Chapter 18

1. Chapter 18 The Tools Of Federal Reserve Policy ©Thomson/South-Western 2006

2. The Federal Reserve Goals and Tools • Goals • influence greater output • lower the unemployment rate • prices level stability • tools of monetary policy or instruments of monetary policy • open market operations • discount window policy • reserve requirement policy • intermediate target variables • short-term interest rates • monetary aggregates (M1, M2, M3)

3. Open Market Operations: Fundamental Considerations • Open market operations • Buying and selling of securities in the open market • The Fed is empowered to buy or sell • U.S. Treasury securities • federal agency securities • banker's acceptances • other securities • If the Fed sells $225 million in U.S. Treasury bills to a government securities dealer

4. Discovery Of Open Market Operations And The Banking Act Of 1935 • Discovery • Prior to 1920,the discount window was the only Fed policy tool, • The Fed's revenues were only the interest received on the Fed's discounts loans. • An early 1920s recession led to a drop in revenue, so individual Fed banks bought U.S. government securities. • When banks purchased securities, interest rates fell, and credit conditions eased. • The Banking Act of 1935: • eliminated individual Fed banks’ power to conduct separate policies, and • shifted a significant amount of power to the Board of Governors in Washington, D.C.

5. Domain of the Fed's Open Market Activity • Federal Reserve's open market operations could be carried out in any asset. • To avoid favoritism, politics, and unintentional signals, the Fed only buys U.S. government and agency securities and banker's acceptances. • When the Fed buys $400 million in Treasury bonds and bills frombanks, • reserves and the monetary base expand dollar-for-dollar, but • the money supply is not directly or immediately affected. • This happens when banks initiate the multiple deposit-expansion process by making loans and buying securities.

6. The Effectiveness Of Open Market Operations • Impacts of Open Market Operations • Impact on Bank Reserves, the Monetary Base, and the Monetary Aggregates: • The Fed can exert relatively accurate control over bank reserves and the monetary base by manipulating its security portfolio. • Impact on Security Prices and Interest Rates (Yields): • When the Fed buys government securities in the open market, it bids up security prices and therefore reduces their yields. • Marketable securities are substitutable, so a decline in government security yields spills over to yields on other assets.

7. Advantages of Open Market Operations • Precision: • firm and accurate control over aggregate bank reserves and the monetary base, while • a high degree of accuracy cannot be achieved through changes in the discount rate or reserve requirements. • Flexibility: • in the market each day, buying and selling large quantities of securities • very easy for the Fed to alter course • Source of Initiative: • The Fed is able to dominate aggregate bank reserves and the monetary base.

8. Early Disadvantages of Open Market Operations • Signaling: • Changes in the discount rate and reserve requirements are superior to open market operations in signaling policy changes to the public. • Regional Bias: • Prior to well-developed financial markets, a regional bias operated in open market operations, because the effects were concentrated in select urban areas where security dealers were located; open market operations did not disperse across the nation.

9. Open Market Operations and the Federal Funds Rate • The effects of the Fed's open market operations transmit very quickly throughout the nation through the federal funds market. • The supply of reserves is determined by Federal Reserve policy. • When the Fed purchases securities, bank reserves are boosted dollar-for-dollar. • When the Fed sells securities, bank reserves decline dollar-for-dollar.

10. Figure 18-1 Purchase of Securities S1 S2 Federal Funds Rate 4.0 3.5 Demand Reserves

11. Technical Aspects Of Open Market Operations • Defensive Operations versus Dynamic Operations • Defensive open market operations • open market operations made for the purpose of "defending" bank reserves and the monetary base against the influence of outside forces • Dynamic open market operations • open market operations made to deliberately change the course of economic activity

12. Outright Transactions versus Repurchase Agreements • Outright transactions • The Fed uses outright purchases to bring about long-run or permanent growth in reserves and the monetary aggregates. • Repurchase agreements (and reverse repurchase agreements) • The Fed uses repurchase agreements (repos) and reverse repurchase agreements to neutralize the impact on reserves and the monetary base of transitory changes. • Recall a repurchase agreement is a money market instrument wherein one party sells securities with an explicit agreement to buy them back at a specified future date and price.

13. Table 18-1

14. The Policy Directive • Arriving at the Policy Directive • Eight times annually, FOMC meets in Washington to formulate monetary policy. • It issues a policy directive to the manager of the System Open Market Account. • Implementation of the Policy Directive • The manager of the System Open Market Account will: • 9:00 a.m.: contact dealers in government securities to get expectations of conditions during the day • 10:00 a.m.: receive a report from the Fed staff on the expected movement of several important factors that influence bank reserves • 10:30 a.m.: phone the U.S. Treasury for forecast on deposits • mid-morning: get approval from reps from the Board of Governors and the FOMC • Implement purchases or sales through TRAPS (Trading Room Automated Trading System)

15. Discount Window Policy • The discount window is a facility through which the Federal Reserve district banks lend reserves directly to depository institutions. • Discount policy is the set of conditions under which banks are permitted to borrow reserves and the interest rate charged (discount rate). • Categories of Conditions: • Primary credit-- • granted to banks in good condition who are permitted to borrow as much as they want • discount rate > fed funds rate • Secondary credit • provided to troubled banks that are experiencing liquidity problems • ½ percentage point higher rate • Seasonal credit • provided to banks subject to seasonal fluctuations in loan demand—like agricultural activity

16. The 2003 Federal Reserve Change in Discount Window Policy • Prior to 2003, • discount rate < fed funds; • the Fed had to create policies to discourage overuse of the discount window, and • Use was a “privilege” not a “right.” • After 2003, • Lombard system • discount rate > fed funds rate; • use became a right rather than a privilege, so • So relatively high discount rate naturally discouraged overuse of the discount window.

17. Figure 18-2

18. The Reserve Requirement Instrument • Since 1935, the Fed has had the authority to set and change reserve requirements or required reserve ratios that banks must maintain. • Before 1980, reserve requirements only existed for member banks, now enforced for all banks.

19. Institutional Aspects of Reserve Requirements • The Monetary Control Act of 1980 established a new structure of reserve requirements for all banks and thrift institutions.

20. Table 18-2

21. Institutional Aspects of Bank Reserve Management • Reserve Averaging • Banks must meet the required reserve ratio (on a daily average) over the settlement period. • Carryover Allowance • 2% leeway may be carried over one settlement period.

22. The Economic Effects Of Changes In The Reserve Requirement • Influence on the Money Supply and Interest Rates • A change in rr has an impact on m1: • Let rr=.1, k=.9, re=.005, then m1=1.891 • Let rr=.09, k=.9, re=.005, then m1=1.910 • Change in m1 is not as large as it was when we used naïve multiplier in chapter 14.

23. Advantages of the Reserve Requirement Tool • Speed of Impact: • When the Fed changes reserve requirements, all institutions experience an immediate change in their excess-reserve position. • Neutrality: • Unlike open market operations and discount rate changes, the impact of reserve requirement changes is spread across all banks and thrift institutions uniformly. • Potential Use in an Emergency: • At rare times when other tools cannot do the job, changes in reserve requirements may be needed to neutralize major changes in the monetary base.

24. Disadvantages of the Reserve Requirement Tool • Bluntness: • A one percentage point reduction (increase) in the reserve requirement would release (absorb) $7 billion of excess reserves. • Such large changes make this tool too clumsy to be used regularly. • Lack of Flexibility: • Unlike other tools, an early reversal of a previous position would constitute the Fed making a significant and obvious admission of error. • Frequent changes in reserve requirements create uncertainty for banks. • Raising the reserve requirement level can trigger liquidity problems for many banks.