Episode 3 - The Committee, Part I
Welcome to the Bankster podcast, my name is Alexander Bagehot and I’ll be your host today. This is Episode 3 - The Committee, Part I. Every episode I dive into the intricate world of central banking! I use one or two pieces of news from the Federal Reserve or monetary policy from around the world to summarize, translate, and explain a few points from the Centralverse, which is the deep, the fascinating, the ever changing, and the incredibly consequential world of central bankers and the economies they attempt to support. As you listen you’ll become more and more versed in Centralverse language/lingo/and history.
Then, when you hear things on NPR or see headlines on CNN or the WSJ about the Fed doing this or the Bank of Japan doing that you’ll understand not only what it actually means but you’ll understand the historical context and relevance (or irrelevance depending on the news item of the day). This historical context will come because after each episode’s news insight, I take a more in depth look into a historical event or person that helped shape what central banking is today. And with a history that easily stretches 400 years there is plenty to learn.
On this episode we will discuss the creation of arguably the most important committee in the entire world - the Federal Open Market Committee (known as the FOMC). For the news section today we are going to review two items related to this committee: a single number and a critique.
A Number and a Critique
The number is zero. I know, unless you’re a central banker or a mathematician you are probably thinking, “zero is not an exceptionally exciting number” but it is one that was very important in the Centralverse last week, and I think as I explain what happened you’ll understand. Zero was the amount by which the Federal Reserve’s Federal Open Market Committee (which I will refer to from now on as FOMC) decided to change their target for the base interest rate. This zero change was what market players expected.
On the next episode, The Committee, Part II, we’ll talk about interest rates and how exactly this committee sets certain interest rates, and signals other interest rates to rise or to fall. But for today, let’s take a small step back and just think about the fundamental role that interest rates play in our day to day lives as consumers.
We have an interesting relationship with interest rates. They affect the money that we already have (in our savings accounts) and the money we don’t have but need (our loan obligations). Chances are if you are like the average household, you spend about a third of your income on housing. And if you have a mortgage, a huge factor in determining how much you pay each month is what the interest rate is on that mortgage. The same holds true for any other debt you may have, interest rates affect how expensive your student loans, automobiles loans, or even credit cards are. If you took on the debt when interest rates were high, you are paying relatively more. If you took on the debt when interest rates were low, you are paying relatively less. On its most basic level an interest rate measures how expensive money is. Or in other words, how much is the lender going to make me pay in the future to use the money now.
So what about the money that we already have or the money we are earning; what role does interest rates play there? Well, if you have a savings account, a 401(k) through your employer, or maybe funds in a Money Market Mutual Fund, then the rate at which your money in any of those accounts is growing is highly dependent upon the current interest rate.
In summary, if you need to take out a loan for something, you hope that interest rates are low. And if you have extra money that you want to put away, then you hope that interest rates are high. And just about all of us have money on both sides of this equation, money coming in and money to pay back, so it’s easy to see how important interest rates are to our lives. And I haven’t even mention how interest rates affect businesses and how that in turn affects how much the things we buy cost and how fast our favorite companies grow or shrink. We’ll expand more next week, but for now I hope you can see why the fact that the FOMC decided to not change the base interest rate last week was so significant.
Now that we understand at a basic level what this committee did let’s talk a little more about the people that make up the FOMC. Who are they? Where do they come from? Are they elected? How many members are there? I’ll try and answer all of these questions and more. And by the end of the episode if you have more questions, send them to me firstname.lastname@example.org.
The FOMC is made up of 19 members. The idea of a federal, centralized government balanced by local, regional governments that is so prevalent in American politics is also seen in the structure of the Federal Reserve. Seven of the members make up the centralized portion and live in Washington DC. These seven are called Governors. They are appointed by the president, and must be confirmed by the Senate. This is a similar to the process used for positions on the Supreme Court or to be in the President’s cabinet, like the Secretary of State.
Now governor is an unfortunate title since the more popular and widely understood use of the title is for the highest elected member of the executive branch of state governments. But nevertheless, the seven members of the FOMC that live in DC are called governors. In his recent memoir The Courage to Act Ben Bernanke said after being confirmed by the Senate, “So I could now officially claim the appellation ‘Governor Bernanke.’ Once, a clerk at an airline ticket counter would ask me what state I was the governor of.” (pg 54). I was glad to hear the governors could laugh about the situation. But remember, a central bank governor, works in Washington DC and has nothing to do with your state government.
The other twelve members make up the local, regional portion of the committee. They are each a president of one of the twelve Federal Reserve Banks that are spread throughout the country. However, if you look at a map of the distribution of the Reserve Banks they are not spread out evenly, but rather heavily concentrated in the East and become more and more spread out as you move west. The process of drawing the boundaries 100 years ago was very political and based on the makeup of a United States that looks very different than it does today. However, the boundaries haven’t changed since the inception of the Fed. You can see a map of the 12 districts on the website under today’s episode.
These twelve presidents are each chosen by the local board of directors of their district’s Federal Reserve Bank and then receive approval from the seven Governors in DC.
The final interesting aspect of the committee we are going to discuss today has to do with voting. On the FOMC although all 19 members gather and participate in every meeting not all of them get to vote. At each meeting there are only 12 voting members. The seven governors from DC plus the president of the New York Fed always vote, but the other four voting positions rotate between the 11 other Reserve Bank presidents on an annual basis.
The FOMC gathers every 6 weeks to make a decision about interest rates. And all of the study, the research, the interviewing, and the economic modeling that they do, it all comes down to one simple vote: raise interest rates, lower them, or leave them be. Leave them be is what they did last week-a change of zero.
Think about the impact the simple vote of this committee has on your life. Every 6 weeks the FOMC gathers in the Eccles building in Washington DC and determines the direction of interest rates. Or in other words, the amount of money you’ll pay on any new loans and the amount of money you're going to make in your savings and retirement accounts. And now you know a little more about who makes up this all incredibly important committee!
An institution that is as old as the Federal Reserve, making decisions as important as they are making with interest rates, and constantly in the political arena like they are is going to receive sharp and frequent criticism. On this podcast I won’t shy away from addressing these criticisms. However, I will avoid the conspiracy theories, which also abound. Last week Peter Fisher, an economics professor at Dartmouth and a former New York Fed official gave a criticizing speech at the Princeton Club in New York City that was both interesting and well thought out.
But for today’s episode I’ve actually decided that it is more important that you understand how the FOMC actually operates before you can begin to think about alternatives or other ways it might be run. That’s why I won’t mention any of his specific ideas here on this episode. But I did want to acknowledge the criticism, and I will have a link to Mr. Fisher’s speech on the transcript for today’s episode on my website (I’ll also include an easy to understand summary from the Wall Street Journal). I hope that some of you take a moment to check out the website and explore his alternatives to the current construct of the FOMC.
Knowing how the FOMC actually works might only be as interesting to you as studying Robert’s Rules of Order or the genealogy chapters of the Old Testament. But like with anything, understanding the history opens it up and helps us appreciate the subtleties. So let’s wind the clock back to the 1930’s.
Remember Marriner Eccles from our very first episode? Well, four years following the near collapse but ultimate survival of one of his banks in Northern Utah he would directly supervise the writing of the Banking Act of 1935.
In Episode 2 - On the Money, I clarified some misconceptions about the relationship between today’s Federal Reserve and US Treasury Department. I also mentioned that their histories were fascinating, intertwining, and often misunderstood. Well, the early 1900’s was the period most “intertwined” of the two histories, and the Banking Act of 1935 began the process of untangling them. See, in the original Federal Reserve Act the Treasury Secretary and the Comptroller of the Currency (another high official of the Treasury Department) were both de facto members of the Federal Reserve Board, and the Treasury Secretary was actually the chairman. However, in the newly reorganized and centralized body (to be known as the FOMC) neither Treasury position would have a seat at the table. This was an important step towards the political independence that is so critical to a central bank’s ability to fulfill its long term mission.
The Federal Reserve in DC would also physically move out of the Treasury Building, where it had been housed for the first 20 years of its history, and into a newly constructed building on Constitution Avenue. It’s in a room in this same building today that the FOMC gathers eight times a year to make that critical and far reaching decision about the direction of interest rates.
From the 23 foot ceiling, in the middle of the room, hangs a one thousand pound chandelier. And beneath the chandelier sits a massive, 27 foot, mahogany table. On one wall a symbolic image of an eagle spreads its wings above a marble fireplace. On the opposite wall a wide-reaching map of the United States is displayed. On the room’s towering windows hang heavy, light colored drapes. At the time of its construction this room was one of the most secure in all of Washington and during World War II would twice serve as home for “crucial war-planning conferences between the British and US Chiefs of Staff.” Now each time you hear about interest rate changes you can picture the very room where the FOMC has the last debate for that cycle and makes the final vote: raise interest rates, lower them, or leave them be.
Before the Banking Act and the move to the Eccles building each of the 12 Federal Reserve Banks was able to make their own policy and the Board in Washington DC was relatively weak. In fact, Benjamin Strong, the President of the New York Fed was the face and leader of the Federal Reserve during those formative, early years. It was he who correlated with his counterpart across the sea at the Bank of England during the crisis that was World War I and its aftermath. It was the New York Fed that controlled the gold that much of the currency around the world was based on at the time.
In fact, interestingly enough, most of the gold that was shipped from all over the world during the chaos of the European war from that time period still remains in the vaults at the New York Fed on Liberty Street. Benjamin Strong would die in 1928 at only 55 years of age. He had been a strong proponent of a more centralized governing body for the Federal Reserve and he would have seen some of his thoughts realized with the passing of the Banking Act of 1935.
Previously, each Federal Reserve Bank was making independent policies for their district that would often have spillover effects into other districts. You can imagine the mixed signals that would arise from 12 different central banks making 12 different policy decisions in the country. Problems abounded even in a time when the country was not as interconnected as it is today. This confusion led to the formation in the 1920’s of a committee that would coordinate policy within the Federal Reserve Banks of Boston, New York, Cleveland, Philadelphia, and Chicago. So five of the twelve. This committee would undergo a number of dramatic evolutions over the following years, but it wouldn’t be until the trials of the Great Depression and the resulting Banking Act of 1935 that the committee would be formalized as the FOMC and be given the binding powers that we recognize today.
As a final note, this same act also created the Federal Deposit Insurance Corporation or FDIC, who is responsible for insuring deposits. The existence of the FDIC is the leading reason that during the Great Recession there were not widespread bank runs by consumers like you and me. We knew that the FDIC would guarantee the money in our deposit accounts up to $250,000. And unfortunately, most of us don’t even come close to that kind of money in our checking or savings accounts.
For today’s history section I have relied heavily on an exceptional article written by Gary Richardson, the current official historian of the Federal Reserve. I have greatly simplified the story, and he goes into wonderful detail about the incremental process that was the creation of the FOMC. I highly recommend you go to my website where you can find a link to the article.
Please reach out with comments, recommendations, or questions about the The Bankster Podcast or the Centralverse in general. You can email me, email@example.com. Find me on twitter at the handle alexbagehot. At my website www.thebanksterpodcast.com you can find a transcript of today’s episode with links to all of the sources I used in creating the content. Keep checking in on the website! This week you’ll find on the Centralverse Connect page a treasure trove of helpful links to many critical websites in the Centralverse.
I’d like to thank those of you that wrote a review last week. Thanks to moorem24 who said, “Really well done - informative and interesting at the same time!” It’s as simple as going to the iTunes store, searching “The Bankster Podcast” and clicking on reviews. If you’ve learned anything new this episode or the previous ones, please write a review. It’s the best way for others to find out about the podcast. Today we learned about the incredibly important committee, the FOMC, that is setting the interest rate that affects how much you pay on your mortgage, car loan, student debt, as well as the interest rate you get on your savings account. You won’t look at your statement the same again! We also took a look at the history and creation of the FOMC. As the podcast continues to grow and strengthen you’ll appreciate more and more the impact that central banks have on our daily lives.
Today’s episode was written, edited, and produced by me, Alexander Bagehot.
I dedicate this episode to Alex Bloomberg, who taught me that it’s okay to be nervous to start something new, dive in. And to all of you, thanks for listening. I’m Alexander Bagehot, and I’ll see you next time on The Bankster Podcast!