Finance Homework
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Chap4.pptxChapter Four
The Federal Reserve System, Monetary Policy, and Interest Rates
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The Federal Reserve
Founded by Congress under the Federal Reserve Act in 1913
Subject to oversight by Congress under its authority to create money
An independent central bank–its decisions do not have to be ratified by the President or Congress
Congressional oversight
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Functions of the Federal Reserve
Conduct monetary policy
Supervise and regulate depository institutions
Provide payment and other financial services to the U.S. government, the public, FIs, and foreign official institutions
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Functions of the Federal Reserve Continued
Maintain financial system stability
The Wall Street Reform and Consumer Protection Act of July 2010 requires the Fed to supervise complex financial institutions that could generate systemic risk to the economy
The Fed (and others) has now been given broader powers to seize or break up institutions whose actions could harm the economy
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Functions of the Federal Reserve Concluded
Maintain financial system stability
Implementing federal laws designed to protect consumers in credit and other financial transactions
Implementing regulations to ensure compliance, investigating complaints, and ensuring availability of services to low and moderate income groups and certain geographic regions
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Structure of the Federal Reserve
Divided into 12 Federal Reserve districts, each with a main Federal Reserve Bank
Federal Reserve Banks operate under the general supervision of the Board of Governors of the Federal Reserve
The Office of the Comptroller of the Currency (OCC) charters national banks, which are members of the Federal Reserve System (FRS)
FRS member banks “own” the 12 Federal Reserve Banks
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Board of Governors of the FRS
Seven member board headquartered in Washington, DC
President appoints and Senate confirms members to nonrenewable 14-year terms
President appoints and Senate confirms Chairman and vice-chairman to renewable 4-year terms
Formulates and conducts monetary policy and supervises and regulates banks
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Federal Open Market Committee (FOMC)
FOMC consists of 12 members
seven members of the Board of Governors
the president of the Federal Reserve Bank of NY
the presidents of four other Federal Reserve Banks (on a rotating basis)
The major monetary policy-making body of the FRS
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Federal Open Market Committee (FOMC) Continued
Policies seek to promote full employment, economic growth, price stability, and a sustainable pattern of international trade
Are there tradeoffs between these goals?
Why is international monetary cooperation necessary?
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There can be tradeoffs between these goals. The Fed must balance expansive monetary policy that tends to generate growth and higher employment against inflationary pressures in the economy. When unemployment is high the Fed’s attempt to stimulate the economy to generate additional jobs may result in inflation.
There are also tradeoffs in U.S. monetary policy and the value of the dollar. A simulative U.S. policy may cause the dollar to drop, particularly if U.S. growth remains slow.
If the Fed keeps U.S. inflation below the rest of the world then the U.S. dollar will tend to strengthen, all else equal, and with a strong dollar U.S. imports are likely to exceed U.S. exports, leading to a trade deficit. This is why international monetary policy cooperation is needed and the Group of 20 meets periodically to coordinate policies.
Federal Open Market Committee (FOMC) Concluded
The FOMC sets ranges for growth of monetary aggregates and the fed funds rate, and also directs operations in FX markets
Open market operations are the main policy tool used to achieve monetary targets:
involve the purchase and sale of U.S. government and federal agency securities
are implemented by the Federal Reserve Board Trading Desk of the New York Federal Reserve Bank
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The Fed and the Crisis
2007
Term Auction Facility (TAF) created
2008
March: Fed facilitates J.P. Morgan Chase purchase of Bear-Stearns
Term Securities Lending Facility (TSLF) created
Primary Dealer Credit Facility (PDCF): Expands discount window borrowing to investment banks
September: Lehman Brothers collapses, Goldman-Sachs and Morgan Stanley become commercial banks, Merrill-Lynch is bought by Bank of America
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The Fed took the unprecedented step of guaranteeing $30 billion of Bear Stearn’s illiquid mortgage assets, presumably via TSLF
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The Fed and the Crisis Continued
2008 (continued)
Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Money Market Investor Funding Facility and the Term Asset-Backed Securities Loan Facility (TALF) are created
Average weekly lending from the Fed grew from about $59 million in 2006 to almost $850 billion per week in late 2008
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The AMLF and the CPFF were created because liquidity collapsed in the commercial paper market. The MMIFF was created to help stem liquidity problems in money market mutual funds that resulted when one fund failed. The TALF was designed to encourage securitization to continue. Slowdowns in securitization have reduced the amount of credit available to borrowers in certain markets.
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The Fed and the Crisis Concluded
August 2006 fed funds rate = 5.25%
April 2008 fed funds rate = 2.00%
By year end 2008 target fed funds rate between 0 and 0.25% and the discount rate was lowered to 0.5%
November 2008 -- The Fed announces it would engage in purchasing up to $600 billion in Treasuries and mortgage-backed securities (quantitative easing)
This amount was increased to $1.7 trillion in March 2009.
November 2010 the Fed announced a new series of bond buying of up to $600 billion in what has been termed QE2
September 2012 began QE3, monthly purchases of Treasuries and mortgage backed securities, tapering began in 2013
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Federal Reserve Banks
Assist in the conduct of monetary policy
Set and change the discount rate (must be approved by the Board of Governors)
Make discount window loans to depository institutions
Supervise and regulate FRS member banks
Conduct examinations and inspections of member banks
Issue warnings when banking activity is unsafe or unsound
Approve bank mergers and acquisitions
Provide government services
Act as the commercial banks of the U.S. Treasury
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Federal Reserve Banks
Issue new currency
Collect and replace currency in circulation as necessary
Clear checks
Act as a central clearing system for U.S. banks
Provide wire transfer services
Fedwire
Automated Clearinghouse (ACH)
Perform banking sector and economic research
Used in the formulation of monetary policy
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The Fed Wire facilitates trading of bank reserves.
The Fed/ACH processes debit and credit transactions and direct deposits and direct bill paying functions. The ACH now processes cross border payments and has recently begun offering same day clearing of certain checks converted to electronic images.
The Clearing House Interbank Payments System (CHIPS) provides yet another payment mechanism. CHIPS is a private sector electronic network operated by about 100 U.S. and foreign banks to facilitate correspondent services and international transactions. It is usually used in conjunction with Society for Worldwide Interbank Financial Telecommunication (SWIFT), an international messaging system, that sends instructions for payment terms. Authorization through SWIFT before money is moved via CHIPS provides a safeguard.
Discussion of the Federal Reserve
What are the implications of the bailouts of the financial crisis? Is the system safer now or can we expect another crisis in the future?
What does it mean to be too big to fail or systemically risky? Does designating an institution as systemically risky make the system safer?
What are the pros and cons of deposit insurance? Should the U.S. employ unlimited deposit insurance as some other countries do?
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Figure 4-5: The Process of Monetary Policy Implementation
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Balance Sheet of the Federal Reserve
Major liabilities
Reserve deposits
Currency in circulation
Note that currency in circulation + reserves = monetary base
Major assets
Treasury securities
U.S. government agency securities
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Monetary Policy Tools
Monetary policy affects the macroeconomy by influencing the supply and demand for excess bank reserves
Influences the money supply and the level of short-term and long-term interest rates
Affects foreign exchange rates, the amount of money and credit in the economy, and the levels of employment, output, and prices
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Monetary Policy Tools Continued
Financial Services Regulatory Relief Act of 2006
Authorized Federal Reserve to pay interest on reserve balances held by depository institutions
Federal Reserve can take one of two basic approaches to affect the market for banks’ excess reserves
Target quantity of reserves
Target interest rate on those reserves
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Open Market Operations
Open market operations
Policy directive of the FOMC is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York
Trading Desk manager buys or sells U.S. Treasury securities in the over-the-counter (OTC) market, which keeps the fed funds rate near its desired target
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Open Market Operations Continued
Open market operations
FRBNY acts through the Trading Desk to implement policy directives each business day
Operations may be permanent or temporary
May use repurchase agreements for temporary increases or decreases in excess reserves
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Discount Rate
The discount rate is the rate Federal Reserve Banks charge on loans to financial institutions in their district
The Federal Reserve rarely uses the discount rate as a policy tool
Discount rate changes are strong signals of the Federal Reserves intentions
There is no guarantee that banks will borrow, nor that they will lend
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The Fed did reduce the discount rate during the financial crisis and broadened access to more institutions.
Reserve Requirements
Reserve requirements are the reserve assets depository institutions must keep to “back” transaction deposits
Reserve assets include vault cash and deposits at Federal Reserve Banks
The multiplier effect
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Reserve Requirements: Example 1
Suppose reserves are $2 billion and the Fed increases reserves by 1%, or $20 million, when bank reserve requirements are 10%.
What is the predicted increase in bank deposits?
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Reserve Requirements: Example 2
Suppose that instead of changing the $2 billion in reserves, the Fed reduces the reserve requirement from 10% to 9%. What is the predicted increase in bank deposits?
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This assumes no drains.
The amount of drains is not very predictable. For instance, decreases in reserve requirements cannot be guaranteed to lead to increases in the money available for lending if banks choose to hold higher amounts of excess reserves at the Fed (as they did in the early 1990s and again in 2008.) Changes in the reserve requirement are rarely used as a monetary policy tool. This is perhaps because it is difficult to predict the effect of changes in the reserve ratio on the money supply. Changing the ratio frequently would likely impose additional costs on the banking system which attempts to manage and minimize its excess reserves.
Monetary Policy
Expansionary monetary policy
open market purchases of securities by the Fed
discount rate decreases
reserve requirement ratio decreases
Contractionary monetary policy
open market sales of securities by the Fed
discount rate increases
reserve requirement ratio increases
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Money Supply versus Interest Rate Targeting
Interest
Rate
Quantity of Money
i’=8%
i*=6%
i’’=4%
MS
MD’
MD’’
MD
Interest
Rate
Quantity of Money
iT = 6%
i’’= 5%
MS’
MS
MD’
MD
MD’’
MS
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Some economists believe that the Federal Reserve should announce a target inflation rate and limit monetary policy changes to hitting this target. Others believe the Fed should employ a different type of monetary policy rule where the rate of money supply growth is tied inflexibly to the economic growth rate. Most economists however believe that there are enough shocks to the system that require more intervention by the Federal Reserve than a rule or inflexible target would allow.
Problems in Conducting Monetary Policy
Significant time lags involved between policy implementation and effect
Supplying money to lenders does not guarantee they will lend
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Problems in Conducting Monetary Policy Continued
Lowering interest rates or supplying money are attempts to stimulate demand, but they may not work
Problems in consumer confidence
High unemployment
High debt levels
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Problems in Conducting Monetary Policy Concluded
Excessive money creation may reduce the value of the dollar and generate inflation
Inflation can cause interest rates to increase, hurting growth
Loss in confidence of foreign investors could cause higher interest rates, hurting growth
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International Monetary Policy
The Federal Reserve generally allows foreign exchange rates to fluctuate freely
Foreign exchange intervention
Commitments between countries about the institutional aspects of their intervention in the foreign exchange markets
similar to open market purchases and sales of Treasury securities
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Global Rescue Programs
Responses by major central banks to the financial crisis:
Expansion of retail deposit insurance
Direct injections of capital to improve lender’s balance sheets
Debt guarantees
Asset purchases or asset guarantees
Stress tests of banks
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