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The Fed and Monetary Policy

Federal Reserve System: Third U. S. Central Bank A central bank is a bank for banks. Here is brief history.

First Bank of the US (1791–1811) but after 20 years the charter expired and was not renewed

Second Bank of the US (1816–1836) but after 20 years the charter again expired and was not renewed

After a major banking crisis, Federal Reserve Act (1913) created the 3rd US Central Bank, the Federal Reserve system we have today. The purpose was to force banks and Fed to have enough reserves is there was a massive run on the bank. http://www.youtube.com/watch?v=9V5OP-VmXgE

Side Note: 1913 was also the same year that the first income tax return was required. First return.

Structure of the Federal Reserve SystemFIVE MAJOR COMPONENTS:

1.Member Commercial Banks

2.12 Fed District Banks

3.7 Members of Board of Governors

4.12 Open Market Committee (FOMC) Members5.Advisory Committees from private sector (Fed Advisory Council, Consumer Advisory Council, Thrift Inst. Advisory Council)

1. Member Banks Nationally-chartered banks must be member banks

(many used to have “federal” in their name, e.g. Commercial Federal Bank)

State chartered banks may be member banks (many used have “state” in their name, e.g. First State Bank of Washington)

Members banks purchase stock in Fed to become members, which pays a max dividend of 6%.

Must meet requirements (min. capital, etc. ) to be a member

35% of banks controlling 70% of all deposits are members

Overview of Fed System

-Sets S/Tinterest rates

Fed. Res. District Banks & Branches

Districts created by dividing up the country in roughly equal portions according to the population in 1912-13

2. Federal Reserve District Banks 12 districts (Fed. Res. Bank for WW is San Francisco,

www.frbsf.org, and the branch is in Seattle) Districts divided by population in 1912 District bank size related to economic wealth of district

(NY & Chicago are big; NY considered most important) District banks owned by private member banks Functions: clear checks, replace old currency, provide

loans at discount window, do research. Megan Clubb, President of Baker Boyer Bank, is a

board member for Fed Res Bank of San Francisco. http://www.bakerboyer.com/content/homepage

3. Board of Governors (Fed. Res. Board)

Headquarters in Wash. DC. See picture next pg. 7 members appointed by the U.S. president and confirmed by the

Senate Each member serves a nonrenewable 14-year term (So how come

Greenspan was on for 19 years, 1987-2006?) U.S. President appoints one member to be chair whose 4-year

term is renewable. Current chair: Janet Yellen replaced Ben Bernanke as of 1/31/14.

One governor is appointed by U.S. President to be VP for Supervision (Fin. Reform Act of 2010).

Independence of Federal Reserve facilitated by staggered terms of Governors (1 term expires every even year) and having budget separate from Congress

Central Bank Independence Around the World

Fed is supposed to be free from political and bureaucratic pressure when it formulates policy BUT the Fed is not immune from the desires of the electorate.

Federal Reserve Headquarters in Wash. DC

The Fed’s Inner Sanctum

The Fed Chair

CHAIRMEN (terms):Paul Volcker (1979-1987)Alan Greenspan (1987-2006, 19 yrs!)Ben Bernanke (2006-2014)Janet Yellen, (2/1/2014 - ??)

Paul Volcker

Alan GreenspanBen Bernanke

Chairman = PowerJanet Yellen

Board of Governors (cont.) Board of Governors has two main functions:

1. Regulate commercial banks Supervise and regulate member banks and bank holding

companies Oversight of 12 Fed district banks

2. Establish and effect monetary policy Direct control over three tools of monetary policy

Set reserve requirements Approve discount rate set by district banks Sets the rate of interest paid on reserves at the Fed

Indirect control of Federal Funds rate through open market operations

All governors are members of the Federal Open Market Committee

4. Fed Open Market Committee Scheduled to meet 8 times per year (or about every 6

weeks) Sometimes has unscheduled meetings in emergencies. Next meeting is? http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

12 members 7 from the Board of Governors 1 President of the New York Fed 4 other district bank presidents on a rotating basis Other district bank presidents participate but do not vote on monetary

policy matters

FOMC (cont.) Monetary policy goals:

high employment price stability (Low inflation deemed most important goal)

economic growth Forward decisions to NY Fed trading desk through policy

directive, which sets target range for federal funds rate. The Beige Book: a periodic report of economic conditions

used by Fed in monetary policy decisions Megan Clubb, Baker Boyer Bank President

helps create Beige Book for NW, who did abusiness colloquium Feb. 13, 2013

http://coursecast.wallawalla.edu/Panopto/Pages/Viewer/Default.aspx?id=cad13e67-7e67-4226-8e5c-c61d3a15bd15

Fed’s Influence on Economy

Fed influences the money supply in order to achieve its goals of growth, price stability, and jobs.

Liquidity,Money Supply

andInterest Rates

Business and ConsumerBorrowing/Spending

Goals of Growth

Price StabilityJobs

5. Advisory Committees• Federal Advisory Council consists of one member

from each Federal Reserve district who represents the banking industry. Meets with the Board of Governors in Washington, D.C., at least four times a year and makes recommendations about economic and banking issues.

• Consumer Advisory Council consists of 30 members who represent the financial institutions industry and its consumers.

• Thrift Institutions Advisory Council consists of 12 members who represent savings banks, S&Ls, and credit unions.

Advisory Committees (cont.)Consumer Financial Protection BureauEstablished as a result of the Financial Reform Act of 2010.Responsible for regulating financial products and services, including online banking, certificates of deposit, and mortgagesRepublicans and Democrats fought over who should lead this Bureau

Current head: Rich Cordray

Initial nomination: Elizabeth Warren

Seven Tools of Monetary Policy

Tools ofMonetary

Policy

3. OpenMarket Oper.

1. Reserve Req. 2. Discount Rate

TEMPORARY TOOLS In response to the creditcrisis, the Fed created 8 newtools to promote liquidity.Only 2 remain today:7. Overnight reverse purchaseagreements, and8. Term Deposit Facility

4. Interest on Required and Excess

Reserve Balances Held at Fed

5. Maturity Extension Program

(expired fall/14)

TOOL#1: Reserve Requirements Banks must maintain reserves as percent of deposits/liabilities,

usually around 10% for larger banks http://www.federalreserve.gov/monetarypolicy/reservereq.htm

Purpose: to have reserves if there’s a run on the bank (Mary Poppins, It’s a Wonderful Life, Bear Sterns, WaMu, IndyBank, etc.) This was the original purpose of the Fed. Reserve Act.

Reserves are deposits at Fed plus vault cash. Fed sets reserve requirements, but this tool is used little as it’s too

powerful (like a sledge hammer to swat a fly) because of the money multiplier effect

The central bank of China recently lowered its reserve requirements to expand the nation’s money supply, since growth has tapered off recently.

Run on Bank

1929 2008

WaMu

It’s a Wonderful Lifehttp://www.youtube.com/watch?v=lbwjS9iJ2Sw

Mary Poppinshttp://www.youtube.com/watch?v=C6DGs3qjRwQ

IndymacBank, 2008http://www.youtube.com/watch?v=IVRgZ9LizZQ

The Power of the Money MultiplierWith a reserve requirement of 10%, single deposit of $1 can create 10 new dollars. Conversely, a single withdrawal of $1 can reduce the money supply by $10

$100,000

$90,000

$81,000

$10,000

$9,000

$8,100

Increase indepositsat banks

Required reservesheld on

new deposits

Funds received fromnew deposits that

can be lent out

$90,000

$81,000

$72,900

Deposits created = initial deposit / req. reserve % = $1 / .10 = $10 minus any leakage

Limiting Factors to Deposit Expansion (Leakage) Banks may not lend all $$ out Public may not re-deposit cash (grandpa stuffs his mattress) $$ is converted to time deposits $$ is transferred to a foreign bank account

(maybe for payment of imports) $$ is invested in the gov’t or taxes are paid

Hopefully not this kind of leakage!

The power of the money multiplier allows small changes to influence economic activity in a large

way, both for good and for bad

TOOL#2: Discount Rate

Banks might borrow from Fed at the “discount window” for 3 reasons:(1) To meet short-term reserve deficiencies(2) Seasonal credit to banks, e.g. loans to banks in agricultural or tourist areas (farmers borrow and then pay back after harvest, or tourists comes only a certain time of year, or seasonal inventory for Christmas/Halloween)(3) Extended credit for longer-term liquidity problems at troubled banks

(NOTE: it is usually cheaper for a bank to borrow federal funds from other banks so the Fed is meant to be used only as a last resort. Borrowing from the Fed is usually a stigma – like spending money foolishly and then having to borrow from dad). However, during the 2008 liquidity crisis, banks were lined up for miles to borrow from the Fed. You want to borrow $10? Sorry, but I’m

staying out of the sub-prime loan business

NOTE: technically, the name for the Discount Rate changed in 2003 to the Primary Credit Loan Lending Rate; however, everyone still calls it the Discount Rate.

Discount Rate (cont.) Discount Rate: Interest rate charged on loans made by

Fed thru the discount window. Comes in 3 forms: (1) Primary credit, for any purpose of sound banks (2) Secondary credit, for banks not as sound (more

risky) (3) Seasonal credit, for small banks needing S/T loans

in ag or tourist areas. see www.frbdiscountwindow.org

Note: For the first time in history, the Fed opened the Discount Window to some non-commercial banks in 2008. In addition, many non-bank institutions (American Express, Morgan Stanley, Goldman Sachs, etc.) rushed to create bank-like holding companies so that they could borrow from the Fed. Tim Geithner, Obama’s Treasury Secretary and then President of Fed Res Bank of NY, said that none of these institutions would have survived the liquidity crisis without the Fed’s help. Congress is today howling for full disclosure about exactly which institutions borrowed from the Fed. See article.

Discount Rate (cont.)Effect of changing rateTraditionally (before 2003)

Lower discount rate: More $$ borrowed from Fed, bank reserves expand, money supply increases

Raise discount rate: less $$ borrowed from Fed, bank reserves contract, money supply decrease

Discount rate changes used serve as a signal for future changes in interest rates (especially federal funds rate)

Today (post 2003) Discount rate simply changes in lock step (usually) with the

federal funds target rate, thus no longer really serving as an effective tool of monetary policy. Usually at least 50bp higher than Fed. Fds. Rate. However, the Fed occasionally unhinges the two for short periods of time.

TOOL #3: Open Market Operations FOMC uses Beige Book and other data to decide what

the target federal funds rate should be Based on the target federal fund rate, FOMC sends a

Policy Directives to the NY Fed Trading Desk (or Open Market Desk).

The Trading Desk buys or sells Treasury securities in order to expand or contract the money supply

Fed purchases (sells) securities, which increases (decreases) bank reserves (federal funds), thereby decreasing (increasing) the Fed. Fds. Rate

Open Market Operations (cont.) The federal funds rate is not directly controlled by the FOMC

but it is influenced by the FOMC; this is why the Fed only sets a target range for the rate.

Federal funds rate: interest rate charged on S/T loans between banks, usually made in order to meet reserve requirements

Federal funds rate is a benchmark rate for other S/T interest rates, such as on bank accounts, credit cards, etc.

Fed purchase (sale) of securities results in an injection of additional funds into the bank system, lowering (raising) federal funds rate and other rates, because there are more (less) funds available for money market and bank lending

Open Market Operations in Response to the Economy2001–2003: The Fed frequently used open market

operations to reduce interest rates during this period of weak economic conditions.

2004–2007: The Fed’s concern shifted from a weak economy to high inflation as the economy improved.

2008: The Fed used open market operations to reduce interest rates in an attempt to stimulate the economy when economic conditions weakened due to the credit crisis

Today, with rates near zero, the Fed’s open market operations are essentially static and mute, replaced by quantitative easing (QE) long-term bond buying.

Open Market Operations (cont.)

Money Supply M1 = coin/currency, traveler checks, demand deposits

(checking), NOW accounts, deposits at Fed M2 = M1 plus savings, small time deposits M3 = M2 plus large time deposits, repos See money stock measures (H.6) at

http://www.federalreserve.gov/releases/h6/ M1 is more volatile than M2 because people’s checking

accounts go up with they get paid and down when they pay their bills; but there’s much less activity in savings accounts.

TOOL #4: Interest on Required and Excess Reserve Balances Held at Fed

The Fed pays interest on required and excess reserve balances held at the Fed. The interest rates are determined by the Board of Governors, who can change the rates effect monetary policy. Interest rates are declared every Wednesday at 4:30pm ET, when the reserve maintenance reports are due. Current rates are posted at

http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm

TOOL #5: Maturity Extension Program(ceased in fall of 2014)

The Fed sold $400 billion of shorter-term Treasury securities and used the proceeds to buy longer-term Treasury securities. This extended the average maturity of the securities in the Fed’s portfolio. By reducing the supply of longer-term Treasury securities in the market, this action put downward pressure on longer-term interest rates. The reduction in longer-term interest rates, in turn, contributed to a broad easing in financial market conditions that provided additional stimulus to support the economic recovery, especially the housing sector (at least in theory).

TOOL #6-8: Credit Crisis Tools (temporary tools)

1. Traditionally, the Fed only lends to depository institutions (commercial banks). But during the 2009 credit crisis, the Fed lent funds to many non-bank institutions. Earlier in 2008, the Fed had also lent funds to Bear Stearns, a non-depository institution. EXPIRED

2. Facilities created by the Fed to provide liquidity include:1. Primary Dealer Credit Facility – overnight loans to bond dealers EXPIRED2. Term Auction Facility – banks can borrow for a fixed term EXPIRED3. Term Securities Lending Facility – dealers can swap mortgage-backed and

other securities for loans (provided liquidity and lowered mortgages rates) EXPIRED

4. Commercial Paper Facilities (two different ones) – created to restore liquidity in CP markets EXPIRED

5. Money Market Investor Facility – provide liquidity to MM EXPIRED6. Term Asset-Backed Securities Loan Facility – provide liquidity for consumer

and small business loans (credit cards, student loans, car loans, etc.) EXPIRED

7. Overnight Reverse Purchase Agreements – helps control money supply affecting the federal funds rate. STILL HERE

8. Term Deposit Facility – offers term deposits to banks thereby draining money supply and helping control the fed funds rate STILL HERE

Using the Tools to Increases the Money Supply and Decrease Interest Rates Increasing the money supply and lowering interest rates

Open market purchase of Treasury securities via the Trading Desk in the secondary market increases money supply and lowers Federal Funds rate (this tool is used most frequently).

Discount rate (usually in lock step with Federal Funds rate) will also be lowered, which might encourage borrowing at the discount window, increasing the money supply. Occasionally the Fed will change the Discount rate independently from the Fed Funds rate.

Reserve requirements can be lowered, causing more money to be loaned out

The interest rate paid on reserves held at the Fed can be lowered

Using the Tools to Decrease the Money Supply and Increase Interest Rates Decreasing the money supply to raise interest rates

Open market sale of Treasury securities via the Trading Desk in the secondary market decreases money supply and raises federal funds rate (this tool is used most frequently).

Discount rate (usually in lock step with Federal Funds rate) will also be raised which might discourage borrowing at the discount window, decreasing the money supply. Occasionally the Fed will change the Discount rate independently from the Fed Funds rate.

Reserve requirements can be raised, causing less money to be loaned out

The interest rate on reserves held at the Fed can be raised

Playing the Fed Chair Game

Go to http://www.frbsf.org/education/activities/chairman/

Keep playing until you are reappointed!

Global Monetary Policy Each country has its own central bank and most industrialized countries have banks with similar goals

Since 1999, European Central Bank (in Frankfurt) works similar to the US Fed. Euro used in 23 countries (Andorra, Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Kosovo, Luxembourg, Malta, Monaco, Montenegro, Netherlands, Portugal, San Marino, Slovakia, Slovenia, Spain and

Vatican City) Fed must consider conditions in other countries when looking at the U.S. economy

Central banks try to work together but conflicting goals can make cooperation difficult at times

Fed Power & Bail-Outs The Fed gave loans to Bear Stearns, AIG and others in

an attempt to prevent a meltdown. Do you think large financial institutions such as these should be rescued by the Fed?

Many in Congress have argued (such as Ron Paul) that the Fed has too much power and that Congress should be involved in decision regarding the use of taxpayer funds to rescue institutions. Do you agree?

Quantitative Easing QE 1, 2 and 3• Quantitative Easing #1 refers to Fed purchasing $1.45T mortgage-

backed securities and $300B in L/T Treasuries from Mar/09 to mar/10, with the goal of holding down L/T rates to spur the mortgage market. This is similar to monetizing the debt. Many are critical of QE because it is like “printing money” and could eventually increase inflation and weaken the US dollar.

• Quantitative Easing #2 refers to the Fed’s bond buying from Nov/10 to June/11 ($660 of L/T Treasuries).

• Quantitative Easing #3 refers to the Fed’s bond buying from Sept/12 to Oct/14 (originally $40B/mo of mortgage-backed securities, and $45B of L/T Treasuries; revised to $35B and $40B in Jan/14 )

• See http://www.youtube.com/watch?v=PTUY16CkS-k• very controversial as it is essentially equivalent to the fed “printing

money” which has caused the Fed’s balance sheet to burgeon

Fed’s Balance Sheet has quadrupled since the 2008