, citizens had the right to exchange their dollars for gold at the fixed price of $20.67/oz.  This lasted until FDR ended the right in 1933.  The gold exchange standard made in easy for the bureaucrats.  All the Fed had to do was watch the gold window.  If citizens lined up to exchange their dollars for gold, it knew it supplied more base money than the market required for transaction purposes.  If citizens lined up to exchange gold for dollars it knew it did not meet the market’s required demand for base money.  The Fed could then use one of its four mechanisms to regulate the flow of money into the system and balance base money supply and demand at the parity price.

These mechanisms work the same regardless of the type of gold standard maintained.  The only two mandatory requirements of a gold standard are a fixed parity price of a currency with gold and a mechanism to maintain the parity price.  Citizens having the right to exchange dollars for gold is an optimum standard because it forces the government currency manager to remain honest, or an outflow of gold is the result.  (Governments always ultimately devalue.)  After 1933 and prior to Bretton Woods in 1944, there was no right for anyone to exchange dollars for gold.  The Bretton Woods international monetary system allowed other central banks to exchange their dollar reserves for gold.  In all three cases as long as the operating mechanism maintained the dollar/gold parity point, the economy  operated at peak monetary efficiency.  When monetary policy is stable and efficient, government policy need only concentrate on changes to fiscal policy that promote growth.

¹ The Fed also acts as lender of last resort and after 2008, Congress increased the Fed’s regulatory power through financial reform legislation.  The Fed uses lender of last resort only in rare instances of severe economic stress.  Its new regulatory power, though significant, is concentrated on systemically important bank holding companies, as well as non-bank financial companies.