How is the production of a Festschrift usually initiated? For the first time I have been asked to contribute to a Festschrift. I was surprised to read in the invitation that it is being prepared "in consultation with XY's institution and himself". I had always expected that the book would be a surprise for the honouree. I also don't quite understand what role the institution has to play in this. So how is a Festschrift usually initiated?
There is no standard, but most frequently, the 'birthday child' themselves initiate the Festschrift. This may be disillusioning, but it is the reality. I can say that as someone who has been involved with a few Festschriften (including once as an editor). 

Only in exceptional cases can I imagine a Festschrift being initiated without the jubilarian's knowledge. In such cases, the jubilarian should have an extremely high reputation; otherwise it is improbable that people would voluntarily use so much resources to initiate and edit such a huge (and not-so-rewarding) project.

But as stated above, usually, it is the jubilarian who expresses a wish to have a Festschrift. They then need to convince friends to take the time to serve as editors. The jubilarian and their friend-editors coordinate the whole Festschrift together so as to ensure that the jubilarian's wishes and preferences are satisfied. (There are quite some sensitivities and vanity involved, e.g. who should contribute, who must not contribute, who and how many hundreds or thousands of people should be listed in the Tabula Gratulatoria etc.)

As regards the involvement of the institution in your case, I can imagine that the institution may have provided a part of the budget (or perhaps administrative work or materials). A Festschrift consumes a lot of money, time and work. The help of an institution can be immensely valuable.