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49 Cards in this Set
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Federal Reserve LO
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Describe the roles of the Federal Reserve System (“Fed”).
Identify various components of the Fed Identify the Fed’s traditional monetary policy tools Understand how each policy tool affects the Fed Funds rate Compare the monetary policy tools Describe new monetary policy tools introduced in response to the financial crisis Discuss the rationale for introducing these new tools Describe features of the Term Auction Facility (TAF) and Commercial Paper Funding Facility (CPFF) |
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Why do we care about the Federal Reserve System?
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It is the central bank of the United States
Key duties: 1) Monetary policy Monetary policy actions affect interest rates, economic conditions and asset prices 2) Supervision and regulation of commercial banks 3) Stability of financial system Key website: http://www.federalreserve.gov |
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Fed Reserve Historical Background
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Federal Reserve Act of 1913
Created the Federal Reserve System What prompted creation of the Fed? Recurring financial panics in 19th and early 20th centuries led to bank failures and business bankruptcies Fed was created to serve as lender of last resort for banks and to prevent future panics |
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Structure of
Federal Reserve System
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Federal Reserve Banks
Member banks Board of Governors Federal Open Market Committee (FOMC) Federal Advisory Council |
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Federal Reserve Banks (FRBs)
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There are twelve Federal Reserve districts
Each district has a Federal Reserve Bank (FRB) Each FRB is a quasi-public institution owned by member banks in the district Member banks buy stock in the FRB and receive dividends limited by law to 6% annually Each FRB has 9 directors: 6 (elected by member banks), 3 (appointed by Board of Governors) Directors appoint FRB president |
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Functions of FRBs
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Clear checks
Issue new currency and withdraw damaged currency from circulation Make discount loans to banks in the district Collect economic data and conduct research Examine bank holding companies and state-chartered member banks Evaluate proposed mergers and applications for banks to expand their activities |
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Member banks
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Member banks
All national banks National bank: bank that receives a federal charter from the Office of the Comptroller of the Currency State-chartered banks are not required to be members but can choose to join About 37% of commercial banks are members No practical difference between member and non-member banks since 1987 |
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Board of Governors
a.k.a. Federal Reserve Board
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Consists of 7 members
Each member is appointed by US President and confirmed by Senate Member term: 14 years, non-renewable Chairman of the Board of Governors One of the members picked by US President 4-year term, renewable. Past chairmen: Paul Volcker, Alan Greenspan Current chairman: Ben Bernanke |
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Board of Governors has 2 roles
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Regulatory/supervisory
Supervises & regulates member banks, bank holding companies, foreign banks operating in the US Oversees Fed Res district banks Regulates consumer finance Monetary policy Controls reserve requirement and discount rate Members of Federal Open Market Committee (FOMC) and vote on conduct of open market operations Both roles were established by the Federal Reserve Act of 1913 |
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Federal Open Market Committee (FOMC)
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Makes decisions on open market operations (discussed later), which influence money supply and interest rates
Open market operation is the most important monetary policy tool Decisions regarding reserve requirement and discount rate effectively made during FOMC meetings FOMC usually meets eight time a year (about every six weeks) |
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FOMC Composition
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Members
Board of Governors Presidents of 5 FRBs NY FRB president always included Four of the remaining eleven FRB presidents serve one-year terms on a rotating basis FOMC Chairman is Chairman of Board of Governors |
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2009 FOMC Composition
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Board of Governors
Ben S. Bernanke, Chairman Elizabeth Duke Donald Kohn Daniel Tarullo Kevin Warsh (two short) Presidents of FRBs William Dudley, New York, Vice Chairman Charles Evans, Chicago Jeffrey Lacker, Richmond Dennis Lockhart, Atlanta Janet Yellen, San Francisco Alternate members: James Bullard, St Louis Thomas Hoenig, Kansas City Sandra Pianalto, Cleveland Eric Rosengren, Boston Christine M. Cumming, First VP, New York |
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Federal Advisory Council
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Consists of 12 representatives from banking industry
Consults with and advises Board of Governors Meets with the Board four times a year, as required by Federal Reserve Act |
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Monetary Policy
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Monetary policy: Management of money supply and interest rates
Fed’s Monetary Policy Goals Specified in Federal Reserve Act, Section 2A Board of Governors & FOMC are to conduct monetary policy to promote the goals of: Maximum employment Stable prices Moderate long-term interest rates |
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Traditional Monetary Policy Tools
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Prior to the financial crisis that began in the summer of 2007, the Fed’s monetary policy tools consisted of:
Open market operations (OMOs) Discount rate (DR) Reserve requirement ratio (RRR) |
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Traditional Monetary Policy Tools
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Federal Reserve uses these tools to influence interest rates, specifically the Federal Funds rate
What is the Federal Funds rate? How does the Fed use monetary policy tools to affect the Federal Funds rate? |
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Federal Funds and
Federal Funds Rate
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Federal Funds (Fed Funds for short)
Fed Funds are reserves (i.e., money) that depository institutions lend to one another on a short term, unsecured basis Loans are usually for 1 day (“overnight”) to 7 days Fed funds rate: interest rate charged on such loans Determined by the demand for and supply of reserves When the Fed uses its monetary policy tools, it changes demand for / supply of reserves, and in turn the Fed Funds rate |
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Reserves
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Money that banks have deposited with the Fed plus currency physically held by banks (vault cash)
Required reserves reserves that Fed requires banks to hold. Set by required reserve ratio (more on this later). Excess reserves additional reserves that banks choose to hold Reserves are part of the money supply |
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Supply of reserves
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Nonborrowed reserves + borrowed reserves
Nonborrowed reserves (NBR) Reserves supplied by Fed’s open market operations Borrowed reserves (BR) Reserves borrowed from the Fed (via discount loans) Supply curve for reserves (“flipped L”): Perfectly inelastic (vertical) at NBR for all interest rates below discount rate, id Perfectly elastic (horizontal) for all interest rates at discount rate, id |
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Simplified Fed Balance Sheet
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Federal Reserve System
Assets Government securities: U.S. Treasury bills and bonds that the Fed purchased in the open market Discount Loans: Loans that the Fed made to banks (more later) Liabilities Currency in circulation: Physical currency in hands of the public, e.g. $20 note in your wallet Reserves: Already discussed |
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Open Market Operations, sl. 1
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Buying and selling of securities in the open market by the Fed
What types of securities? Usually U.S. Government securities/ Treasury securities, especially Treasury bills Why? Market for Treasuries is very liquid and has huge trading volume Allows Fed to buy and sell large quantities without causing excessive price fluctuations and disruption |
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Open Market Operations, sl. 2
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Most important monetary policy tool because they directly affect reserves and therefore the Fed Funds rate
FOMC makes the decision to either raise or lower the target for Fed Funds rate At each meeting, FOMC members are briefed on economic forecasts and current economic conditions in each district (see p.155 of text for details) Members vote on whether to maintain or change Fed Funds rate target Instructions sent to Trading Desk at NY FRB to conduct the necessary open market operations |
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Open Market Operations, sl. 3
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If FOMC decides to decrease the target for Fed Funds rate
Trading desk instructed to BUY government securities ↑ NBR and shifts supply curve for reserves to the right Equilibrium Fed Funds rate ↓ , ceteris paribus If FOMC decides to increase the target for Fed Funds rate Trading desk instructed to SELL government securities. ↓ NBR and shifts supply curve for reserves to the right Equilibrium Fed Funds rate ↑, ceteris paribus |
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Response to an Open Market Operation
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An open market purchase increases nonborrowed reservs and hence the reserves supplied, and shifts the supply curve from Rs1 to Rs2. The equilibrium moves from point 1 to point 2, lowering the federal funds rate from i1ff to i2ff
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Discount rate
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Interest rate charged to depository institutions (DIs) on loans they receive from their FRB’s lending facility--the discount window.
Discount window loans are: historically, very short term loans, e.g., 1 day or 1 week fully secured, i.e., require collateral There are actually three discount window lending facilities. |
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Discount window lending facilities
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Primary credit
Available to DIs in good financial condition Fed’s main discount window lending facility Interest rate charged is the “discount rate” referred to by the Fed and financial press 3/18/2008: max maturity increased to 90 days Secondary credit Available to DIs that are financially weaker and cannot borrow from Primary Credit facility Seasonal credit Available to small DIs that have recurring funding needs (i.e., cash flow problems) during the year |
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Different discount windows, different discount rates
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Primary Credit
Discount rate is higher than Fed Funds rate Secondary Credit Discount rate is higher than Primary Credit discount rate (why?) Seasonal Credit Discount rate is average of selected market rates Rates on all three facilities are the same for all Federal Reserve District banks |
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Acceptable collateral
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Long list that includes:
US Treasury securities (T-bills, T-notes, T-bonds) US Government/Agency obligations backed by Full Faith and Credit of US government. Example: Government National Mortgage Association (Ginnie Mae) bonds US Government Sponsored Enterprise obligations. Examples: bond issued by Federal National Mortgage Association (Fannie Mae) Municipal bonds, corporate bonds and commercial paper of investment quality (i.e., low risk) Loans held by depository institutions |
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Current interest rates
from the Fed
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As of 2/14/2010:
Primary Credit: 0.50% Secondary Credit: 1.00% Seasonal Credit: 0.15% Fed Funds Target: 0-0.25% Source: Fed Res Discount Window web site, http://www.frbdiscountwindow.org/index.cfm |
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Discount rate
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Fed can influence Fed Funds rate by changing discount rate. But, not always effective:
Effectiveness depends on whether demand curve intersects supply curve in the vertical or horizontal section Vertical (no discount lending) Change in discount rate (either ↑ or ↓) will not move intersection between demand and supply curves. Therefore, no change in equilibrium Fed funds rate Typical situation because Fed usually keeps discount rate above Fed Funds rate target |
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Discount rate
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Horizontal (some discount lending)
When discount rate is decreased, horizontal section of the supply curve falls, decreasing the equilibrium Fed Funds rate When discount rate is increased, horizontal section of the supply curve rises, increasing the equilibrium Fed Funds rate |
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Lender of Last Resort (sl. 1)
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Besides being a monetary policy tool, discount window lending has a second function:
Allows Fed to be the lender of last resort for banks and thus help prevent financial panics Lender of last resort = Fed makes loans (via discount window facility) to banks when no one else would Discount loans ensure that banks have sufficient cash to meet depositor withdrawals and payments to other creditors, thereby preventing bank failures, restoring public confidence and avoiding financial panic Example: 1984, Continental Illinois |
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Lender of Last Resort (sl. 2)
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As lender of last resort, Fed can also prevent financial failures not triggered by bank failures, e.g.,
Oct 19, 1987 Black Monday stock market crash Sept 11, 2001 terrorist attack But there are costs! Banks and other financial institutions may take on more risk (moral hazard) knowing the Fed will come to the rescue |
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Reserve Requirement Ratio (RRR)
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The proportion of checkable deposits that must be held as required reserves
Required reserves = money that banks cannot lend out As of Jan 1, 2009, reserve requirement ratio: 0% : $0 <= deposits <= $10.3 mil 3% : $10.3 mil < deposits <= $44.4 mil 10% : deposits > $44.4 mil All depository institutions subject to same requirements |
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RRR and Fed Funds rate
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When RRR ↑, required reserves ↑
Demand curve shifts to the right, Fed Funds rate ↑ When RRR ↓, required reserves ↓ Demand curve shifts to the left, Fed Funds rate ↓ |
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Response to a Change in Required Reserves
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When the Fed raises reserve requirements, required reserves increase, which increases the demand for reserves. The demand curve shifts from R^d,sub1 to R^2,sub2. The equilibrium moves from point 1 to 2, and the federal funds rate rises from i^1,subff to i^2,subff.
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Reserve Requirement Ratio
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Rarely used as a tool
Raising the ratio causes liquidity problems for banks with low excess reserves Continually fluctuating reserve requirements create more uncertainty for banks and make liquidity management more difficult |
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Comparing the three tools
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OMOs
Effective, always works: Open market purchases ↑ NBR and ↓ Fed Funds rate, vice versa Convenient; can be implemented quickly Discount rate Not reliable. Doesn’t work if no discount lending Reserve requirement Leads to unintended consequences – liquidity problems for banks. Hence OMOs is Fed’s most important tool. |
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New Monetary Policy Tools (sl. 1)
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Since the onset of the financial crisis, the Fed has introduced a number of new monetary policy tools
These tools are temporary in nature and use asset side of Fed’s balance sheet (i.e., make loans or buy securities) The tools fall into three categories: Short-term loans to financial institutions Loans to borrowers and investors in key credit markets Support for longer-term credit markets |
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New Monetary Policy Tools (sl. 2)
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Common goal: increase supply of credit to the financial system and reduce interest rates
During the crisis, the supply of credit dried up in many parts of the financial system (i.e., investors were scared and unwilling to lend) and interest rates spiked As a result, financial system had difficulty channeling needed funds from surplus to deficit units. This had an adverse impact on the economy. The tools were intended to inject funds into (various parts of) the financial system so that it can resume its role of financing productive activities in the economy |
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Support for longer-term credit markets
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Aim: increase supply of funds in longer-term credit markets to push down long term interest rates, including mortgage rates
How? Fed will purchase: $300 billion of longer-term Treasury securities $175 billion of government-sponsored enterprise (GSE) debt Up to $1.25 trillion of GSE mortgage-backed securities |
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Term Auction Facility (TAF)
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Fed makes longer term loans to DIs using a single-price auction
Loan maturities: 28-days or 84-days Eligibility: DIs that can borrow from the Primary Credit facility (see Discount Window) All loans are fully secured by collateral Acceptable collateral: any collateral acceptable for discount window loans Typically, auctions are held every 2 weeks Fed announces in advance dates of upcoming auctions |
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How does TAF auction work?
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All bids are ordered from highest rate to lowest rate
Bids are accepted starting with the highest rate Fed continues to accept successively lower bids until Offering Amount is fully allocated, or Minimum Bid Rate is reached, whichever comes first Stop-out rate Lowest accepted interest rate Interest rate charged on ALL winning bids |
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Commercial Paper Funding Facility (CPFF) (sl. 1)
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Commercial paper: Short-term debt
How does CPFF work? NY Fed lends money to a special purpose vehicle (SPV) SPV then buys commercial paper (CP) from issuers SPV holds CP till maturity and uses the proceeds to pay back NY Fed Who can sell CP to SPV? U.S. issuers, i.e., an entity organized under the law of the US or a US branch of a foreign bank |
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Commercial Paper Funding Facility (CPFF) (sl. 2)
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Registration
Issuers must register with the CPFF Registration period began 10/20/2008 Issuer must state the max amount of US$ denominated CP it had outstanding between 1/1/08 and 8/31/08 (“max amount”) Issuer must pay a fee equal to 10 b.p. of max amount |
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Commercial Paper Funding Facility (CPFF) (sl. 3)
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Limit on SPV purchase
SPV’s purchase from any issuer cannot exceed the max amount of that issuer Type of CP that can be sold 3-month, in US$, non interest bearing Has highest credit rating (lowest credit risk) If rated by 1 credit rating agency => at least A1/P1/F1 If rated by multiple agencies => at least 2 or more ratings must be A1/P1/F1 |
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Fed Reserve Exit Strategy (1)
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To fight the financial crisis, we know the Fed has substantially increased the supply of funds in the economy
As the economy begins to recover, the Fed is preparing to reduce the supply of funds to forestall inflationary pressures What is the Fed’s strategy? Source: Chairman Bernanke’s Prepared Statement before Committee on Financial Services, US House of Representatives, Washington, D.C., Feb 10, 2010 |
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Fed Reserve Exit Strategy (2)
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1) Stop using new monetary policy tools
Last lending program to stop operations is TALF (3/31/10) 2) Reduce max maturity on primary credit discount loans from 90 to 28 days 3) Increase spread between primary credit discount rate and Fed Funds rate target 4) Increase interest paid on excess reserves 5) Use OMOs: sell securities 6) Term deposits (under development) |
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Fed Reserve Summary
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The Federal Reserve is the central bank of the U.S.
The Fed conducts monetary policy and regulates commercial banks. The Fed’s actions affect the financial system and the economy The Fed’s traditional monetary policy tools are: 1) open market operations, 2) discount lending, 3) reserve requirement ratio. Open market operations is currently the most important. In response to the financial crisis, the Fed introduced new, temporary monetary policy tools aimed at providing funds to affected parts of the financial system |
