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Contents ~ Foreword ~ Central Banking in the United States: A Fragile Commitment to Price Stability and Independence ~ Comparative Financial Statements ~ Directors ~ Officers Forevvord ~ ineteen ninety-one was a year of changesand often the changes took unexpected turns. The long-awaited bank reform bill was passed, but disappointed many in its lack of vision. The economy, which many observers expected to recover, seemed to stall and then founder at the close of the year. At the Federal Reserve Bank of Cleveland, change also occurred with the departure of our president, W Lee Hoskins, and the appointment of our new president, Jerry L. Jordan. Lee, who left to become president and chief executive officer of The Huntington National Bank, made noteworthy contributions on several fronts. He developed influential public policy positions on the importance of price stability and financial regulatory reform. Under his leadership, the Fourth District made significant progress toward becoming the lowest-cost provider of high -quality services in the Federal Reserve System. Speaking for the directors, officers, and employees of the Federal Reserve Bank of Cleveland, I wish him well in his new responsibilities. Jerry, who joined the Bank in March of this year, was most recently senior vice president and chief economist of First Interstate Bancorp in Los Angeles, California. He has extensive knowledge of monetary policy, banking, and economic issues. Jerry also has a national reputation in the public policy arena and experience in both the private and public sectors. We look forward to working with him on the challenges ahead. One of those challenges is maintaining our progress toward a goal of price stability. Monetary policy was eased often and much throughout 1991, and in a manner that we believe does not compromise long-term price stability. As we argue in this year's annual report essay, future policy adjustments-and there will doubtless be many - should focus on this goal. Twenty -three directors, representing banking, business, agriculture, consumer, and labor interests, guide the Federal Reserve Bank of Cleveland and its Branches. Their contributions are highly valued, as is the participation of our Small Bank and Small Business Advisory Councils. Special thanks are extended to those directors who have completed their terms of service on our boards. We are especially grateful for the leadership of Kate Ireland (national chairman, Frontier Nursing Service of Wendover, Kentucky), who was chairman of our Cincinnati Branch board of directors. We also appreciate the contributions of Allen L. Davis (president and chief executive officer of The Provident Bank, Cincinnati, Ohio), who served on our Cincinnati Branch board; and E. James Trimarchi (president and chief executive officer of First Commonwealth Financial Corporation, Indiana, Pennsylvania), who served on our Pittsburgh Branch board. In addition, the Fourth District has been well represented on the Federal Advisory Council by John B. McCoy ( chairman, preSident, and chief executive officer of Banc One Corporation), and we are grateful for his continuing dedication. Finally, on behalf of the board of directors, I want to express my appreciation to the officers and employees of the Bank for making 1991 a successful year. I particularly want to commend them on their admirable performance during the transition period between presidents. To their credit, the Bank continued to function extremely well. Sincerely, ~~ ~.Miller Chairman of the Board Central Banking in the United States: A Fragile Commitment to Price Stability and Independence ~ uring the past seven years, inflation in the United States averaged 3.9 percent, declining to a low of 2.9 percent in 1991. This represents a substantial improvement from the decade of the 1970s and marks our return to an elite group of low-inflation countries in the world. This achievement may be largely uncelebrated, because many Americans are currently focused on the stability of their jobs and incomes. However, both history and research suggest that very low inflation will improve economic performance, gi ving us reason to expect better times are ahead. When the Federal Reserve System wa created in 1913 to improve the functioning of the commercial banking system, price stability was taken for granted. Yet, the Federal Reserve's creators recognized the dangers of political control of the money creation process and designed the ystem to withstand it. A review of history illustrates the wisdom of this approach : attempts to realize short-term objectives through the manipulation of money and credit inevitably lead to financial and economic distress. Conventional measures of inflation expectations indicate that most people believe that this This essay reviews the evol u tion of cen tral banking in the United States and emphasizes the deliberate efforts to create a structure that would be insulated from partisan politics. We conclude favorable pattern will continue in 1992. But will the commitment to maintaining price stability that the Federal Reserve's accountability can be strengthened by having Congress resolve that be fleeting or enduring? price stability should be the Federal Reserve's first and foremost goal. With this mandate, and Given the mixed performance of our nation's central bank over the past few decades, this commitment to price stability seems fragile indeed. Over the years, the focus of policymakers ha turned away from long-term economic growth and price stability, and has turned toward achieving short-term economic objectives for production, employment, long-term interest with continued insulation from political influence, the Federal Reserve can make a major contribution toward efforts to achieve maximum, sustainable economic growth . rates, and occaSionally, foreign exchange rates. B e for e the Fed era ~ Res e ~ ur country's founders were aware of the dangers involved with granting the government or one of its agencies direct and unchecked con trol over the issuance of currency that has little or no intrinsic value. These leaders had witnessed firsthand the economic damage that ensued from debasing money to serve political needs during and in the aftermath of the American Revolution. Similar debasements and currency overissues had occurred during the prior century in Europe. Unbacked paper currencies, combined with legal tender laws, ruined the public credit of many of the prerevolutionary colonies and of the independent states that existed before the signing of the Constitution. The overissue of currency often resulted in inflation, financial chaos, and economic ruin , and our nation's leaders sought to guard against it. The Constitution gave Congress the power "to coin money" and " to regulate the value thereof.' Historians maintain that this language reflected specific intent that the new nation adopt a specie standard - that is , coin actually made of a precious commodity. Soon after the Constitution was ratified, Congress established its monetary standard : a dollar had to contain 371.25 grains of fine silver or 24.75 grains of fine gold.1 In effect, the United States had adopted a silver standard and an official exchange rate between silver and go ld . The founders had not only stabilized the value of the nation's currency, but had also guarded against political influence by failing to grant the Executive Branch the power to issue a paper cur rency. Paper Currency I Until the Civil War, the use of paper money in the United tates largely developed outside the direct control of the federal government. As banks were chartered by states and established r:. ':!~~ around the country, they began to issue their own circulating liability notes to their customers. These notes, which circulated as "currency," were implicitly backed by gold and silver held at the issuing bank and could be redeemed for such by the bearer. Also, the First and Second Banks of the United States issued circulating notes that were receivable for taxes as long as they were redeemable at par in gold or silver. State-chartered banks were constrained by market forces in their ability to issue notes. The probability that the notes would be redeemed at the bank for specie - gold and silver coin - served as a constraint on a bank's ability to issue notes. Under normal circumstances and market pressures, then, each bank had to be careful to reserve an appropriate amount of specie in relation to its issue of bank notes. Between the charters of the First and econd Banks of the United tates (1812-1816) and after the expiration of the Second Bank's charter (1836), the natural constraint on bank note issue was tested. Banks wishing to take advantage of the rules of the Circulating bank note regime placed themselves at long distances from financial and commercial centers and issued much larger volumes of notes than their reserve of specie warranted. However, when bank notes circulated to places far away from their point of issue, recipients often demanded discounts commensurate with the difficulty of sending the notes back for redemption. Market forces, in effect, "priced' the value of the notes. The U.S. banking system showed great promise in its ability to formulate private market solutions for the problems associated with a maturing financial system and economy. By the 1850s, the banking system was far from perfect, but it displayed enough stability and effiCiency so that there was no real political impetus to change the system until the Civil War. Greenbacks The outbreak of the Civil War cleared the way for the very development that the nation's founders had sought to prevent: discretiona ry control of money by the Executive Branch, within loose limits imposed by Congress. During the early 1860s, the U.S. Treasury found it increasingly difficult to issue more debt to finance the war. The 'freasury had already drained available specie from the nation's largest banks, and there was widespread concern about the possibility of default on government bonds. The Legal Tender Acts were passed to provide the 'freasury with an alternate method of finanCing its debt. Through the Acts, the 'freasury acquired the authority to issue legal tender paper, known as "greenbacks:' This action was strongly opposed by creditors, because the Treasury could now use the notes' legal tender status to force the public, including banks, to accept them as payment for the government's bills. The Treasury expected greenbacks, as legal tender for all public and private debts, to circulate as currency. In effect, the banking system was allowed to monetize federal debt. In retrospect, Congress clearly was searching for an expedient way to finance the Civil War and the Reconstruction, despite constitutional obstacles. In fact, the legality of the Legal Tender Acts was challenged after the war and, although eventually upheld by the Supreme Court, the constitutionality of the Acts is debated by legal scholars to this day. The new issue of greenbacks was finally terminated in 1878, but the Treasury's control of money and credit had already been firmly established by the ational Banking Act of 1863 and its subsequent amendments in 1864 and 1865. These statutes created nationally chartered banks and allowed them to issue notes only if they were secured with deposits of U.S. Treasury bonds. By expanding and contracting federal debt, the Treasury could indirectly control the amount of national bank notes in the economy. Time and again, however, this system displayed its inadequaCies. From 1863 until the creation of the Federal Reserve System in 1913, the U.S. economy was marked by periodic episodes of volatile prices and interest rates, financial panics, and severe economic booms and busts. Many observers attributed the intermittent economic chaos to the "inelasticity" of note circulation under the Treasury's bond -deposit system. The quantity of authorized federal debt was strictly limited because the 'freasury generally operated with a surplus. In addition, until the 'freasury adopted modern debt auction procedures in 1896, the process of purchaSing new bonds by banks was unduly expensive and occaSionally slow. Banks were therefore o&en prevented from purchasing new bonds and depositing them with the Comptroller, even when additional note issues could have been justified from a strict monetary policy perspective. At the same time, banks had difficulty retiring notes, since the same formalities and expense had to be endured for cancellation. Consequently, the banking system was unable to provide easily for an expanding and contracting volume of currency in response to the public's seasonal and cyclical demand for money. Because national banks placed such a high demand on U. . 'freasury bonds to support currency note issues, these securities became unprofitable for banks to hold. In what might be the first modern financial market innovation in response to government regulation, demand deposits became the most important source of bank funds. Banks were not required to hold bonds against demand deposits and, furthermore, could count demand deposits held by other banks as reserves. From time to time, depositors put substantial pressure on banks for cash withdrawals. However, with a low supply of bank notes in their reserves and because of the difficulty in quickly obtaining an additional supply, banks were sometimes forced to suspend payments and sharply restrict credit, contributing to financial panics and economic collapse. The complex system of banks that developed under the National Banking Act was believed to exacerbate panics. Country banks were required to keep part of their reserves in deposits at deSignated ' reserve city banks;' and reserve city banks were required to keep part of their reserves in larger city banks, known as "central reserve city banks;' located in ew York, Chicago, and St. Louis. These relationships served to transmit payment suspensions and panics from one region or particular bank to another and, ultimately, throughout the system. Another common but somewhat more controversial belief was that financial panics stemmed fundamentally from the lack of an institutional mechanism that would allow the nation's money supply to expand and contract with currency demand, which in turn expanded and contracted with real economic activity. ~ he political and social heritage of the United States resulted in a confluence of pressures that were, and to a large degree still are, uniquely American. From the very inception of central banking in the United tates with the chartering of the First Bank of the United States in 1791, the political debate about central banking has been focused on the values and dangers of centralized authority. The structure of the Federal Reserve System reflects the nature of these tensions. After a deep and acute panic in 1907, Congress set up the ational Monetary Commission to study these monetary problems. The Commission's recommendations resulted in two courses of action. First, the Aldrich-Vreeland Emergency Currency Act of 1908 authorized private bank clearinghouses to temporarily issue bank note currency against trade-related paper, not just government bonds. Later, the Federal Reserve Act of 1913 established a quaSi-governmental organization to issue currency notes based on either gold or commercial paper. Thus, the new Federal Reserve Banks were designed to displace the clearinghouses. In addition, the perceived need for a mechanism to allow the expansion and contraction of the nation's money supply was made explicit in the very legislation that created the Federal Reserve System. The preamble to the Federal Reserve Act describes it as "An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency... :' An early attempt to create a central bank that would serve to "furnish an elastic currency" was presented by Senator elson Aldrich of Rhode Island in 1911. The Aldrich plan proposed a ingle central authority, with branches throughout the country, that would be run and directed by private bankers~ This plan was fiercely opposed by so-called progressive Democrats, most notably the threetime Democratic presidential candidate and future ecretary of State, William Jennings Bryan. Bryan and his allies favored a central bank controlled by public interests, with centralized authority outside the control of private banking interests. But the seeming irreconcilability of these opposing views did not eliminate the impulse for the creation of a central bank. Consistent with the American political experience, the ultimate outcome was a compromise that was sufficient to satisfy the majority needed to pass the Federal Reserve Act. New Orleans and other regional banking centers. The Federal Reserve System allowed equal access to its clearinghouse by all banks. Financial shocks could be more easily absorbed under this new framework, because the resources of the entire Federal Reserve, not just the resources of a single clearinghouse, could be directed at banking panics. The Federal Reserve System could also accom modate fluctuations in the demand for currency. The goal of supplying an elastic currency was Harold H. Greene, United States District Judge, fohn Melcher v. Federal Open Market Committee, 1986 Fashioned largely by Virginia Representative Carter Glass, President Woodrow Wilson, and economic advisor H. Parker Willis, the Federal Reserve System emerged as a hybrid institution, a balance between public and private decision making. The genius of the compromise was to create an entity with no dominant centra l authority, thereby assuring each faction that it would not be overwhelmed by the other. The Federal Reserve Act called for not less than 8 nor more than 12 Federal Reserve Banks, each with a substantial degree of autonomy within the System, and a Board of Governors to provide coordination and oversight. The Board of Governors is a government agency, and the Board members are government officials. The Reserve Banks are government instrumentalitiescorporations chartered by the federal government to act in the public interest. Essentially, the Federal Reserve replaced or competed directly with the private clearinghouse arrangements, which were operated by the largest banks. Such clearinghouse arrangements had been created in 1853 in New York and earlier in to avoid banking panics, in which the public sought to shift their funds from deposits to currency. To prevent such panics from either destroying banks or causing the restriction of cash payments by banks, the new central bank aimed to convert deposits to currency without reducing the total of the two. The issuance of the new currency, Federal Reserve notes, could be rapidly expanded in panics, but was fully convertible, on demand, into gold. The Federal Reserve's discount window prOvided an easier way for banks to convert their commercial and agricultural assets into that currency. A measure of local control and expertise was prOVided by the fact that each Federal Reserve Bank was made responsible for administering the discount window. The regional Reserve Bank preSidents had an important voice in the operation of the Federal Reserve System, provided practical experience in banking and commerce, and kept the Federal Reserve Board abreast of regional economic conditions. central banks - that is, "bankers' banks" - were much closer in character to the First and Second A Modern Central Bank Bank of the United States. The Federal Re erve System truly was the first central banking insti- Central banks, of course, were not unknown at the turn of the century; virtually all industrialized tution speCifically designed to address issues relating to the interaction of financial instability countries had formed central banks by 1900. Furthermore, some central bankers regarded their and macroeconomic risk. responsibilitie as having grown to encompass the same general concern for the safety of financial markets and the payment system that motivated the debate surrounding the enactment of the At its inception, the Federal Reserve may have been more dedicated to controlling short-term fluctuations in the price level than to planning for long-run price stability . But the long-run stability of prices was presumed because the creation of the Federal Reserve System occurred in the context of the gold standard. ot until much later, after the gold standard gave way to Federal Reserve Act. In important respects, however, the context into which the Federal Reserve ystem was organized was decidedly unique. The European and Japanese central banks were created primarily to organize our present monetary system, did the long-run stability of prices emerge as a serious concern in the conduct of monetary policy. note issue and to facilitate clearinghouse operations among private banks. In this regard, exi ting ~ n it earl y days, the Federal Reserve Banks' primary policy tool was making loans secured by sound collateral through their discount lending facilities . The interest received from these loans was the primary source of revenue for the Federal Reserve Banks. Today, open market operationsthe purcha e and sale of government securities in the money market - is the major tool of monetary policy. The transition from di count lending to open market operations created conflicts within the Federal Reserve over the ystem's governance. In the early 1920s, after the war finance program for World War I was completed, the volume of Federal Reserve Bank loans to commercial banks dropped severely, thus impairing ystem revenue. In order to shore up weak profits, the Re erve Banks took advantage of their authority '~ .. to purchase Government bonds within the limits of prudence, as they might see fit;'4 Open market operation grew and noticeably influenced credit markets and banking reserves. Establishing the FOMC I The Federal Re erve Act contained no explicit provision for the current form of open market operations, since its use as a policy tool developed quite unexpectedly. In fear that the U.S. Treasury might step in and assert its authority in open market operations, the Reserve Banks formed a committee of four Reserve Bank preSidents in 1922, under the leadership of New York Fed President Benjamin Strong, to coordinate the 12 Districts' open market operations. Later that year the committee was expanded to five presidents, who at that time were called "governor ;' Throughout the 1920s, the Board in Washington, D.C. - which included five members, plus the Secretary of the Treasury and the Comptroller of the Currency as ex officio members-displayed increasing displeasure about its lack of input in open market operations. In fact, Board member Adolph Miller complained that the Board should have a more active voice in decisions concerning open market operations? Board's political independence was strengthened by eliminating the Secretary of the ueasury and the Comptroller of Currency from the Board of Governors, and by again extending the governors' terms - this time from 12 years to 14 yea rs. In March 1923, the Board decided to claim its own jurisdiction by dissolving the Reserve Banks' committee . The Board then reestablished a similar group, the Open Market Investment Committee, to carryon its work under principles and regulations determined by the Board. Because Thus, having confronted several opportunities to eliminate the public - private mix that had characterized the Federal Reserve System, legislators instead strengthened that feature by writing into law the role of the Federal Reserve Bank preSidents in open market operations and removing the Secretary of the Treasury and the Comptroller of the Currency. Since the Banking Act of 1935 and the subsequent amendment in 1942, which gave the ew York Federal Reserve Bank permanent representation on the FOMC, no major legislative changes have been made to the monetary policymaking structure of the Federal Reserve System. In short, the Banking Act of 1935 established the monetary policy structure of the Federal Reserve System largely as it exists today. the ueasury was represented on the Board by both its Secretary and the Comptroller of the Currency, this structure provided the ueasury with a means for direct influence over monetary policy. The Board's influence over open market operations was strengthened as a result of policy disagreements among the Reserve Banks in the late 1920s. However, monetary policy was used ineffectively at the on et of the Depression. In 1930, the Open Market Investment Committee was replaced by the Open Market Policy Conference, which included a representative of each Federal Reserve Bank. The new Committee sub mitted all decisions to the Board for approval and, without the Board's approval, the Committee could not act. This reallocation of power was ratified and somewhat amplified in the Banking Act of 1933. The consolidation of control over open market operations at the Board was consistent with sentiment in favor of a greatly enlarged federal presence in the national economy during the troubled Depression years . While the Banking Act of 1933 shifted some of the administrative power over open market operations to the Board, the Act, at the same time, strengthened the independence of the Federal Reserve System by lengthening Board members' terms from 10 to 12 years. The Banking Act of 1935 brought more sweeping changes. The Committee (renamed the Federal Open Market Committee, or FOMC) would now include five voting representatives of the Reserve Banks along with the full Board, giving the Board a 7 -to-5 majority on the FOMe. In addition, the Financing US_ Debt I When the United tates entered World War II in December 1941, the Federal Reserve's primary objective was to facilitate-as it did during World War I - the Treasury's finanCing of the country's huge deficits. The Federal Reserve's assistance during World War II differed, however, in two important aspects from its activities during World War 1. In the earlier war, the Federal Re erve encouraged banks to buy government securities by maintaining low discount rates. Banks bought government securities at yields higher than the discount rate, and the discount window guaranteed short-term liquidity for those bank assets. Of course, this steered bank credits away from commerce, industry, and agriculture and toward government bonds. The Federal Reserve Banks bought few Treasury securities themselves, largely confining their monetary operations to discount window activities and purchases of bankers acceptances. During World War II, at the Treasury 's behest, interest rates were not allowed to rise at all. As As the postwar period progressed, the Federal Reserve and the 'freasury increasingly disagreed wartime financing grew, however, the Fed became more concerned about the inflationary conse- about the appropriate monetary policy for the nation. In essence, the 'freasury argued that the quences of maintaining constant interest rates. When the Fed threatened to break away from Federal Reserve could best support the expansion of the economy by maintaining a relatively fixed Treasury policy, the Treasury emphasized the problems that a change in the structure of rates price structure for federal debt instead of allowing prices to fluctuate with market demand. Allan Sproul, "Reflections of a Central Banker," 1956 was likely to cau e, becau e federal government securitie and government-guaranteed loans made The Federal Reserve maintained that it could not achieve the goals of the Employment Act by up an important share of the assets structure of banks and other public and private institutions? pegging the price of government securities, because that would subordinate monetary policy to the fiscal needs of the U.S. 'freasury. In addition , the outbreak of the Korean War in 1950 To limit inflation and to prevent ri ing private demands from diverting resources away from the war effort, direct wage and price contro ls were established. The Federal Reserve regulated the expansion of private- ector credit directly. While the controls kept consumer and business spending in check, the inflationary potential wa la rge indeed, once the controls were lifted. Setting Goals I set off a wave of inflation and intensified policy disputes between the Federal Reserve and the 'freasury. After much debate, the Federal Reserve and the Treasury reached an agreement, commonly refe rred to as the 1951 Accord. The Accord reestablished the Federal Reserve's independence within government and gave the central bank the flexibility to decide how, and for what purpose, to cond uct open market operations. After World War II, concern about inflation and economic growth resu lted in the enactment of the Employment Act of 1946, which called for " maximum employment, production, and purchaSing power."8 Re pon ibility for achieving the goals of the Employment Act of 1946 was not assigned specifically to the Federal Re erve ystem or to any other agency of government. Rather, the Act was an expression of goals to be pursued by all government agencie to the extent that their u ual operation and powers enabled them to do o. Bretton Woods The two World Wars affected more than th e interaction between monetary and fiscal policy. For all practical purposes, the international gold exchange standard had effectively vani hed during World War I. After that war, many co untries attempted to return to their former gold standard , but were unsuccessful. In 1933, in the depths of the Great Depression, the United States ceased gold convertibility. At the conclusion of World War II, at Bretton Woods, ew Hampshire, a system was established that required each country to set a "par" value of its currency relative to the dollar. The U.S. Treasury was committed to redeem surplus dollar claims of foreign central banks, in gold, at the rate of one ounce for every $35. Under the Bretton Woods agreements , deficit countries had to use their international gold reserves to redeem their own currencies from the surplus countries at the fixed exchange rate. Alternately, countries with trade deficits would have to use restrictive monetary or fiscal poliCies to curb their imports, thereby restoring a balance of payments with their trading partners at the declared fixed exchange rates. As long as the United States ran trade surpluses, running out of gold reserves was not a concern . However, pressures on the U.S. gold reserve began as early as 1958, and despite efforts to adjust the U.S. economy and curtail the gold outflows, these pressures continued and intensified as Vietnam War expenditures increased. Because the domestic economy was straining against its productive capacity, the U.S. balance of payments position deteriorated rapidly, and inflation escalated. A speculative run on the dollar commenced when world markets became convinced that the United States would not restrict the growth of its domestic economy to support the purchaSing power of its dollar. After more than 25 years, the Bretton Woods system of fixed exchange rates collapsed in August 1971, when the United States suspended foreign gold sales. Although severing the dollar from gold in the international arena initially disrupted trade and somewhat reduced U.S. foreign policy stature, it really did not cause immense domestic economic problems. The volume of foreign trade was small relative to the size of our economy at the time. evertheless, the event was highly Significant, in hindSight, as a reminder of the lengths to which our government was willing to go to prevent domestic economic slowdowns. This realization did little to restore foreigners' confidence in the dollar during the 1970s. Multiple Objectives I In their 1962 Report, the Council of Economic Advisers argued that discretionary policy was essential for achieving the employment, production, and price stability goals of the Employment Act of 1946? Some economists called for closer coordination of fiscal and monetary policies. Throughout the 1960s and 1970s, as policymakers learned that monetary and fiscal poliCies could have powerful effects on the economy, they began advocating frequent policy changes (that is, using fiscal and monetary policies to "fine-tune" the economy) in an attempt to keep the economy constantly at full capacity. Legislation was enacted that encouraged fine-tuning. The Full Employment and Balanced Growth Act of 1978, also known as the Humphrey-Hawkins Act, expanded the list of national goals to include "... full employment and prodUction, increased real income, balanced growth, a balanced federal budget, adequate productivity growth ... an improved trade balance ... and reasonable price stability."lo Like the original Employment Act of 1946, the Humphrey-Hawkins Act established general goals for all agencies of government rather than specific assignments for each one. The 1978 Act also established procedures to help coordinate the policies of the various agencies of government to achieve those goals. For example, the Federal Reserve is required to report its monetary policy plans to Congress semiannually, and to comment on the relationship of those plans to the President's goals. Balancing Goals I In contrast to those laws, the Federal Reserve Reform Act of 1977 assigned some specific goals to the nation's central bank. Congress amended the Federal Reserve Act of 1913 to require the Federal Reserve ~ .. to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates:'u However, the Federal Reserve has the responsibility to decide how best to pursue those goals. goal over time. The absence of any prioritization of the legally mandated goals emboldens political and special-interest groups to campaign for the policy stance of greatest current importance to each group. Ironically, elevating the importance of price stability could enhance the Federal Reserve's ability to craft short-run policy actions in response to problems and crises without affecting inflation expectations. Although the long-term relationship between money and prices appears Edvvard.J_ Kane, 'Bureaucratic elf-Interest as an Obstacle to Monetary Policy Reform;' 1990 The major drawback to the statutory encouragement of fine-tuning is its infeasibility. To st rike a balance among the multiple goals requires that they be reliably linked to one another. Furthermore, the existing legislative framework assumes that monetary policy is capable of influenCing to be strong and stable, temporary and unforeseen factors may cause the price level to deviate from its desired course. Fortunately, achieving long-run price stability does not require close, short-run control of the price level. Taking full imultaneousl y all three economic dimension (maximum employment, stable prices, and moderate long-term interest rates) in the desired directions and quantities. This approach to advantage of the hort-term flexibility that these relationships afford, however, requires a profound economic policymaking is no longer supported by most new academic thinking nor by practical experience. The United tates has experienced long periods of both price tability and inflation. A sober respect for the price stability objective. assessment of our modern history brings the conclusion that inflation neither buys economic By attempting to maintain a balancing act among complex economic goals, the Federal Reserve growth nor eliminates business cycles. How much more beneficial for the country it would be to causes substantial confusion about its capabilities and intentions. Rather than being held account- aim for something that monetary policy can actuall y deliver - price stabili ty - than to un rea - able for accomplishing anything in particular, the Federal Reserve is expected to manage the entire sonably demand satisfaction on all fronts. economy without possessing the tools to do so. Having multiple goals permits the Federal Reserve to choo e which goal is emphaSized at any moment, rather than committing to a particular ~ rom our early history, we know that political leaders aspired to achieve one simple goal for the country's monetary standard - to protect it from debasement. In particular, they wanted to prevent the government from issuing debt and repaying it later with inflated dollars . They did not countenance unbacked, governmentissued paper money. A Strong Commitment I Thi commitment to a Single goal of price stability seems to be gathering adherents around the world. By law, the German central bank is "not subject to instructions from the Federal Government or, of cour e, to instructions from any other authority." Legislation pas ed in 1957 The transformation of the pre-1933 economy into today's economy required the abandonment of also specifies that the Bundesbank "support the general economic policy of the Federal Govern- commodity-backed money for two main reasons: gold and silver are expensive to move around ment, but only in 0 far a this is consistent with its duty of safeguarding the currency."13 safely in large quantities, and a banking system chained to convertibility of bank liabi lities proved to be inflexible in accommodating changes in money demand. These shortCOmings gave rise to our Federal Reserve System and to other central banks around the world. But eventually, along with the development of central banks came the belief that monetary and fiscal poliCies could be used to precisely control the growth of the economy. This view was imposed on the Federal Reserve System by Congress, and the result wa that our central bank became accountable for all of the nation's economic goals-an impossible mission. In this respect, the Bundesbank's situation is different from the Federal Reserve's. More than one goal is specified by law for the German bank, but the law states that the goal of price stability is to be given highest priority whenever another goal might conflict with maintaining price stability. That is a major reason why Germany's price performance has surpassed that of the United tates. The U. . inflation rate was twice the German rate between 1960 and 1990.14 Austria and ew Zealand have amended their central bank laws to make price stability the central bank's primary mandate. In addition, the Maastricht agreement, which spells out the How can nations design their monetary authorities to be both independent within government, framework for establi hing a European central bank in 1999, makes price stability the primary and yet accountable to government? Accountability, improperly framed, can become a serious objective for the new central bank. impediment to the necessary functioning of central banks. But if expectations are limited to Even ome countries with poor inflation performance, such a Chile, have sought to restore their achieving one goal, and if expectations for achieving that goal are correspondingly strength- central bank's credibility. By enacting legislation that gives them more formal independence from ened by CongreSSional mandate accountability can provide useful support for central banks. their governments in conducting monetary policy, such nations have taken the first step toward achieving price stability. imilar steps are being considered in Argentina, Czechoslovakia, and Poland. If the United States were to legislate a clear price stability objective for the Federal Reserve, the nation would benefit. The next best solution (the one actually followed, in fact, in this country from the time of Alexander Hamilton) calls for a central bank whose structure provides the most independence that the political system can bear. The framers of the Federal Reserve Act intentionally built in provisions to keep the Federal Reserve independent from political pressures. Subsequent revisions to the Federal Reserve's structure, especially in 1935, added more layers of insulation to protect the System from the countervailing economic and political realities that evolved. Long terms for members of the Board of Governors are a keystone of the System's structure. The seven governors are appointed by the President of the United States and approved by the enate. Governors are appointed for 14-year terms, which are staggered, every two years, to keep turnover on the Board at a measured pace. 0 two governors can be from the same Federal Reserve District. RemOving the ecretary of the Treasury from the Board in 1935 further emphasized the congressional desire to shield the Federal Reserve from the partisan political arena. Reserve Bank presidents and directors also contribute to the Federal Reserve's independence. Directors oversee Bank operations, which are conducted like for-profit businesses. These individuals have vast experience in banking and commerce, and continue to provide the practical and regional input to the Federal Reserve that was a hallmark of the System at its inception. Because directors are not political appointees (in fact, they are prohibited from partiCipating in partisan politi cal activities during their tenure as directors), they provide an added degree of insulation to the System . The Board of Governors appoints three of the nine directors and, from those three, designates a chairman and deputy chairman of each Bank's board. Each Reserve Bank's board of directors, in turn, is responsible for appointing the president of its Reserve Bank - subject to approval by the Board of Governors. The presidents participate in the monetary policy process through the FOMe. The president of the ew York Fed is a permanent voting member, along with the 7 governors. The remaining 11 presidents vote on the FOMe on a rotating basis (only 4 of the 11 vote at each meeting). The entire process yields an FOMe consisting of a majority set of public officials and a minority set of Reserve Bank presidents acting for the public good. The majority set of officials ensures that the legitimate interests of government are represented. The President of the United States also designates and appoints the chairman of the Board of Governors to a four-year term. The Board of Governors has exclusive power to determine the discount rate upon receiving recommendations for changes from the boards of directors of the Federal Reserve Banks. The minority set of FOMe members is selected by a process designed to minimize the effects of short -term political pressures. Their presence se rves as an institutional, flesh-and-blood buttress to the commitment of central bank independence within government. To some, the Federal Reserve System 's design might appear needlessly complex, but an appreciation of history and politics reveals why economic statesmen crafted an institution with such a broadly dispersed power structure. If they had thought of monetary policy as a cookie jar, eternally tempting to politicians, the Federal Reserve's sponsors would have regarded their structure as a means of placing that jar on the top shelf of a tall, locked cupboard. A determined and persistent government could eventually get that jar down from the shelf, but it would have to be very serious about its mission to do so. Conclusion Our performance on price stability since 1935 could have been better. Once the nation formally broke away from the gold exchange standard , the U.S. dollar lost its anchor to price stability, and inflation rapidly spun out of control in the 1970s. The political will to rein in inflation took nearly a decade to muster. More recently, the Federal Reserve has made great progress in reducing inflation from the high levels of the late 1970s and early 1980s. However, inflation has not been eliminated, and the important progress of recent years rests on a fragile commitment that may be abandoned. The nation should not be wholly satisfied with the performance of the Federal Reserve System. By assigning the Federal Reserve multiple monetary policy objectives, Congress has provided insufficient guidance. Consequently, some people are correctly suspicious of the Federal Reserve's ultimate commitment to price stahility. A price stability mandate would shift the focu of monetary policy away from short-term finetuning to the long term, where it belongs. Such a mandate would enforce accountability for the one vital objective that the Federal Reserve can achieve, and it would officially sanction those sometimes unpopular short-run policy actions that most certainly are in our nation's longterm interestFortunately, the Federal Reserve has a structure that permits it to operate with some degree of independence from partisan political pressures. The present structure originated in a different era, when the responsibilities and powers of the Federal Reserve were thought of quite differently. As the role of the central bank evolved, Congress contemplated changing the structure many times, but essentially has not done so for more than 50 years. Changes that are made should be conistent with strengthening, not weakening, the Federal Reserve's commitment to price stability and its independence. Contemplated changes to the Federal Reserve System should be debated widely, openly, and at length. In this e say, we argue that the focus of the debate should be on how to improve the Federal Reserve's performance. Setting clear, achievable objectives and holding the Federal Reserve publicly accountable for achieving those objective will result in monetary policy that contributes to maximum ustainable economic growth . Footnotes I Edwin Vieira, Pieces oJ Eight: The Monetary Powers and Disabilities oJ the United States Constitution (Darby, 1983), pp. 98-9. r' 2 uggested Plan for Monetary Legislation, Senate Document 0.784,61 Congo 3 Sess. (Government Printing Office, 1911). 3 fohn Mekher V. Federal Open Market Committee, United States District Court for the District of Columbia, Civil Action 0.84-1335 (1986). 4 Board of Governor of the Federal Reserve System, First A nnual Report oJ the Federal Reserve Board, 1914 (GPO, 1915), p. 16. 5 Le ter V. Chandler, Benjamin trong, Central Banker (The Brookings Institution, 1958), p. 222. 6 Allan proul, "Reflections of a Central Banker," journal oJ Finance, vol. XI (March 1956), pp. 4-5. 7 A. Jerome Clifford, The independence oJthe Federal Reserve System (University of Pennsylvania Press, 1965), pp. 163-96. 8 Employment Act ofl946, ection 2, as recorded in the United States Code: Congressional Service, Laws oJ 79th Congress, Second Session (West Publishing Company), p.20. 9 Economic Report oJthe President, January 1962 (GPO,1962). 10 Full Employment and Balanced Growth Act of 1978, as recorded in the United States Code: Congressional Service and Administrotive News, Laws oJ 95th Congress, econd Session (West Publishjng Company). 11 Federal Reserve Reform Act of 1977, as recorded in the United States Code: Congressional Service and Administrotive News, Laws oJ 95th Congress, First Session (West Publishing Company). 12 Edward J. Kane, "Bureaucratic elf· Interest as an Obstacle to Monetary Reform," in Thomas Mayer, ed., The Political Economy oJ American Policy (Cambridge University Press, 1990), pp. 287-8. 13 Bank for International ettlements, Eight European Central Banks (George Allen and Unwin Ltd., 1963), pp. 56-7. 14 Economic Report oJ the President, January 1991 (GPO, 1991), p. 408. Comparative Financial Statement For years ended December 31 Assets Gold certificate account Special drawing rights certificate account Coin Loans and securities: Loans to depository institutions Federal agency obligations bought outright U. . government securities Bills otes Bonds Total U. . government securities Total loans and securities Cash items in proces of collection Bank premises Other assets Interdistrict settlement account TOTALA ETS 1 9 1 1 9 $ 692,000,000 645,000,000 30,183,268 $ 688,000,000 645,000,000 39,289,608 9 9 0 -0378,205,795 -0379,907,713 8,299,003,637 6,352,112,831 2,022,987,976 16,674,104,444 17,052,310,239 353,848,298 34,300,807 1,777,907,651 1,765,980,255 6,740,802,414 5,475,949,688 1,866,912,501 14,083,664,603 14,463,572,316 256,888,868 36,121,850 2,126,715,647 1,076,627,132 $22,351,530,518 $19,332,215,421 $19,949,460,886 $17,005,076,555 1,571,163,262 7,755,000 87,808,726 1,666,726,988 269,814,840 143,216,304 1,816,463,408 8,250,000 2,061,427 1,826,774,835 82,867,142 166,785,489 $22,029,219,018 $19,081,504,021 $ 161,155,750 161,155,750 $ 125,355,700 125,355,700 322,311,500 $ 250,711,400 Liabilities Federal Reserve notes Deposits: Depository institutions Foreign Other deposits Total deposits Deferred availability cash items Other liabilities TOTAL LIABILITIES Capital accounts I Capital paid in urplus TOTAL CAPITAL ACCOU T TOTAL LIABILITIES AND CAPITAL ACCOU TS $22,351,530,518 $19,332,215,421 Current income 199 Interest on loans Interest on government securities Earnings on foreign currency Income from services All other income Total current income 1 1 477,189 1,181,833,460 129,935,784 43,638,765 635,040 $ 1,356,520,238 $ $ 773,106 1,176,904,432 143,052,007 43,460,030 623,087 $ 1,364,812,662 77,244,050 8,545,603 69,518,138 10,432,184 $ 1,270,730,585 $ 1,284,862,340 Current operating expenses Cost of earnings credits CURRE T NET I COME 990 Profit and loss Additions to current net income Profit on foreign exchange transactions Profit on sales of government securities All other additions Total additions Deductions from current net income Loss on foreign exchange transactions All other deductions Total deductions et additions or deductions $ $ $ $ $ 21,833,126 8,018,932 935 29,852,993 $ -06,240 6,240 29,846,753 $ 9,694,406 6,028,900 16,602,497 32,325,803 $ $ $ $ 3,772,191 117,666,511 11,432 121,450,134 -01,712 1,712 121,448,422 Assessments by Board of Governors I Cost of Unreimbursable Treasury ervices Board of Governors expenditures Federal Reserve currency costs Total assessments by Board of Governors $ NET I COME AVAILABLE FOR DI TRIBUTIO $ 1,268,251,535 11,878,601 5,676,400 12,427,914 29,982,915 $ 1,376,327,847 Distribution of net income Dividends paid Payments to U.S. Treasury (in terest on Federal Reserve notes) Transferred to surplus Total distributed $ 9,032,226 1,223,419,259 35,800,050 $ 1,268,251,535 $ 7,488,534 1,366,983,763 1,855,550 $ 1,376,327,847 As of December 31, 1991 Cleveland Directors (standing) Alfred C. Leist; William T. McConnell; Frank Wobst; Laban P. .Jackson, .Jr.; (seated) Deputy Chairman A. William Reynolds; Chairman .John R. Miller. Cleveland I Chairman & Federal Reserve Agent John R. Miller Former Presiden t & Chief Operating Offi cer Standard Oil Company of Ohio Cleveland, Ohio Deput y Chairman A. William Reynolds Chairman & Chief Executive Officer Douglas E. Olesen Pres ident & Chief Execu tive Officer Battell e Memorial In stitute Columbus, Ohio Frank Wobst Chairman & Chief Execu tive Officer Huntington Ban cshare Incorpora ted Columbu , Ohio GenCorp Fairlawn , Ohio Verna K. Gibson Business Con s ultant Columbu s, Ohio John R. Hodges Pre ident , Ohio AFL·CIO Columbu , Ohi o Laban P. Jackson, Jr. Chairman , Cl earcreek Properti es Lexington , Kentu cky Alfred C. Leist Ch airman, Presiden t & Chief Executive Officer Th e Appl e Creek Banking Co. Appl e Creek, Ohio William T. McConnell President , The Park alional Bank ewark , Ohio Federal Advisory Council John B. McCoy Chairman, President & Chief Executi ve Officer Ban c On e Corporation Columbus, Ohio Cincinnati Directors (standing) Harry A . Shavv. III; .Jack W. Buchanan; Clay Parker Davis. (seated) Marvin Rosenberg; Allen L. Davis. Cincinnati Pittsburgh Directors Sandra L. Phillips; William F. Roemer; I.N. Rendall Harper• .Jr. Pittsburgh I Chairman Chairman Kate Ireland Robert P. Bozzone President & Chief Executive Officer alional Chairman Frontier urs ing ervice Wendover. Kentucky .Jack W. Buchanan President. phar & Company. Inc. Winche ter, Kentucky Allen L. Davis President & Chief Executive Officer The Provident Bank Cin innali , Ohio Clay Parker Davis President & Chief Executive Officer Citizens ational Bank omer et, Kentucky Eleanor Hicks Advisor for International Liaison Univer ity of Cincinnati Cincinnati, Ohio Marvin Rosenberg Partner, Towne Propertie ,Ltd. Cincinnati, Ohio Harry A. Shavv. III Chairman & Chief Execu tive Officer Huffy Corporation Dayton , Ohio Allegheny Ludlum Corporation Pittsburgh, Penn ylvania George A. Davidson• .Jr. Chairman & Chief Executive Officer Con olidated Natural Gas Company Pittsburgh , Pennsylvania Sandra L. Phillips Executive Director, Pittsburgh Partnership for eighborhood Development Pitt burgh , Pennsylvania .Jack B. Piatt Chairman of the Board Millcraft Industrie , In c. Washington, Pennsylvania William F.. Roemer Chairman & Chief Executive Officer Integra Financial Corporation Pitt burgh, Pennsylvania E . .James Trimarchi President & Chief Executive Officer First Commonwealth Financial Corporation Indiana, Pennsylvania I.N. Rendall Harper, .Jr. Pre iden!, American Micrographic Co., Inc. Monroeville, Pennsylvania As of December 31, 1991 William H. Hendricks Andre\IV .1 . Bazar First Vice Presiden t Vice President Randolph G. Coleman Jake D. Breland Senior Vice President Vice President John M. Davis William S. Bro\IVn Senior Vice President & Director of Research Vice President Andre\IV C . Burkle, Jr. John .1. Ritchey Vice President Senior Vice Pres ident & General Counsel Jill Goubeaux Clark Samuel D. Smith Senior Vice President Donald G. Vincel Senior Vice Presid ent Robert F. Ware Senior Vice President John .1. Wixted, Jr. Senior Vice President Vice President & Associate General Counsel Patrick V. Cost Vice President & General Auditor La\IVrence Cuy Vice Pre ident Creighton R. Fricek Vice President Elena M. McCall Vice PreSident R . Chris Moore Vice PreSident Sandra Pianalto Vice President & Secretary Robert W. Price Vice Presiden t Ed\IVard E. Richardson Vice President Mark S. Sniderman Vice Pre ident & Associate Director of Research Joseph C . Thorp Vice President Robert Van Valkenbu r g Vice President Andre\IV W. Watts Vice President & Regulator y Counsel Margret A. Beekel James W. Rakovvsky Assistant Vice Pre ident A si tant Vice President Terry N. Bennett David E. Rich As istant Vice President Assistant Vice President Thomas J. Callahan John P. Robins As i tant Vice Pre ident & Assi tant ecretar y Ex amining Offi cer A sistant Vi ce Pres ident A istant Vice Pre iden t & Econ omist Susan G. Schueller A i tant Vice President Charles A. Cerino Senior Vice President Roscoe E. Harrison A sistant Vice President Terrence J. Roth Randall W. Eberts John J. Erceg Cincinnati Barbara H. Hertz A si tant Vice President Jerry S. Wilson Assistant Vice Pres ident Burton G. Shutack & Economist A si tant Vice Pres id ent William T. Gavin William J. Smith A si tant Vi ce Pre id ent & Economist Ass is tan t Vice Pres iden t Edvvard J. Stevens Assistant Vice Presid ent Pittsburgh I Harold J. Svvart enior Vice Pres iden t As istant Vi ce Pre ident Raymond L. Brinkman Assistant Vice Pre ident & Economist Assistant Vice Presid ent Robert J. Gorius James B. Thomson Lois A. Riback Elaine G. Geller Assistant Vice President Norman K. Hagen A si tant Vice Pre ident Eddie L. Hardy Examining Officer David P. Jager Assistant Vice Pres id ent Rayford P. Kalich A i tant Vice Pres ident & Eco nomi t Walker F. Todd A sistant General Coun el & Re earch Offi cer Charles F. Williams Robert E. White Vice President Kevin P. Kelley Darell R. Wittrup As i tant Vice Pres id ent Ass istant Vice Pres ident William J. Major Assistant Vice Pre ident Laura K. McGovvan Ass istant Vice Pre ident Columbus Ass istant Vi ce Pre ident Assi tant Vice Pre ident As istant Vice President Assistant Vice President Henry P. Trolio A i tant Vice Pres ident & Assistant General Auditor John E. Kleinhenz Assistant Vice Pres ident Robert B. Schaub ~ he Federal Reserve ystem is res pons ibl e for formulating and implementing U. . monetary policy. It also upervi es ban ks and bank h oldin g co mpani e , and provide finan cial services to depo itor y in tituti ons and the federal governm ent. Th e Federal Rese rve Ban k o f Cl eveland is on e of 12 regional Reser ve Banks in th e nit ed ta te that , toge th er with th e B oa rd o f G ove rn o r i n Washington, D .C. , compri e the Federal Reserve y tern . Th e Fede ra l Rese r ve Bank o f Cl eveland , its two bran c hes in Cin cinn ati and Pitts burgh , and its Columbu Offi ce se r ve th e Fourth Federal Reserve Di trict. Th e Fourth Di s tri ct in cl ud es Ohio, western Penn ylvania, the n o rth e rn pa nh a ndl e o f We t Virginia, and eas tern Kentu cky. Federal Reserve Bank of Cleveland Main Office East 6th Street and Superior Avenue Cleveland, OH 44114 216.579.2000 Cincinnati Branch 150 East 4th Street Cincinnati, OH 45202 513.721.4787 Pittsburgh Branch 717 Grant Street Pi ttsbu rgh, PA 15219 412.261.7800 Columbus Office 965 Kingsmill Parkway Columbus, OH 43229 6]4.846.7494 Design: Michael Galka Photography: Bill Pappas This annual report was prepared by the the Public Affairs and Bank Relations Department and the Research Department, Federal Reserve Bank of Cleveland. For additional copies of this report, contact the Public Affairs and Bank Relations Department, Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland, OH 44101, or call 1-800-543-3489.
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