The Federal Reserve faced its first major test during World War I, helping to finance the war by facilitating war bond sales and by providing loans at preferential rates to banks purchasing Treasury certificates. The Fed also took actions to bring inflation down following the conflict, emerging from the period better equipped to serve as a central bank.
World War I was the first test of the new Federal Reserve System, and it was a trial by fire.
The outbreak of war in Europe in August 1914 touched off a financial crisis. The stock market closed and banks faced runs by depositors. Meanwhile, the Federal Reserve Board and the twelve Reserve Banks were still getting organized. The crisis soon passed, but within months a new problem emerged. A large inflow of European gold to pay for US exports increased the money supply. The young Fed was powerless to offset the gold inflow or halt the resulting inflation. And once the nation entered the war, the Fed dedicated itself mainly to supporting the war effort.
But the conflict accelerated the evolution of the Federal Reserve into a true central bank by increasing its financial resources and transforming the US dollar into a major international currency. “The war reshaped the Federal Reserve System in many ways,” writes economist Allan Meltzer in his landmark work A History of the Federal Reserve.
Most important, the Fed leveraged its position as a lender to the banking system to facilitate war bond sales. To purchase war bonds over $1,000, the Treasury urged the public to “borrow and buy,” that is, to finance their purchases at local banks. The Fed supported this policy by lending to member banks at low interest rates when the proceeds were used to buy bonds. Between bond drives, the Federal Reserve also lent at preferential rates to banks purchasing Treasury certificates –– short-term borrowings issued in anticipation of tax receipts.
These fundraising efforts were very successful. By the spring of 1918, the federal government had sold roughly $10 billion ($155 billion in 2012 dollars) in war bonds and Treasury certificates.
As a result of Fed lending at low interest rates, credit conditions eased throughout the domestic economy, which was thriving on increased exports to Europe. Extensive borrowing by businesses and households stimulated economic growth but also increased the money supply, fueling inflation. In this period, raising or lowering interest rates on loans to member banks was the Federal Reserve’s main tool for regulating credit and controlling inflation. Changes in the Federal Reserve “discount” rate in turn affected interest rates on commercial paper and other types of loans and securities.
Soldiers returning from World War I parading through Victory Arch on Pennsylvania Avenue in Washington, D.C.
Soldiers returning from World War I parading through Victory Arch on Pennsylvania Avenue in Washington, D.C.
The Fed Comes Into its Own
Although the Fed focused on war finance at the expense of inflation during World War I, it emerged as a major player on the world stage after the war as it developed into a full-fledged central bank.
The war resulted in larger Federal Reserve gold holdings as gold flowed from Europe to pay for munitions, food, and other US exports. Under the gold standard in force at the time, every dollar in the economy was at least partially backed by the precious metal. Some of the additional gold flowed into Federal Reserve Bank vaults as reserves, allowing the Fed to take on more assets in the form of government securities. A sizable portfolio of securities would become an increasingly important monetary tool after the war. Just as it does today, the Fed in the 1920s used purchases and sales of securities to influence market interest rates and implement monetary policy.
By wreaking financial havoc in Europe, the war also enhanced the standing of the U.S. dollar among the world’s currencies. Huge military expenditures forced warring nations to abandon the gold standard; their money could no longer be redeemed for gold coin. But the dollar remained linked to gold. As the British pound and other European currencies became unstable, financiers and traders turned to the US dollar as a preferred medium of exchange.
World War I was a watershed event that put the Federal Reserve System to a stern test. The war made the Federal Reserve subservient to the Treasury for a time. But it also helped the Fed develop the financial resources and expertise necessary to function as a central bank. After the war the Fed asserted its independence from the Treasury and took measures to bring down the inflation that threatened to stifle economic growth.
