Federal Reserve Paper
4 Functions of the Fed
CHAPTER OBJECTIVES
The specific objectives of this chapter are to:
· ▪ describe the organizational structure of the Fed,
· ▪ describe how the Fed influences monetary policy,
· ▪ explain how the Fed revised its lending role in response to the credit crisis, and
· ▪ explain how monetary policy is used in other countries.
The Federal Reserve System (the Fed) is involved (along with other agencies) in regulating commercial banks. It is responsible for conducting periodic evaluations of state-chartered banks and savings institutions with more than $50 billion in assets. Its role as regulator is discussed in Chapter 18 .
4-1 OVERVIEW
As the central bank of the United States, the Fed has the responsibility for conducting national monetary policy in an attempt to achieve full employment and price stability (low or zero inflation) in the United States. With its monetary policy, the Fed can influence the state of the U.S. economy in the following ways. First, since the Fed's monetary policy affects interest rates, it has a strong influence on the cost of borrowing by households and thus affects the amount of monthly payments on mortgages, car loans, and other loans. In this way, monetary policy determines what households can afford and therefore how much consumers spend.
Second, monetary policy also affects the cost of borrowing by businesses and thereby influences how much money businesses are willing to borrow to support or expand their operations. By its effect on the amount of spending by households and businesses, monetary policy influences the aggregate demand for products and services in the United States and therefore influences the national income level and employment level. Since the aggregate demand can affect the price level of products and services, the Fed indirectly influences the price level and hence the rate of inflation in the United States.
Because the Fed's monetary policy affects interest rates, it has a direct effect on the prices of debt securities. It can also indirectly affect the prices of equity securities by affecting economic conditions, which influence the future cash flows generated by publicly traded businesses. Overall, the Fed's monetary policy can have a major impact on households, businesses, and investors. A more detailed explanation of how the Fed's monetary policy affects interest rates is provided in Chapter 5 .
WEB
Features economic and banking topics.
4-2 ORGANIZATIONAL STRUCTURE OF THE FED
During the late 1800s and early 1900s, the United States experienced several banking panics that culminated in a major crisis in 1907. This motivated Congress to establish a central bank. In 1913, the Federal Reserve Act was implemented, which established reserve requirements for the commercial banks that chose to become members. It also specified 12 districts across the United States as well as a city in each district where a Federal Reserve district bank was to be established. Initially, each district bank had the ability to affect the money supply (as will be explained later in this chapter). Each district bank focused on its particular district without much concern for other districts. Over time, the system became more centralized, and money supply decisions were assigned to a particular group of individuals rather than across 12 district banks.
The Fed earns most of its income from the interest on its holdings of U.S. government securities (to be discussed shortly). It also earns some income from providing services to financial institutions. Most of its income is transferred to the Treasury.
The Fed as it exists today has five major components:
· ▪ Federal Reserve district banks
· ▪ Member banks
· ▪ Board of Governors
· ▪ Federal Open Market Committee (FOMC)
· ▪ Advisory committees
4-2a Federal Reserve District Banks
The 12 Federal Reserve districts are identified in Exhibit 4.1 , along with the city where each district bank is located. The New York district bank is considered the most important because many large banks are located in this district. Commercial banks that become members of the Fed are required to purchase stock in their Federal Reserve district bank . This stock, which is not traded in a secondary market, pays a maximum dividend of 6 percent annually.
Each Fed district bank has nine directors. There are three Class A directors, who are employees or officers of a bank in that district and are elected by member banks to represent member banks. There are three Class B directors, who are not affiliated with any bank and are elected by member banks to represent the public. There are also three Class C directors, who are not affiliated with any bank and are appointed by the Board of Governors (to be discussed shortly). The president of each Fed district bank is appointed by the three Class B and three Class C directors representing that district.
Fed district banks facilitate operations within the banking system by clearing checks, replacing old currency, and providing loans (through the so-called discount window) to depository institutions in need of funds. They also collect economic data and conduct research projects on commercial banking and economic trends.
4-2b Member Banks
Commercial banks can elect to become member banks if they meet specific requirements of the Board of Governors. All national banks (chartered by the Comptroller of the Currency) are required to be members of the Fed, but other banks (chartered by their respective states) are not. Currently, about 35 percent of all banks are members; these banks account for about 70 percent of all bank deposits.
4-2c Board of Governors
The Board of Governors (sometimes called the Federal Reserve Board) is made up of seven individual members with offices in Washington, D.C. Each member is appointed by the President of the United States and serves a nonrenewable 14-year term. This long term is thought to reduce political pressure on the governors and thus encourage the development of policies that will benefit the U.S. economy over the long run. The terms are staggered so that one term expires in every even-numbered year.
WEB
Background on the Board of Governors, board meetings, board members, and the structure of the Fed.
Exhibit 4.1 Locations of Federal Reserve District Banks
One of the seven board members is selected by the president to be the Federal Reserve chairman for a four-year term, which may be renewed. The chairman has no more voting power than any other member but may have more influence. Paul Volcker (chairman from 1979 to 1987), Alan Greenspan (chairman from 1987 to 2006), and Ben Bernanke (whose term began in 2006) were regarded as being highly persuasive.
As a result of the Financial Reform Act of 2010, one of the seven board members is designated by the president to be the Vice Chairman for Supervision; this member is responsible for developing policy recommendations that concern regulating the Board of Governors. The Vice Chairman reports to Congress semiannually. The board participates in setting credit controls, such as margin requirements (percentage of a purchase of securities that must be paid with no borrowed funds). With regard to monetary policy, the board has the power to revise reserve requirements imposed on depository institutions. The board can also control the money supply by participating in the decisions of the Federal Open Market Committee, discussed next.
WEB
www.federalreserve.gov/monetarypolicy/fomc.htm
Find information about the Federal Open Market Committee (FOMC).
4-2d Federal Open Market Committee
The Federal Open Market Committee (FOMC) is made up of the seven members of the Board of Governors plus the presidents of five Fed district banks (the New York district bank plus 4 of the other 11 Fed district banks as determined on a rotating basis). Presidents of the seven remaining Fed district banks typically participate in the FOMC meetings but are not allowed to vote on policy decisions. The chairman of the Board of Governors serves as chairman of the FOMC.
The main goals of the FOMC are to achieve stable economic growth and price stability (low inflation). Achievement of these goals would stabilize financial markets and interest rates. The FOMC attempts to achieve its goals by controlling the money supply, as described shortly.
4-2e Advisory Committees
The Federal Advisory Council consists of one member from each Federal Reserve district who represents the banking industry. Each district's member is elected each year by the board of directors of the respective district bank. The council meets with the Board of Governors in Washington, D.C., at least four times a year and makes recommendations about economic and banking issues.
The Consumer Advisory Council is made up of 30 members who represent the financial institutions industry and its consumers. This committee normally meets with the Board of Governors four times a year to discuss consumer issues.
The Thrift Institutions Advisory Council is made up of 12 members who represent savings banks, savings and loan associations, and credit unions. Its purpose is to offer views on issues specifically related to these institutions. It meets with the Board of Governors three times a year.
4-2f Integration of Federal Reserve Components
Exhibit 4.2 shows the relationships among the various components of the Federal Reserve System. The advisory committees advise the board, while the board oversees operations of the district banks. The board and representatives of the district banks make up the FOMC.
4-2g Consumer Financial Protection Bureau
As a result of the Financial Reform Act of 2010, the Consumer Financial Protection Bureau was established. It is housed within the Federal Reserve but is independent of the other Fed committees. The bureau's director is appointed by the president with consent of the Senate. The bureau is responsible for regulating financial products and services, including online banking, certificates of deposit, and mortgages. In theory, the bureau can act quickly to protect consumers from deceptive practices rather than waiting for Congress to pass new laws. Financial services administered by auto dealers are exempt from the bureau's oversight. An Office of Financial Literacy will also be created to educate individuals about financial products and services.
WEB
www.federalreserve.gov/monetarypolicy/fomccalendars.htm
Provides minutes of FOMC meetings. Notice from the minutes how much attention is given to any economic indicators that can be used to anticipate future economic growth or inflation.
4-3 HOW THE FED CONTROLS MONEY SUPPLY
The Fed controls the money supply in order to affect interest rates and thereby affect economic conditions. Financial market participants closely monitor the Fed's actions so that they can anticipate how the money supply will be affected. They then use this information to forecast economic conditions and securities prices. The relationship between the money supply and economic conditions is discussed in detail in the following chapter. First, it is important to understand how the Fed controls the money supply.
Exhibit 4.2 Integration of Federal Reserve Components
4-3a Open Market Operations
The FOMC meets eight times a year. At each meeting, targets for the money supply growth level and the interest rate level are determined, and actions are taken to implement the monetary policy dictated by the FOMC. If the Fed wants to consider changing its targets for money growth or interest rates before its next scheduled meeting it may hold a conference call meeting.
Pre-Meeting Economic Reports About two weeks before the FOMC meeting, FOMC members are sent the Beige Book , which is a consolidated report of regional economic conditions in each of the 12 districts. Each Federal Reserve district bank is responsible for reporting its regional conditions, and all of these reports are consolidated to compose the Beige Book.
About one week before the FOMC meeting, participants receive analyses of the economy and economic forecasts. Thus there is much information for participants to study before the meeting.
Economic Presentations The FOMC meeting is conducted in the boardroom of the Federal Reserve Building in Washington, D.C. The seven members of the Board of Governors, the 12 presidents of the Fed district banks, and staff members (typically economists) of the Board of Governors are in attendance. The meeting begins with presentations by the staff members about current economic conditions and recent economic trends. Presentations include data and trends for wages, consumer prices, unemployment, gross domestic product, business inventories, foreign exchange rates, interest rates, and financial market conditions.
The staff members also assess production levels, business investment, residential construction, international trade, and international economic growth. This assessment is conducted in order to predict economic growth and inflation in the United States, assuming that the Fed does not adjust its monetary policy. For example, a decline in business inventories may lead to an expectation of stronger economic growth, since firms will need to boost production in order to replenish inventories. Conversely, an increase in inventories may indicate that firms will reduce their production and possibly their workforces as well. An increase in business investment indicates that businesses are expanding their production capacity and are likely to increase production in the future. An increase in economic growth in foreign countries is important because a portion of the rising incomes in those countries will be spent on U.S. products or services. The Fed uses this information to determine whether U.S. economic growth is adequate.
Much attention is also given to any factors that can affect inflation. For example, oil prices are closely monitored because they affect the cost of producing and transporting many products. A decline in business inventories when production is near full capacity may indicate an excessive demand for products that will pull prices up. This condition indicates the potential for higher inflation because firms may raise the prices of their products when they are producing near full capacity and experience shortages. Firms that attempt to expand their capacity under these conditions will have to raise wages to obtain additional qualified employees. The firms will incur higher costs from raising wages and therefore raise the prices of their products. The Fed becomes concerned when several indicators suggest that higher inflation is likely.
The staff members typically base their forecasts for economic conditions on the assumption that the prevailing monetary growth level will continue in the future. When it is highly likely that the monetary growth level will be changed, they provide forecasts for economic conditions under different monetary growth scenarios. Their goal is to provide facts and economic forecasts, not to make judgments about the appropriate monetary policy. The members normally receive some economic information a few days before the meeting so that they are prepared when the staff members make their presentations.
FOMC Decisions Once the presentations are completed, each FOMC member has a chance to offer recommendations as to whether the federal funds rate target should be changed. The target may be specified as a specific point estimate, such as 2.5 percent, or as a range, such as from 2.5 to 2.75 percent.
In general, evidence that the economy is weakening may result in recommendations that the Fed implement a monetary policy to reduce the federal funds rate and stimulate the economy. For example, Exhibit 4.3 shows how the federal funds rate was reduced near the end of 2007 and in 2008 as the economy weakened. In December 2008, the Fed set the targeted federal funds rate in the form of a range between 0 and 0.25 percent. The goal was to stimulate the economy by reducing interest rates in order to encourage more borrowing and spending by households and businesses. The Fed maintained the federal funds rate within this range over the 2009–2013 period.
When there is evidence of a very strong economy and high inflation, the Fed tends to implement a monetary policy that will increase the federal funds rate and reduce economic growth. This policy would be intended to reduce any inflationary pressure that is attributed to excess demand for products and services. The participants are commonly given three options for monetary policy, which are intended to cover a range of the most reasonable policies and should include at least one policy that is satisfactory to each member.
Exhibit 4.3 Federal Funds Rate over Time
The FOMC meeting allows for participation by voting and nonvoting members. The chairman of the Fed may also offer a recommendation and usually has some influence over the other members. After all members have provided their recommendations, the voting members of the FOMC vote on whether the interest rate target levels should be revised. Most FOMC decisions on monetary policy are unanimous, although it is not unusual for some decisions to have one or two dissenting votes.
FOMC Statement Following the FOMC meeting, the committee provides a statement that summarizes its conclusion. The FOMC has in recent years begun to recognize the importance of this statement, which is used (along with other information) by many participants in the financial markets to generate forecasts of the economy. Since 2007, voting members vote not only on the proper policy but also on the corresponding communication (statement) of that policy to the public. The statement is clearly written with meaningful details. This is an improvement over previous years, when the statement contained vague phrases that made it difficult for the public to understand the FOMC's plans. The statement provided by the committee following each meeting is widely publicized in the news media and also can be accessed on Federal Reserve websites.
Minutes of FOMC Meeting Within three weeks of a FOMC meeting, the minutes for that meeting are provided to the public and are also accessible on Federal Reserve websites. The minutes commonly illustrate the different points of view held by various participants at the FOMC meeting.
4-3b Role of the Fed's Trading Desk
If the FOMC determines that a change in its monetary policy is appropriate, its decision is forwarded to the Trading Desk (or the Open Market Desk ) at the New York Federal Reserve District Bank through a statement called the policy directive . The FOMC specifies a desired target for the federal funds rate, the rate charged by banks on short-term loans to each other. Even though this rate is determined by the banks that participate in the federal funds market, it is subject to the supply and demand for funds in the banking system. Thus, the Fed influences the federal funds rate by revising the amount of funds in the banking system.
Since all short-term interest rates are affected by the supply of and demand for funds, they tend to move together. Thus the Fed's actions affect all short-term interest rates that are market determined and may even affect long-term interest rates as well.
After receiving a policy directive from the FOMC, the manager of the Trading Desk instructs traders who work at that desk on the amount of Treasury securities to buy or sell in the secondary market based on the directive. The buying and selling of government securities (through the Trading Desk) is referred to as open market operations. Even though the Trading Desk at the Federal Reserve Bank of New York receives a policy directive from the FOMC only eight times a year, it continuously conducts open market operations to control the money supply in response to ongoing changes in bank deposit levels. The FOMC is not limited to issuing new policy directives only on its scheduled meeting dates. It can hold additional meetings at any time to consider changing the federal funds rate.
WEB
Treasury note and bond auction results.
Fed Purchase of Securities When traders at the Trading Desk at the New York Fed are instructed to lower the federal funds rate, they purchase Treasury securities in the secondary market. First, they call government securities dealers to obtain their list of securities for sale, including the denomination and maturity of each security, and the dealer's ask quote (the price at which the dealer is willing to sell the security). From this list, the traders attempt to purchase those Treasury securities that are most attractive (lowest prices for whatever maturities are desired) until they have purchased the amount requested by the manager of the Trading Desk. The accounting department of the New York Fed then notifies the government bond department to receive and pay for those securities.
When the Fed purchases securities through government securities dealers, the bank account balances of the dealers increase and so the total deposits in the banking system increase. This increase in the supply of funds places downward pressure on the federal funds rate. The Fed increases the total amount of funds at the dealers' banks until the federal funds rate declines to the new targeted level. Such activity, which is initiated by the FOMC's policy directive, represents a loosening of money supply growth.
The Fed's purchase of government securities has a different impact than a purchase by another investor would have because the Fed's purchase results in additional bank funds and increases the ability of banks to make loans and create new deposits. An increase in funds can allow for a net increase in deposit balances and therefore an increase in the money supply. Conversely, the purchase of government securities by someone other than the Fed (such as an investor) results in offsetting account balance positions at commercial banks. For example, as investors purchase Treasury securities in the secondary market, their bank balances decline while the bank balances of the sellers of the Treasury securities increase.
Fed Sale of Securities If the Trading Desk at the New York Fed is instructed to increase the federal funds rate, its traders sell government securities (obtained from previous purchases) to government securities dealers. The securities are sold to the dealers that submit the highest bids. As the dealers pay for the securities, their bank account balances are reduced. Thus the total amount of funds in the banking system is reduced by the market value of the securities sold by the Fed. This reduction in the supply of funds in the banking system places upward pressure on the federal funds rate. Such activity, which also is initiated by the FOMC's policy directive, is referred to as a tightening of money supply growth.
Fed Trading of Repurchase Agreements In some cases, the Fed may wish to increase the aggregate level of bank funds for only a few days in order to ensure adequate liquidity in the banking system on those days. Under these conditions, the Trading Desk may trade repurchase agreements rather than government securities. It purchases Treasury securities from government securities dealers with an agreement to sell back the securities at a specified date in the near future. Initially, the level of funds rises as the securities are sold; it is then reduced when the dealers repurchase the securities. The Trading Desk uses repurchase agreements during holidays and other such periods to correct temporary imbalances in the level of bank funds. To correct a temporary excess of funds, the Trading Desk sells some of its Treasury securities holdings to securities dealers and agrees to repurchase them at a specified future date.
Control of M1 versus M2 When the Fed conducts open market operations to adjust the money supply, it must also consider the measure of money on which it will focus. For the Fed's purposes, the optimal form of money should (1) be controllable by the Fed and (2) have a predictable impact on economic variables when adjusted by the Fed. The most narrow form of money, known as M1, includes currency held by the public and checking deposits (such as demand deposits, NOW accounts, and automatic transfer balances) at depository institutions. The M1 measure does not include all funds that can be used for transactions purposes. For example, checks can be written against a money market deposit account (MMDA) offered by depository institutions or against a money market mutual fund. In addition, funds can easily be withdrawn from savings accounts to make transactions. For this reason, a broader measure of money, called M2, also deserves consideration. It includes everything in M1 as well as savings accounts and small time deposits, MMDAs, and some other items. Another measure of money, called M3, includes everything in M2 in addition to large time deposits and other items. Although there are even a few broader measures of money, it is M1, M2, and M3 that receive the most attention. A comparison of these measures of money is provided in Exhibit 4.4 .
The M1 money measure is more volatile than M2 or M3. Since M1 can change owing simply to changes in the types of deposits maintained by households, M2 and M3 are more reliable measures for monitoring and controlling the money supply.
WEB
Click on “Economic Research & Data” to obtain Federal Reserve statistical releases.
Consideration of Technical Factors The money supply can shift abruptly as a result of so-called technical factors, such as currency in circulation and Federal Reserve float. When the amount of currency in circulation increases (such as during the holiday season), the corresponding increase in net deposit withdrawals reduces funds; when it decreases, the net addition to deposits increases funds. Federal Reserve float is the amount of checks credited to bank funds that have not yet been collected. A rise in float causes an increase in bank funds, and a decrease in float causes a reduction in bank funds.
Exhibit 4.4 Comparison of Money Supply Measures
|
MONEY SUPPLY MEASURES |
|
M1 = currency + checking deposits |
|
M2 = M1 + savings deposits, MMDAs, overnight repurchase agreements, Eurodollars, no institutional money market mutual funds, and small time deposits |
|
M3 = M2 + institutional money market mutual funds, large time deposits, and repurchase agreements and Eurodollars lasting more than one day |
The manager of the Trading Desk incorporates the expected impact of technical factors on funds into the instructions to traders. If the policy directive calls for growth in funds but technical factors are expected to increase funds, the instructions will call for a smaller injection of funds than if the technical factors did not exist. Conversely, if technical factors are expected to reduce funds, the instructions will call for a larger injection of funds to offset the impact of the technical factors.
Dynamic versus Defensive Open Market Operations Depending on the intent, open market operations can be classified as either dynamic or defensive. Dynamic operations are implemented to increase or decrease the level of funds, whereas defensive operations offset the impact of other conditions that affect the level of funds. For example, if the Fed expected a large inflow of cash into commercial banks then it could offset this inflow by selling some of its Treasury security holdings.
4-3c How Fed Operations Affect All Interest Rates
Even though most interest rates are market determined, the Fed can have a strong influence on these rates by controlling the supply of loanable funds. The use of open market operations to increase bank funds can affect various market-determined interest rates. First, the federal funds rate may decline because some banks have a larger supply of excess funds to lend out in the federal funds market. Second, banks with excess funds may offer new loans at a lower interest rate in order to make use of these funds. Third, these banks may also lower interest rates offered on deposits because they have more than adequate funds to conduct existing operations.
Because open market operations commonly involve the buying or selling of Treasury bills, the yields on Treasury securities are influenced along with the yields (interest rates) offered on bank deposits. For example, when the Fed buys Treasury bills as a means of increasing the money supply, it places upward pressure on their prices. Since these securities offer a fixed value to investors at maturity, a higher price translates into a lower yield for investors who buy them and hold them until maturity. While Treasury yields are affected directly by open market operations, bank rates are also affected because of the change in the money supply that open market operations bring about.
As the yields on Treasury bills and bank deposits decline, investors search for alternative investments such as other debt securities. As more funds are invested in these securities, the yields will decline. Thus open market operations used to increase bank funds influence not only bank deposit and loan rates but also the yields on other debt securities. The reduction in yields on debt securities lowers the cost of borrowing for the issuers of new debt securities. This can encourage potential borrowers (including corporations and individuals) to borrow and make expenditures that they might not have made if interest rates were higher.
If open market operations are used to reduce bank funds, the opposite effects occur. There is upward pressure on the federal funds rate, on the loan rates charged to individuals and firms, and on the rates offered to bank depositors. As bank deposit rates rise, some investors may be encouraged to create bank deposits rather than invest in other debt securities. This activity reduces the amount of funds available for these debt instruments, thereby increasing the yield offered on the instruments.
Open Market Operations in Response to the Economy During the 2001–2003 period, when economic conditions were weak, the Fed frequently used open market operations to reduce interest rates. During 2004–2007 the economy improved, and the Fed's concern shifted from a weak economy to high inflation. Therefore, it used a policy of raising interest rates in an attempt to keep the economy from overheating and to reduce inflationary pressure.
In 2008, the credit crisis began, and the economy remained weak through 2012. During this period, the Fed used open market operations and reduced interest rates in an attempt to stimulate the economy. Its operations brought short-term T-bill rates down to close to zero percent in an effort to reduce loan rates charged by financial institutions, and thus encourage more borrowing and spending. The impact of monetary policy on economic conditions is given much more attention in the following chapter.
4-3d Adjusting the Reserve Requirement Ratio
Depository institutions are subject to a reserve requirement ratio, which is the proportion of their deposit accounts that must be held as required reserves (funds held in reserve). This ratio is set by the Board of Governors. Depository institutions have historically been forced to maintain between 8 and 12 percent of their transactions accounts (such as checking accounts) and a smaller proportion of their other savings accounts as required reserves. The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 established that all depository institutions are subject to the Fed's reserve requirements. Required reserves were held in a non–interest-bearing form until 2008, when the rule was changed. Now the Fed pays interest on required reserves maintained by depository institutions.
Because the reserve requirement ratio affects the degree to which the money supply can change, it is considered a monetary policy tool. By changing it, the Board of Governors can adjust the money supply. When the board reduces the reserve requirement ratio, it increases the proportion of a bank's deposits that can be lent out by depository institutions. As the funds loaned out are spent, a portion of them will return to the depository institutions in the form of new deposits. The lower the reserve requirement ratio, the greater the lending capacity of depository institutions; for this reason, any initial change in bank required reserves can cause a larger change in the money supply. In 1992, the Fed reduced the reserve requirement ratio on transactions accounts from 12 to 10 percent, where it has remained.
Impact of Reserve Requirements on Money Growth An adjustment in the reserve requirement ratio changes the proportion of financial institution funds that can be lent out, and this affects the degree to which the money supply can grow.
EXAMPLE
Assume the following conditions in the banking system:
· Assumption 1. Banks obtain all their funds from demand deposits and use all funds except required reserves to make loans.
· Assumption 2. The public does not store any cash; any funds withdrawn from banks are spent; and any funds received are deposited in banks.
· Assumption 3. The reserve requirement ratio on demand deposits is 10 percent.
Based on these assumptions, 10 percent of all bank deposits are maintained as required reserves and the other 90 percent are loaned out (zero excess reserves). Now assume that the Fed initially uses open market operations by purchasing $100 million worth of Treasury securities.
As the Treasury securities dealers sell securities to the Fed, their deposit balances at commercial banks increase by $100 million. Banks maintain 10 percent of the $100 million, or $10 million, as required reserves and lend out the rest. As the $90 million lent out is spent, it returns to banks as new demand deposit accounts (by whoever received the funds that were spent). Banks maintain 10 percent, or $9 million, of these new deposits as required reserves and lend out the remainder ($81 million). The initial increase in demand deposits (money) multiplies into a much larger amount.
Exhibit 4.5 Illustration of Multiplier Effect
This process, illustrated in Exhibit 4.5 , will not continue forever. Every time the funds lent out return to a bank, a portion (10 percent) is retained as required reserves. Thus the amount of new deposits created is less for each round. Under the previous assumptions, the initial money supply injection of $100 million would multiply by 1 divided by the reserve requirement ratio, or 1/0.10, to equal 10; hence the total change in the money supply, once the cycle is complete, is $100 million × 10 = $1 billion.
As this simplified example demonstrates, an initial injection of funds will multiply into a larger amount. The reserve requirement controls the amount of loanable funds that can be created from new deposits. A higher reserve requirement ratio causes an initial injection of funds to multiply by a smaller amount. Conversely, a lower reserve requirement ratio causes it to multiply by a greater amount. In this way, the Fed can adjust money supply growth by changing the reserve requirement ratio.
In reality, households sometimes hold cash and banks sometimes hold excess reserves, contrary to the example's initial assumptions. Hence major leakages occur, and money does not multiply to the extent shown in the example. The money multiplier can change over time because of changes in the excess reserve level and in household preferences for demand deposits versus time deposits, as time deposits are not included in the most narrow definition of money. This complicates the task of forecasting how an initial adjustment in bank-required reserves will ultimately affect the money supply level. Another disadvantage of using the reserve requirement as a monetary policy tool is that an adjustment in its ratio can cause erratic shifts in the money supply. Thus the probability of missing the target money supply level is higher when using the reserve requirement ratio. Because of these limitations, the Fed normally relies on open market operations rather than adjustments in the reserve requirement ratio when controlling the money supply.
4-3e Adjusting the Fed's Loan Rate
The Fed has traditionally provided short-term loans to depository institutions through its discount window. Before 2003, the Fed set its loan rate (then called the “discount rate”) at low levels when it wanted to encourage banks to borrow, since this activity increased the amount of funds injected into the financial system. The discount rate was viewed as a monetary policy tool because it could have been used to affect the money supply (although it was not an effective tool).
Exhibit 4.6 Primary Credit Rate over Time
Since 2003, the Fed's rate on short-term loans to depository institutions has been called the primary credit lending rate, which is set slightly above the federal funds rate (the rate charged on short-term loans between depository institutions). Depository institutions therefore rely on the Fed only as a backup for loans, since they should be able to obtain short-term loans from other institutions at a lower interest rate.
The primary credit rate is shown in Exhibit 4.6 . The Fed periodically increased this rate during the 2003–2007 period when economic conditions were strong. It then periodically reduced this rate during the 2008–2010 period when economic conditions were weak, to keep it in line with the targeted federal funds rate.
In 2003, the Fed began classifying the loans it provides into primary and secondary credit. Primary credit may be used for any purpose and is available only to depository institutions that satisfy specific criteria reflecting financial soundness. The loans are typically for a one-day period. Secondary credit is provided to depository institutions that do not satisfy those criteria, so they must pay a premium above the loan rate charged on primary credit. The Fed's lending facility can be an important source of liquidity for some depository institutions, but it is no longer used to control the money supply.
4-4 THE FED'S INTERVENTION DURING THE CREDIT CRISIS
During and after the credit crisis, the Fed not only engaged in traditional open market operations (purchasing Treasury securities) to reduce interest rates, but also implemented various nontraditional strategies in an effort to improve economic conditions.
4-4a Fed Loans to Facilitate Rescue of Bear Stearns
Normally, depository institutions use the federal funds market rather than the Fed's discount window to borrow short-term funds. During the credit crisis in 2008, however, some depository institutions that were unable to obtain credit in the federal funds market were allowed to obtain funding from the Fed's discount window. In March 2008, the Fed's discount window provided funding that enabled Bear Stearns, a large securities firm, to avoid filing for bankruptcy. Bear Stearns was not a depository institution, so it would not ordinarily be allowed to borrow funds from the Fed. However, it was a major provider of clearing operations for many types of financial transactions conducted by firms and individuals. If it had gone bankrupt those financial transactions might have been delayed, potentially creating liquidity problems for many individuals and firms that were to receive cash as a result of the transactions. On March 16, 2008, the Fed's discount window provided a loan to J.P. Morgan Chase that was passed through to Bear Stearns. This ensured that the clearing operations would continue and avoided liquidity problems.
4-4b Fed Purchases of Mortgage-Backed Securities
In 2008 and 2009, the Fed purchased a large amount of outstanding mortgage-backed securities. It normally did not purchase mortgage-backed securities, but implemented this strategy to offset the reduction in the market demand for these securities due to investor fears. These fears were partially triggered by the failure of Lehman Brothers (a very large financial institution) in 2008, which suffered serious losses in its investments in mortgages and mortgage-backed securities. The market values of these securities had weakened substantially due to the high default rate on mortgages. The Fed's strategy was intended to create a demand for mortgages and securities backed by mortgages in order to stimulate the housing market. The Fed has continued to periodically purchase mortgage-backed securities in recent years.
4-4c Fed's Purchase of Bonds Backed by Loans
In November 2008, the Federal Reserve created a term asset-backed security loan facility (TALF) that provided financing to financial institutions purchasing high-quality bonds backed by consumer loans, credit card loans, or automobile loans. The market for these types of bonds became inactive during the credit crisis, and this discouraged lenders from making consumer loans because they could not easily sell the loans in the secondary market. The facility provided loans to institutional investors that purchased these types of loans. In this way, the Fed encouraged financial institutions to return to this market and thereby increased its liquidity. This was important because it indirectly ensured that more funding would be available to support consumer loans.
4-4d Fed's Purchase of Commercial Paper
During 2008 and 2009, the Fed purchased a large amount of commercial paper. It normally did not purchase commercial paper, but implemented this strategy to offset the reduction in the market demand for commercial paper due to investor fears of defaults on commercial paper. Those fears were partially triggered by the failure of Lehman Brothers, which caused Lehman to default on the commercial paper that it had previously issued. Investors presumed that if Lehman's asset quality was so weak that it could not cover its payments on commercial paper, other financial institutions that issued commercial paper and had large holdings of mortgage-backed securities might have the same outcome.
Furthermore, the issuance of commercial paper and other debt securities in the primary market declined because institutional investors were unwilling to purchase securities that could not be sold in the secondary market. Hence credit was no longer easily accessible, and this made the credit crisis worse. The Fed recognized that some of these debt securities had low risk, yet the financial markets were paralyzed by fear of potential default. The Fed's willingness to purchase commercial paper and other debt securities restored trading and liquidity in some debt markets.
4-4e Fed's Purchase of Long-term Treasury Securities
In 2010, the Fed purchased a large amount of long-term Treasury notes and bonds, which was different from its normal open market operations that focused on purchasing short-term Treasury securities. The emphasis on purchasing long-term securities was intended to reduce long-term Treasury bond yields, which would indirectly result in lower long-term borrowing rates. The Fed was attempting to reduce long-term interest rates to encourage more long-term borrowing by corporations for capital expenditures, or more long-term borrowing by individuals to purchase homes. This strategy is discussed in more detail in the following chapter.
4-4f Perception of Fed Intervention During the Crisis
Most people would agree that the Fed took much initiative to improve economic conditions during the credit crisis. However, opinions vary on exactly what the Fed should have done to improve the economy. Many of the Fed's actions during the credit crisis reflected the purchasing of securities to either lower interest rates (traditional monetary policy) or to restore liquidity in the markets for various types of debt securities. The Fed's focus was on improving conditions in financial markets, which can increase the flow of funds from financial markets to corporations or individuals.
However, some critics argue that the actions taken by the Fed were focused on the financial institutions and not on other sectors in the economy. A portion of the criticism is linked to the very high compensation levels paid by some financial institutions (such as some securities firms) to their employees. Critics contend that if these securities firms can afford to pay such high salaries, they should not need to be bailed out by the government.
The Fed might respond that it did not bail out Lehman Brothers (a securities firm), which is why Lehman failed. In addition, the Fed's actions to restore liquidity in debt markets did not just help financial institutions, but were necessary to ensure that all types of corporations and individuals could obtain funding. That funding is needed for corporations and individuals to increase their spending, which can stimulate the economy and create jobs.
It might seem from the previous discussion that there are primarily two opinions regarding the Fed's intervention. In reality, there are many other opinions not covered here. Consider a classroom exercise in which all students are allowed to express their opinion about what the Fed (or U.S. government in general) should have done to correct the credit crisis. Answers will likely range from “the U.S. government should do nothing and let the market fix itself” to “the U.S. government should completely manage all banks and should control salaries.” Many students might suggest that the U.S. government should intervene by directing more of its funds to the automotive, health care, or other industries in which they have a personal interest. Some answers might even suggest that major trade barriers should be imposed to correct the credit crisis, which leads to another set of opposing arguments. The point is that during a severe credit crisis, many critics will believe that intervention taken by the Fed is not serving their own interests because they have diverse special interests. Students would likely agree more on the causes of the credit crisis (which are discussed in detail in Chapter 9 ) than on how the Fed or U.S. government in general should have resolved the crisis.
4-5 GLOBAL MONETARY POLICY
Each country has its own central bank that conducts monetary policy. The central banks of industrialized countries tend to have somewhat similar goals, which essentially reflect price stability (low inflation) and economic growth (low unemployment). Resources and conditions vary among countries, however, so a given central bank may focus more on a particular economic goal.
Like the Fed, central banks of other industrialized countries use open market operations and reserve requirement adjustments as monetary tools. They also make adjustments in the interest rate they charge on loans to banks as a monetary policy tool. The monetary policy tools are generally used as a means of affecting local market interest rates in order to influence economic conditions.
Because country economies are integrated, the Fed must consider economic conditions in other major countries when assessing the U.S. economy. The Fed may be most effective when it coordinates its activities with those of central banks of other countries. Central banks commonly work together when they intervene in the foreign exchange market, but conflicts of interest can make it difficult to coordinate monetary policies.
4-5a A Single Eurozone Monetary Policy
One of the goals of the European Union (EU) has been to establish a single currency for its members. In 2002, the following European countries replaced their national currencies with the euro: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Since that time, five more countries have also adopted the euro: Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, and Estonia in 2011. When the euro was introduced, three of the EU's members at that time (Denmark, Sweden, and the United Kingdom) decided not to adopt the euro, although they may join later. Since the euro was introduced, 12 emerging countries in Europe have joined the EU (10 countries, including the Czech Republic and Hungary, joined in 2004; Bulgaria and Romania joined in 2007). Five of these new members have already adopted the euro, and others may eventually do so after satisfying the limitations imposed on government deficits.
The European Central Bank (ECB), based in Frankfurt, is responsible for setting monetary policy for all European countries that use the euro as their currency. This bank's objective is to control inflation in the participating countries and to stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies. Thus the ECB's monetary goals of price and currency stability are similar to those of individual countries around the world; they differ in that they are focused on a group of countries rather than a single country. Because participating countries are subject to the monetary policy imposed by the ECB, a given country no longer has full control over the monetary policy implemented within its borders at any given time. The implementation of a common monetary policy may lead to more political unification among participating countries and encourage them to develop similar national defense and foreign policies.
WEB
Provides links on the European Central Bank and other foreign central banks.
Impact of the Euro on Monetary Policy As just described, the use of a common currency forces countries to abide by a common monetary policy. Changes in the money supply affect all European countries that use the euro as their currency. A single currency also means that the risk-free interest rate offered on government securities must be similar across the participating European countries. Any discrepancy in risk-free rates would encourage investors within these countries to invest in the country with the highest rate, which would realign the interest rates among the countries.
Although having a single monetary policy may allow for more consistent economic conditions across the euro zone countries, it prevents any participating country from solving local economic problems with its own unique monetary policy. Euro zone governments may disagree on the ideal monetary policy for their local economies, but they must nevertheless agree on a single monetary policy. Yet any given policy used in a particular period may enhance economic conditions in some countries and adversely affect others. Each participating country is still able to apply its own fiscal policy (tax and government expenditure decisions), however.
One concern about the euro is that each of the participating countries has its own agenda, which may prevent unified decisions about the future direction of the euro zone economies. Each country was supposed to show restraint on fiscal policy spending so that it could improve its budget deficit situation. Nevertheless, some countries have ignored restraint in favor of resolving domestic unemployment problems. The euro's initial instability was partially attributed to political maneuvering as individual countries tried to serve their own interests at the expense of the other participating countries. This lack of solidarity is exactly the reason why there was some concern about using a single currency (and therefore monetary policy) among several European countries. Disagreements over policy intensified as the European economies weakened during 2008 and 2009.
4-5b Global Central Bank Coordination
In some cases, the central banks of various countries coordinate their efforts for a common cause. Shortly after the terrorist attack on the United States on September 11, 2001, the central banks of several countries injected money denominated in their respective currencies into the banking system to provide more liquidity. This strategy was intended to ensure that sufficient money would be available in case customers began to withdraw funds from banks or cash machines. On September 17, 2001, the Fed's move to reduce interest rates before the U.S. stock market reopened was immediately followed by similar decisions by the Bank of Canada (Canada's central bank) and the European Central Bank.
Sometimes, however, central banks have conflicting objectives. For example, it is not unusual for two countries to simultaneously experience weak economies. In this situation, each central bank may consider intervening to weaken its home currency, which could increase foreign demand for exports denominated in that currency. But if both central banks attempt this type of intervention simultaneously, the exchange rate between the two currencies will be subject to conflicting forces.
EXAMPLE
Today, the Fed plans to intervene directly in the foreign exchange market by selling dollars for yen in an attempt to weaken the dollar. Meanwhile, the Bank of Japan plans to sell yen for dollars in the foreign exchange market in an attempt to weaken the yen. The effects are offsetting. One central bank can attempt to have a greater impact by selling more of its home currency in the foreign exchange market, but the other central bank may respond to offset that force.
Global Monetary Policy during the Credit Crisis During 2008, the effects of the credit crisis began to spread internationally. During August-October, stock market prices in the United States, Canada, China, France, Germany, Italy, Japan, Mexico, Russia, Spain, and many other countries declined by more than 25 percent. Each central bank has its own local interest rate that it might influence with monetary policy in order to control its local economy. Exhibit 4.7 shows how the targeted interest rate level by various central banks changed over time. Notice how these banks increased their targeted interest rate level during the 2006–2007 period because their economies were strong at that time. However, during the financial crisis in 2008, these economies weakened, and the central banks (like the Fed) reduced their interest rates in an effort to stimulate their respective economies.
Exhibit 4.7 Targeted Interest Rates by Central Banks over Time
SUMMARY
· ▪ The key components of the Federal Reserve System are the Board of Governors and the Federal Open Market Committee. The Board of Governors determines the reserve requirements on account balances at depository institutions. It is also an important subset of the Federal Open Market Committee (FOMC), which determines U.S. monetary policy. The FOMC's monetary policy has a major influence on interest rates and other economic conditions.
· ▪ The Fed uses open market operations (the buying and selling of securities) as a means of adjusting the money supply. The Fed purchases securities to increase the money supply and sells them to reduce the money supply.
· ▪ In response to the credit crisis, the Fed provided indirect funding to Bear Stearns (a large securities firm) so that it did not have to file for bankruptcy. It also created various facilities for providing funds to financial institutions and other corporations. One facility allowed primary dealers that serve as financial intermediaries for bonds and other securities to obtain overnight loans. Another facility purchased commercial paper issued by corporations.
· ▪ Each country has its own central bank, which is responsible for conducting monetary policy to achieve economic goals such as low inflation and low unemployment. Seventeen countries in Europe have adopted a single currency, which means that all of these countries are subject to the same monetary policy.
POINT COUNTER-POINT
Should There Be a Global Central Bank?
Point Yes. A global central bank could serve all countries in the manner that the European Central Bank now serves several European countries. With a single central bank, there could be a single monetary policy across all countries.
Counter-Point No. A global central bank could create a global monetary policy only if a single currency were used throughout the world. Moreover, all countries would not agree on the monetary policy that would be appropriate.
Who Is Correct? Use the Internet to learn more about this issue and then formulate your own opinion.
QUESTIONS AND APPLICATIONS
· 1. The Fed Briefly describe the origin of the Federal Reserve System. Describe the functions of the Fed district banks.
· 2. FOMC What are the main goals of the Federal Open Market Committee (FOMC)? How does it attempt to achieve these goals?
· 3. Open Market Operations Explain how the Fed increases the money supply through open market operations.
· 4. Policy Directive What is the policy directive, and who carries it out?
· 5. Beige Book What is the Beige Book, and why is it important to the FOMC?
· 6. Reserve Requirements How is money supply growth affected by an increase in the reserve requirement ratio?
· 7. Control of Money Supply Describe the characteristics that a measure of money should have if it is to be manipulated by the Fed.
· 8. FOMC Economic Presentations What is the purpose of economic presentations during an FOMC meeting?
· 9. Open Market Operations Explain how the Fed can use open market operations to reduce the money supply.
· 10. Effect on Money Supply Why do the Fed's open market operations have a different effect on the money supply than do transactions between two depository institutions?
· 11. Discount Window Lending during Credit Crisis Explain how and why the Fed extended its discount window lending to nonbank financial institutions during the credit crisis.
· 12. The Fed versus Congress Should the Fed or Congress decide the fate of large financial institutions that are near bankruptcy?
· 13. Bailouts by the Fed Do you think that the Fed should have bailed out large financial institutions during the credit crisis?
· 14. The Fed's Impact on Unemployment Explain how the Fed's monetary policy affects the unemployment level.
· 15. The Fed's Impact on Home Purchases Explain how the Fed influences the monthly mortgage payments on homes. How might the Fed indirectly influence the total demand for homes by consumers?
· 16. The Fed's Impact on Security Prices Explain how the Fed's monetary policy may indirectly affect the price of equity securities.
· 17. Impact of FOMC Statement How might the FOMC statement (following the committee's meeting) stabilize financial markets more than if no statement were provided?
· 18. Fed Facility Programs during the Credit Crisis Explain how the Fed's facility programs improved liquidity in some debt markets.
· 19. Consumer Financial Protection Bureau As a result of the Financial Reform Act of 2010, the Consumer Financial Protection Bureau was established and housed within the Federal Reserve. Explain the role of this bureau.
· 20. Euro zone Monetary Policy Explain why participating in the euro zone causes a country to give up its independent monetary policy and control over its domestic interest rates.
· 21. The Fed's Power What should be the Fed's role? Should it be focused only on monetary policy? Or should it be allowed to engage in the trading of various types of securities in order to stabilize the financial system when securities markets are suffering from investor fears and the potential for high default risk?
· 22. The Fed and Mortgage-Backed Securities How has the Fed used mortgage-backed securities in recent years, and what has it been trying to accomplish?
· 23. The Fed and Commercial Paper Why and how did the Fed intervene in the commercial paper market during the credit crisis?
· 24. The Fed and Long-term Treasury Securities Why did the Fed purchase long-term Treasury securities in 2010, and how did this strategy differ from the Fed's usual operations?
· 25. The Fed and TALF What was T ALF, and why did the Fed create it?
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
· a. “The Fed's future monetary policy will be dependent on the economic indicators to be reported this week.”
· b. “The Fed's role is to take the punch bowl away just as the party is coming alive.”
· c. “Inflation will likely increase because real short-term interest rates currently are negative.”
Managing in Financial Markets
Anticipating the Fed's Actions As a manager of a large U.S. firm, one of your assignments is to monitor U.S. economic conditions so that you can forecast the demand for products sold by your firm. You realize that the Federal Reserve implements monetary policy-and that the federal government implements spending and tax policies, or fiscal policy-to affect economic growth and inflation. However, it is difficult to achieve high economic growth without igniting inflation. Although the Federal Reserve is often said to be independent of the administration in office, there is much interaction between monetary and fiscal policies.
Assume that the economy is currently stagnant and that some economists are concerned about the possibility of a recession. Yet some industries are experiencing high growth, and inflation is higher this year than in the previous five years. Assume that the Federal Reserve chairman's term will expire in four months and that the President of the United States will have to appoint a new chairman (or reappoint the existing chairman). It is widely known that the existing chairman would like to be reappointed. Also assume that next year is an election year for the administration.
· a. Given the circumstances, do you expect that the administration will be more concerned about increasing economic growth or reducing inflation?
· b. Given the circumstances, do you expect that the Fed will be more concerned about increasing economic growth or reducing inflation?
· c. Your firm is relying on you for some insight on how the government will influence economic conditions and hence the demand for your firm's products. Given the circumstances, what is your forecast of how the government will affect economic conditions?
FLOW OF FUNDS EXERCISE
Monitoring the Fed
Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Expecting a strong U.S. economy, Carson plans to grow by expanding its business and by making acquisitions. The company expects that it will need substantial long-term financing, and it plans to borrow additional funds either through loans or by issuing bonds. The Carson Company is also considering issuing stock to raise funds in the next year.
Given its large exposure to interest rates charged on its debt, Carson closely monitors Fed actions. It subscribes to a special service that attempts to monitor the Fed's actions in the Treasury security markets. It recently received an alert from the service that suggested the Fed has been selling large holdings of its Treasury securities in the secondary Treasury securities market.
· a. How should Carson interpret the actions by the Fed? That is, will these actions place upward or downward pressure on the price of Treasury securities? Explain.
· b. Will these actions place upward or downward pressure on Treasury yields? Explain.
· c. Will these actions place upward or downward pressure on interest rates? Explain.
INTERNET/EXCEL EXERCISE
Assess the current structure of the Federal Reserve System by using the website www.federalreserve.gov/monetarypolicy/fomc.htm .
Go to the minutes of the most recent meeting. Who is the current chairman? Who is the current vice chairman? How many people attended the meeting? Describe the main issues discussed at the meeting.
WSJ EXERCISE
Reviewing Fed Policies
Review recent issues of the Wall Street Journal and search for any comments that relate to the Fed. Does Chapter 4 : Functions of the Fed 101 downward pressure on the price of Treasury securities? Explain. b. Will these actions place upward or downward pressure on Treasury yields? Explain. c. Will these actions place upward or downward pressure on interest rates? Explain. Go to the minutes of the most recent meeting. Who is the current chairman? Who is the current vice chairman? How many people attended the meeting? Describe the main issues discussed at the meeting. it appear that the Fed may attempt to revise the federal funds rate? If so, how and why?
ONLINE ARTICLES WITH REAL-WORLD EXAMPLES
Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.
If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.
For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):
· 1. Federal Reserve AND interest rate
· 2. Federal Reserve AND monetary policy
· 3. Board of Governors
· 4. FOMC meeting
· 5. FOMC AND interest rate
· 6. Federal Reserve AND policy
· 7. Federal Reserve AND open market operations
· 8. money supply AND interest rate
· 9. open market operations AND interest rate
· 10. Federal Reserve AND economy