Large Bank Influence on U.S. Monetary Policy

Edwin Dickens
Professor and Chair, Department of Economics and Finance, Saint Peter’s University
Edickens@saintpeters.edu

“If you want to anticipate what the Federal Reserve will do next, the best approach is to ascertain what open market operations on its part will best help the large banks manage their asset portfolios.”

Almost all economists agree that the U.S. central bank — the Federal Reserve — serves the public interest by stabilizing the economy on a noninflationary growth path. For example, we are told that during the pandemic, the Federal Reserve lowered interest rates to alleviate unemployment and stimulate economic growth then, since March, has raised interest rates to fight inflation.

This is a myth. Instead of serving the public interest, the Federal Reserve serves the interests of the large U.S. banks. In the short run, it does this by helping the large banks manage their asset portfolios. And in the long run, it serves the interests of these large U.S. banks by helping them maintain their privileged position at the center of the dollar-based international financial system.

In this blog entry, I will focus on the short run and, for historical perspective, place the Federal Reserve’s behavior during the pandemic in the context of its reactions to the Great Recession, the Great Depression, and the 1953–4 recession.

In all four cases, financial crises destroyed the market value of securities, and thus bankrupted the large banks who hold most of the outstanding securities. And in all four cases the Federal Reserve bailed out the banks by printing enough money to buy the toxic securities from the banks at their par values even though the securities were selling at steep discounts from par in the open market. Then, as soon as the banks had sold their toxic assets to the Federal Reserve, the Federal Reserve raised interest rates to guarantee the banks a return on the assets they still held.

During the pandemic, the Federal Reserve printed more than $120 billion a month to buy toxic securities from the banks at par, bringing the banks total cash reserves to about $9 trillion. Since March, it has increased the interest rate it pays the banks on this $9 trillion of excess reserves from 15 basis points to 1.68 percent.

During the Great Recession, the Federal Reserve did the same thing, printing enough money to increase its securities holdings from about $800 million to $4.5 trillion. These securities purchases came in three rounds, starting in November 2008, November 2010, and August 2012, respectively. The first round was the most profitable for the banks, since the securities purchased were selling at the steepest discount in the open market. The second round also increased bank profits but by less than the first round, and bank profits were affected hardly at all by the third round because, by that time, the largest banks had already dumped their most toxic securities onto the Federal Reserve.

Therefore, as Gerald Epstein demonstrates in his seminal book, The Political Economy of Central Banking: Contested Control and the Power of Finance, the Federal Reserve halted its securities purchases even though the economy continued to stagnate below its potential. And it was at this time that the Federal Reserve hit upon the idea of simply paying the banks interest on the $4.5 trillion of excess reserves they held on deposit at the Federal Reserve, ensuring the banks of profits regardless of whether or not they made loans or purchased private-sector assets.

In a chapter of his book co-written by Thomas Ferguson, Epstein demonstrates that the Federal Reserve also bought and sold securities during the Great Depression in a way that best served the short-run interests of the large U.S. banks. In particular, between January and July 1932, the Federal Reserve printed $70 billion in order to bail out the banks from the consequences of the October 1929 stock market crash. The large banks responded to the stock-market crash by calling in their loans to everyone who had suffered losses, then using the funds thus obtained to build up portfolios of long-term securities. By January 1932, loans had dropped from 70 percent to 50 percent of the earning assets at the large banks, with their holdings of long-term securities rising proportionately.

All these long-term securities blew up in September 1931, when Britain abandoned the Gold Standard and speculators bet that the United States would follow suit. The speculators rushed to sell their dollar-denominated securities then exchange the dollars thus obtained for gold in anticipation that, when the Federal Reserve allowed the price of gold to rise in dollar terms, they would profit by re-selling the gold for the depreciated dollars.

The speculators made a bad bet. Instead of abandoning the Gold Standard, in October and November 1931, despite the fact that the economy was sinking into an ever-deeper depression, the Federal Reserve defended the dollar price of gold by raising interest rates, thereby putting a bear squeeze on the speculators, forcing them to unwind their positions in gold at the same fixed rate of exchange with the dollar that they had built them up at.

Nonetheless, the sell-off of securities in order to undertake the speculation caused the market price of the securities held by the large banks to fall far below their par values. Consequently, in January 1932 the Federal Reserve stepped in to relieve the large banks of their now toxic holdings of securities with its $70 billion of purchases of them at per.

In 1932, it was not yet possible for the banks to earn interest incomes by simply holding cash on deposit at the Federal Reserve. Therefore, by July 1932, the large banks had substituted for their most toxic securities the only safe asset that remained available in large quantities — the government’s three-month Treasury bill.

Between January and July 1932, the large banks’ holdings of Treasury bills increased to 23 percent of their total securities holdings, making them largely dependent on the interest rate on Treasury bills for their profits. Consequently, the Federal Reserve halted its own purchases of securities in order to help the banks out by propping up the interest rate on Treasury bills.

President Franklin Roosevelt was outraged that the Federal Reserve prioritized the interests of the large banks rather than stabilizing the economy on a noninflationary growth path, which would have called for continued large purchases of securities with newly printed money. The Roosevelt administration, with the support of solid Democratic majorities in both the House of Representatives and the Senate, thus reduced the Federal Reserve to the status of a bureau within the Treasury Department, and compelled it to maintain a term structure of interest rates ranging from 3/8th of a percent on Treasury bills to 2.5 percent on long-term government bonds.

Throughout the Roosevelt administration, the large banks fought rearguard actions against this subordination of the Federal Reserve to the Treasury Department. Nonetheless, it was not until the Truman administration that the large banks were able to help the Federal Reserve regain its independence, with the Treasury-Federal Reserve Accord of March 1951. For example, Russell Leffingwell, Chair of J.P. Morgan, was a major Democratic campaign contributor who helped finance Truman’s rise to the presidency. Consequently, Leffingwell had easy access to Truman’s White House. In fact, the day before the Accord was announced, Leffingwell spent thirty minutes with Truman in the Oval Office, persuading him to throw his support behind the Accord even though up until that time Truman had been adamantly opposed to it.

In March 1953, the Federal Reserve triggered a financial crisis and the 1953–4 recession by exercising its newfound independence for the first time. That is, it let a new issue of Treasury securities fall below par. The value of outstanding securities then fell in tandem with the new issue as the large banks panicked and changed the composition of their asset portfolios in the same way that they had during the Great Depression.

In May 1954, just as the recession reached its nadir, the composition of the large banks’ asset portfolios reached the tipping point between when the large banks needed the Federal Reserve’s help getting toxic securities off their balance sheets at par and when they were more in need of the Federal Reserve’s help in propping up the interest rate on the securities they still held. Therefore, the Federal Advisory Council (FAC) told the Federal Reserve Board that “a [Treasury] bill rate below one per cent is too low…open market operations could have been conducted so that the bill rate would not have fallen as low as it has recently” (FAC Minutes, 16 May 1954, p. 7).

The FAC is the principal lobbying organization for the large U.S. banks insofar as monetary policy is concerned. It is composed of the chairs of the largest banks; the Federal Reserve Board is required by law to meet with the FAC four times a year. In my book, The Political Economy of U.S. Monetary Policy: How the Federal Reserve Gained Control and Uses It, I demonstrate that what the FAC tells the Federal Reserve Board to do at these meetings is a highly statistically significant determinant of monetary policy, both before and after its subordination to the Treasury Department by the Roosevelt administration. In other words, if you want to anticipate what the Federal Reserve will do next, the best approach is to ascertain what open market operations on its part will best help the large banks manage their asset portfolios.