It is well known that the Federal Reserve System was established by an Act of Congress in 1913 to provide our nation with a safer, more flexible and more stable monetary and financial system. At its founding, the Federal Reserve was structured by Congress to be independent within the government. Perhaps not as well known is that the Fed’s independence was tested during the tumultuous political and economic periods of World War I, the Great Depression and World War II, culminating with the outbreak of the Korean War in 1950.
During World War II, the Treasury asked the Fed to keep longer-term interest rates low to allow the government debt accrued during the war to be financed more cheaply. After the war ended, the Fed continued its wartime pegging of interest rates. However, keeping interest rates low even as the economy was growing strongly risked economic overheating and inflation.
In summer 1947, the Fed raised the peg on the Treasury bill rate. However, the Treasury insisted that the Fed continue to place a floor under the price of government debt by placing a ceiling on its yield. By the time of the outbreak of the Korean War in June 1950, policymakers at the Fed saw the experience of World War II through the lens of price controls and suppressed inflation. They did not want to repeat that experience in the Korean War.
In 1951, the Treasury agreed to end the arrangement and let the Fed set interest rates independently as needed to achieve economic stability. The Fed has remained independent since 1951, conducting monetary policy to foster economic stability without responding to short-term political pressures.
Read more about the Treasury-Federal Reserve Accord (Off-site) and additional Federal Reserve history at FederalReserveHistory.org (Off-site).
