Chapters 4, 5, & 6: Introduction to Financial Markets .PDF

Introduction and Overview of Financial Markets part one The Federal Reserve chapter System, Monetary Policy, and Interest...

Introduction and Overview of Financial Markets part one The Federal Reserve chapter System, Monetary Policy, and Interest 4 Rates O U T L I N E Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview Structure of the Federal Reserve System Learning Goals Organization of the Federal Reserve System LG 4-1 Understand the major functions of the Federal Reserve System. Board of Governors of the Federal Reserve System LG 4-2 Identify the structure of the Federal Reserve System. Federal Open Market Committee LG 4-3 Identify the monetary policy tools used by the Federal Reserve. Functions Performed by LG 4-4 Appreciate how monetary policy changes affect key economic variables. Federal Reserve Banks Balance Sheet of the LG 4-5 Understand how central banks around the world adjusted their monetary Federal Reserve policy during the recent financial crisis. Monetary Policy Tools Open Market Operations The Discount Rate Reserve Requirements MAJOR DUTIES AND RESPONSIBILITIES OF THE FEDERAL (Reserve Ratios) RESERVE SYSTEM: CHAPTER OVERVIEW The Federal Reserve, the Money Central banks determine, implement, and control the monetary policy in their home Supply, and Interest Rates countries. The Federal Reserve (the Fed) is the central bank of the United States. Founded Effects of Monetary Tools by Congress under the Federal Reserve Act in 1913, the Fed’s original duties were to pro- on Various Economic vide the nation with a safer, more flexible, and more stable monetary and financial system. Variables This was needed following a number of banking crises and panics that had occurred in Money Supply versus the first decade of the 20th century (particularly 1907)1 and the last decades of the 19th Interest Rate Targeting century. As time passed, additional legislation, including the Banking Act of 1935, the Full International Monetary Policies Employment Act of 1946, and the Full Employment and Balanced Growth Act of 1978 and Strategies (also called the Humphrey-Hawkins Act), revised and supplemented the original purposes and objectives of the Federal Reserve System. These objectives included economic growth Systemwide Rescue Programs Employed during the Financial Crisis 1. The Panic of 1907 was a financial crisis that hit the United States at the turn of the 20th century while the country was in the midst of an economic recession. The New York Stock Exchange index fell by 50 percent in less than a year, Challenges Remain after and a severe drop in market liquidity by banks resulted in numerous bank runs; bank, corporate, and municipal bank- the Crisis ruptcies; and a near collapse of the U.S. financial system. 95 96 Part 1 Introduction and Overview of Financial Markets central banks in line with the economy’s potential to expand, a high level of employment, stable prices, Banks that determine, and moderate long-term interest rates. implement, and control the The Federal Reserve System is an independent central bank in that its decisions do monetary policy in their not have to be ratified by the president or another member of the executive branch of the home countries. U.S. government. The system is, however, subject to oversight by the U.S. Congress under its authority to coin money. Further, the Federal Reserve is required to work within the framework of the overall objectives of economic and financial policies established by the U.S. government. LG 4-1 The Federal Reserve System has evolved into one of the most powerful economic bodies in the world and was critical in implementing policies to address the worldwide financial crisis in 2008–2009. Even the hint of a change in interest rate policy by the Fed can have an impact on markets around the world. Its duties incorporate four major functions: (1) conducting monetary policy; (2) supervising and regulating depository institutions; (3) maintaining the stability of the financial system; and (4) providing payment and other financial services to the U.S. government, the public, financial institutions, and foreign official institutions. In this chapter, we present an overview of the Federal Reserve System. We start with a basic description, highlighting its organization and structure. We then examine the mon- etary policy tools available to the Fed and how the Fed uses these tools to influence the U.S. money supply and interest rates both domestically and internationally. As part of the discussion, the chapter highlights actions taken by the Fed during the recent financial cri- sis (e.g., expanding its role as a lender of last resort and purchaser/guarantor of distressed assets of banks and other FIs). Finally, we look at the independent and coordinated efforts of central banks around the world as they adjusted their international monetary policies during the financial crisis. STRUCTURE OF THE FEDERAL RESERVE SYSTEM LG 4-2 The Federal Reserve System consists of 12 Federal Reserve Banks located in major cities throughout the United States and a seven-member Board of Governors located in Washington, DC. This structure was implemented in 1913 to spread power along regional lines, between the private sector and the government, and among bankers, businesspeople, and the public. Federal Reserve Banks and the Federal Reserve Board of Governors together comprise and operate the Federal Open Market Committee (FOMC), which is responsible for the formulation and implementation of monetary policy. www.federalreserve.gov Organization of the Federal Reserve System The Federal Reserve System is divided into 12 Federal Reserve districts that are the “operat- ing arms” of the central banking system (see Figure 4–1). Each district has one main Federal www.newyorkfed.org Reserve Bank, some of which also have branches in other cities within the district (identified in Figure 4–1). In addition to carrying out the functions for the central banking system as a whole, each Reserve bank acts as a depository institution for the banks in its district. In terms of total assets, the three largest Federal Reserve Banks are the New York, San Francisco, and Richmond banks. As of December 2018, these three banks hold over 74 percent of the total assets (discussed later) of the Federal Reserve System. The Federal Reserve Bank of New York (FRBNY) is generally considered the most important of the Federal Reserve Banks because so many of the largest U.S. and international banks are located in the New York dis- trict. Further, the Federal Reserve’s Trading Desk, which (as discussed below) carries out all the open market purchases for the Federal Reserve, is located at the FRBNY. Federal Reserve Banks operate under the general supervision of the Board of Governors of the Federal Reserve based in Washington, DC. Each Federal Reserve Bank has its own nine-member board of directors that oversees its operations: six are elected by member banks in the district (three are professional bankers and three are businesspeople) and three are appointed by the Federal Reserve Board of Governors  Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 97 Figure 4–1 Federal Reserve Districts Minneapolis Cleveland Chicago Boston Kansas City New York St. Louis San Francisco Philadelphia Board of Atlanta Governors Richmond Dallas Alaska and Hawaii are part of the San Francisco District Board of Governors of the Federal Reserve System, Washington, DC Federal Reserve Bank city Federal Reserve Branch city, by District Buffalo Little Rock, Louisville, Memphis Cincinnati, Pittsburgh Helena Baltimore, Charlotte Denver, Oklahoma City, Omaha Birmingham, Jacksonville, El Paso, Houston, San Antonio Miami, Nashville, Los Angeles, Portland, New Orleans Salt Lake City, Seattle Detroit Source: Federal Reserve Board website, “The Structure of the Federal Reserve System,” December 2019, www.federalreserve.gov (directors in this group are prohibited from being employees, officers, or stockholders of a member bank). These nine directors are responsible for appointing the president of their Federal Reserve Bank. Nationally chartered banks, those chartered by the federal government through the Office of the Comptroller of the Currency (OCC),2 are required to become members of the Federal Reserve System (FRS). State-chartered banks (those not chartered by the OCC) www.occ.treas.gov can also elect to become FRS members if they meet the standards set by the FRS.3 The primary advantage of FRS membership is direct access to the federal funds wire transfer network for interbank borrowing and lending of reserves (discussed below). Commercial banks that become members of the FRS are required to buy stock in their Federal Reserve district bank. Thus, Federal Reserve Banks are quasipublic (part private, part government) entities owned by member commercial banks in their district. Their stock, however, is not publicly traded and pays a predetermined dividend (at a maximum rate of 6 percent annually). Approximately 38 percent of all U.S. banks are currently members of the Federal Reserve System. 2. The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises national banks in the United States to ensure a safe, sound, and competitive banking system (see Chapters 11 and 13). 3. These state-chartered banks are called state-chartered member banks. State-chartered banks that are not members of the FRS are called state-chartered nonmember banks (see Chapter 11). 98 Part 1 Introduction and Overview of Financial Markets Federal Reserve Banks operate as nonprofit organizations. They generate income pri- marily from three sources: (1) interest earned on government securities acquired in the course of Federal Reserve open market transactions (see below), (2) interest earned on reserves that banks are required to deposit at the Fed (see reserve requirements below), and (3) fees from the provision of payment and other services to member depository institutions. Board of Governors of the Federal Reserve System The Board of Governors of the Federal Reserve (also called the Federal Reserve Board) is a seven-member board headquartered in Washington, DC. Each member is appointed by the president of the United States and must be confirmed by the Senate. Board mem- bers serve a nonrenewable 14-year term.4 Board members are often individuals with PhD degrees in economics and/or an extensive background in economic research and political service, particularly in the area of banking. Board members’ terms are staggered so that one term expires every other January. The president designates two members of the board to be the chair and vice chair for four-year terms. The board usually meets several times per week. As they carry out their duties, members routinely confer with officials of other gov- ernment agencies, representatives of banking industry groups, officials of central banks of other countries, members of Congress, and academics. The primary responsibilities of the Federal Reserve Board are the formulation and con- duct of monetary policy and the supervision and regulation of banks. All seven board mem- bers sit on the Federal Open Market Committee, which makes key decisions affecting the availability of money and credit in the economy (see below). For example, the Federal Reserve Board, through the FOMC, can and usually does set money supply and interest rate targets. The Federal Reserve Board also sets bank reserve requirements (discussed in Chapter 13) and reviews and approves the discount rates (see below) set by the 12 Federal Reserve Banks. The Federal Reserve Board also has primary responsibility for the supervision and regulation of (1) all bank holding companies (their nonbank subsidiaries and their foreign subsidiaries), (2) state-chartered banks that are members of the Federal Reserve System (state-chartered member banks), and (3) Edge Act and agreement corporations (through which U.S. banks conduct foreign operations).5 The Fed also shares supervisory and regu- www.occ.treas.gov latory responsibilities with state and other federal supervisors (e.g., the OCC, the FDIC), including overseeing both the operations of foreign banking organizations in the United States and the establishment, examination, and termination of branches, commercial lend- www.fdic.gov ing subsidiaries, and representative offices of foreign banks in the United States. The board approves member bank mergers and acquisitions and specifies permissible nonbank activities of bank holding companies. The board is also responsible for the development and administration of regulations governing the fair provision of consumer credit (e.g., the Truth in Lending Act, the Equal Credit Opportunity Act). Finally, the Wall Street Reform and Consumer Protection Act of 2010 provided unprecedented powers to the Federal Reserve, putting it in charge of monitoring any of the country’s biggest financial firms— those considered critical to the health of the financial system as a whole. The chair of the Federal Reserve Board, currently Jerome Powell, often advises the president of the United States on economic policy and serves as the spokesperson for the Federal Reserve System in Congress and to the public. All board members share the duties of conferring with officials of other government agencies, representatives of banking industry groups, officials of the central banks of other countries, and members of Congress. 4. The length of the term is intended to limit the president’s control over the Fed and thus to reduce political pressure on board members; the nonrenewable nature of an appointment prevents any incentives for governors to take actions that may not be in the best interests of the economy yet may improve their chances of being reappointed. 5. An Edge Act corporation is a subsidiary of a federally chartered domestic bank holding company that generally spe- cializes in financing international transactions. An agreement corporation operates like an Edge Act but is a subsidiary of a state-chartered domestic bank. Created by the Edge Act of 1919, Edge Act corporations are exempt from certain U.S. bank regulations, thus allowing U.S. banks to compete against foreign banks on an even level. For example, Edge Act corporations are exempt from prohibitions on investing in equities of foreign corporations. Ordinarily, U.S. banks are not allowed to undertake such investments.  Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 99 Federal Open Market Committee Federal Open Market The Federal Open Market Committee (FOMC) is the major monetary policy-making Committee (FOMC) body of the Federal Reserve System. As alluded to earlier, the FOMC consists of the seven The major monetary members of the Federal Reserve Board of Governors, the president of the Federal Reserve policy-making body of the Bank of New York, and the presidents of four other Federal Reserve Banks (on a rotating Federal Reserve System. basis). The chair of the Board of Governors is also the chair of the FOMC. The FOMC is required to meet at least four times each year in Washington, DC. However, eight regularly scheduled meetings have been held each year since 1980. The main responsibilities of the FOMC are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade. The FOMC seeks to accomplish this by setting guidelines regarding open market open market operations. Open market operations—the purchase and sale of U.S. government and fed- operations eral agency securities—is the main policy tool that the Fed uses to achieve its monetary tar- Purchases and sales of gets (although the operations themselves are normally carried out by traders at the Federal U.S. government and fed- Reserve Bank of New York, as discussed below). The FOMC also sets ranges for the growth eral agency securities by of the monetary aggregates, sets the federal funds rate (see below), and directs operations the Federal Reserve. of the Federal Reserve in foreign exchange markets (see Chapter 9). In addition, although reserve requirements and the discount rate are not specifically set by the FOMC, their levels are monitored and guided by the FOMC. Associated with each meeting of the FOMC is the release of the Beige Book. The Beige Book summarizes information on current economic conditions by Federal Reserve district. Information included in the Beige Book is drawn from reports from bank directors, interviews with key business leaders, economists, market experts, and other sources. Meetings of the FOMC are some of the most closely watched economic meetings in the world. As the FOMC formulates and implements monetary pol- icy, its actions affect not only the U.S. economy, but economies worldwide. Functions Performed by Federal Reserve Banks As part of the Federal Reserve System, Federal Reserve Banks (FRBs) perform multiple func- tions. These include assistance in the conduct of monetary policy; supervision and regulation of member banks and other large financial institutions; consumer protection; and the provision of services such as new currency issue, check clearing, wire transfer, and research services to the federal government, member banks, or the general public. We summarize these functions in Table 4–1. The In the News box in this section describes how the Federal Reserve provided extraordinary services in many of these areas in response to the recent financial crisis. TABLE 4–1 Functions Performed by the Federal Reserve Banks Assistance in the conduct of monetary policy—Federal Reserve Bank presidents serve on the Federal Open Market Committee (FOMC). FRBs set and change discount rates. Supervision and regulation—FRBs have supervisory and regulatory authority over the activities of banks and other large financial institutions located in their district. Consumer protection and community affairs—FRBs write regulations to implement many of the major consumer protection laws and establish programs to promote community development and fair and impartial access to credit. Government services—FRBs serve as the commercial bank for the U.S. Treasury. New currency issue—FRBs are responsible for the collection and replacement of damaged currency from circulation. Check clearing—FRBs process, route, and transfer funds from one bank to another as checks clear through the Federal Reserve System. Wire transfer services—FRBs and their member banks are linked electronically through the Federal Reserve Communications System. Research services—each FRB has a staff of professional economists who gather, analyze, and interpret economic data and developments in the banking sector in their district and economywide. IN THE NEWS The Financial Crisis: Toward an Explanation and Policy Response In the first half of 2007, as the extent the company’s balance sheet. That 2009. The TALF was designed to of declining home prices became month, the board also announced support the issuance of asset-backed apparent, banks and other financial the creation of the Term Securities securities collateralized by student market participants started to reas- Lending Facility (TSLF), swapping loans, auto loans, credit card loans, sess the value of mortgages and Treasury securities on its balance and loans guaranteed by the Small mortgage-backed securities that sheet for less liquid private securities Business Administration, while also they owned, especially those in the held in the private sector, and the expanding the TAF and the TSLF. The subprime segment of the housing Primary Dealer Credit Facility (PDCF). creation of these programs resulted market. The autumn of 2007 saw These actions, particularly the latter, in a tremendous expansion of the increasing strains in a number of represented a significant expansion Federal Reserve’s balance sheet. market segments, including asset- of the federal financial safety net by Furthermore, Congress passed the backed commercial paper, and banks making available a greater amount of Troubled Asset Relief Program (TARP) also began to exhibit a reluctance to central bank credit, at prices unavail- to be administered by the Treasury lend to one another for terms much able in the market, to institutions (the Department. And in February 2009, longer than overnight. This reluctance primary dealers) beyond those banks the president signed the American was reflected in a dramatic rise in that typically borrow at the discount Recovery and Reinvestment Act, a the London Interbank Offered Rate window.... fiscal stimulus program of roughly (LIBOR) at most maturities greater than In the fall of 2008, financial mar- $789 billion.... overnight. LIBOR is a measure of the kets worldwide experienced another Much of the public policy response rates at which international banks round of heightened volatility and his- to turmoil in financial markets over the make dollar loans to one another. toric changes: Lehman Brothers filed two years took the form of expanded Since that initial disruption, financial for Chapter 11 bankruptcy protec- lending by the Fed and central banks markets have remained in a state of tion; investment banking companies in other countries. The extension high volatility, with many interest rate Goldman Sachs and Morgan Stanley of credit to financial institutions has spreads at historically high levels. successfully submitted applications long been one of the tools available In response to this turbulence, the to become bank holding companies; to a central bank for managing the Fed and the federal government have Bank of America purchased Merrill supply of money—specifically, bank taken a series of dramatic steps. As Lynch; Wells Fargo acquired Wachovia; reserves—to the economy. Indeed, 2007 came to a close, the Federal PNC Financial Services Group pur- discount window lending by the Reserve Board announced the cre- chased National City Corporation; and 12 Reserve Banks was the primary ation of a Term Auction Facility (TAF), the American International means for affecting the money sup- in which fixed amounts of term funds Group received significant financial ply at the time the Fed was created. are auctioned to depository institu- assistance from the Federal Reserve Over time, open market operations, in tions against any collateral eligible for and the Treasury Department. On which the Fed buys and sells securi- discount window loans. So while the the policy front, the Federal Reserve ties in transactions with market partici- TAF substituted an auction mecha- announced the creation of several pants, have become the main tool for nism for the usual fixed interest rate, new lending facilities—including the managing the money supply. Lending this facility can be seen essentially as Asset-Backed Commercial Paper has become a relatively little-used an extension of more conventional Money Market Mutual Fund Liquidity tool, mainly accessed by banks with discount window lending. In March Facility (AMLF), the Commercial Paper occasional unexpected flows into or 2008, the New York Fed provided Funding Facility (CPFF), the Money out of their Fed reserve accounts late term financing to facilitate the pur- Market Investor Funding Facility in the day. If such banks were to seek chase of Bear Stearns by JPMorgan (MMIFF), and the Term Asset-Backed funding in the market, they would Chase through the creation of a facil- Securities Loan Facility (TALF), the last likely have to pay above-normal ity that took a set of risky assets off of which became operational in March rates for a short-term (overnight) loan. continued 100  IN THE NEWS CONTINUED The Financial Crisis: Toward an Explanation and Policy Response In this way, the discount window Since the outset of the widespread averaged $132.2 billion, and in the became a tool for dampening day-to- market disruptions in the summer of fourth quarter of the year, that figure day fluctuations in the federal funds 2007, the Fed has changed the terms rose to $847.8 billion. rate. In 2006, average weekly lending of its lending to banks and created Source: Aaron Steelman and John A. by the Reserve Banks through the new lending facilities. In the first three Weinberg, Federal Reserve Bank of discount window was $59 million. quarters of 2008, weekly Fed lending Richmond Annual Report 2008, April 2009. Assistance in the Conduct of Monetary Policy. As mentioned, a primary responsibility of the Federal Reserve System is to influence the monetary (and financial) conditions in U.S. financial markets and thus the economy. Federal Reserve Banks conduct monetary policy in several ways. For example, as discussed previously, 5 of the 12 Federal Reserve Bank presidents serve on the Federal Open Market Committee (FOMC), which determines monetary policy with respect to the open market sale and purchase of government securi- ties and, therefore, interest rates. The Boards of Directors of each Federal Reserve Bank set discount rate and change the discount rate (the interest rate on loans made by Federal Reserve Banks The interest rate on to financial institutions). These loans are transacted through each Federal Reserve Bank’s loans made by Federal discount window and involve the discounting of eligible short-term securities in return Reserve Banks to financial for cash loans. Federal Reserve Bank Boards also have discretion in deciding which banks institutions. qualify for discount window loans. As discussed above, any discount rate change must be reviewed by the Board of Governors of the Federal Reserve. For example, in an attempt to discount window stimulate the U.S. economy and prevent a severe economic recession, the Federal Reserve The facility through which approved 11 decreases in the discount (and federal funds) rate in 2001. Federal Reserve Banks In the spring of 2008, in an attempt to avoid a deep recession and rescue a failing issue loans to financial financial system, the Federal Reserve took a series of unprecedented steps in the conduct institutions. of monetary policy. First, Federal Reserve Banks cut interest rates sharply, including one cut on a Sunday night in March 2008 (see below). Second, the Federal Reserve Bank of New York brokered the sale of Bear Stearns, the then fifth-largest investment bank in the United States, to JPMorgan Chase. Without this deal, Bear Stearns was highly likely to fail (and along with it other investment banks in similar situations as Bear Stearns). To get JPMorgan Chase to purchase Bear Stearns, the Fed agreed to take any losses in Bear Stearns’s investment portfolio up to $29 billion. Similarly, in September 2008 AIG (one of the world’s largest insurance companies) met with Federal Reserve officials to ask for desperately needed cash. Concerned about how the firm’s failure would impact the U.S. financial system, the Federal Reserve agreed to lend $40 billion to AIG to prevent its failure. The financial crisis saw the Fed’s widening regulatory arm moving beyond depository institutions to other types of financial institutions. Third, for the first time Federal Reserve Banks lent directly to Wall Street investment banks. In the first three days, securities firms borrowed an average of $31.3 billion per day from the Fed. While the Federal Reserve’s conduct of monetary policy is primarily designed to affect the U.S. economy, in our ever increasing global economy, any policy changes made by the Fed also influence, and are influenced by, international developments. For example, as discussed below and in Chapter 9, the Fed’s monetary policy actions affect the U.S. dollar for foreign currency exchange rates. A change in the foreign exchange value of the dollar affects the foreign currency price of U.S. goods bought and sold on world markets as well as the dollar price of foreign goods purchased by U.S. citizens. These transactions, in turn, affect output and price levels in the U.S. economy. Therefore, it is essential that the Federal Reserve and the FOMC incorporate information about and analysis of international transactions, movements in foreign exchange rates, and other international developments as well as U.S. domestic influences when formulating appropriate monetary policy. 101 102 Part 1 Introduction and Overview of Financial Markets Supervision and Regulation. Each Federal Reserve Bank has supervisory and regulatory authority over the activities of state-chartered member banks and bank holding compa- nies located in their districts. These activities include (1) the conduct of examinations and inspections of member banks, bank holding companies, and foreign bank offices by teams of bank examiners; (2) the authority to issue warnings (e.g., cease and desist orders should some banking activity be viewed as unsafe or unsound); and (3) the authority to approve various bank and bank holding company applications for expanded activities (e.g., mergers and acquisitions). Further, in the area of bank supervision and regulation, innovations in international banking require continual assessments of, and occasional modifications in, the Federal Reserve’s procedures and regulations. Notably, after March 2008, as the Fed stepped in to save investment bank Bear Stearns from failure, politicians proposed an expanded role for the Fed as the main supervisor for all financial institutions. In July 2010, the U.S. Congress passed the Wall Street Reform and Consumer Protection Act, which called for the Fed to supervise the most complex financial companies in the United States and gave regulators (including the Fed) author- ity to seize and break up any troubled financial firm whose collapse might cause wide- spread economic damage. Thus, the Fed’s supervision and regulation duties have spread to include commercial banks as well as other types of financial institutions. Consumer Protection and Community Affairs. The U.S. Congress has assigned the Federal Reserve, through FRBs, with the responsibility to implement federal laws intended to protect consumers in credit and other financial transactions. These responsibilities include writing and interpreting regulations to carry out many of the major consumer protection laws, reviewing bank compliance with the regulations, investigating complaints from the public about state member banks’ compliance with consumer protection laws, addressing issues of state and federal jurisdiction, testifying before Congress on consumer protection issues, and conducting community development activities. Further, community affairs offices at FRBs engage in a wide variety of activities to help financial institutions, community-based organizations, government entities, and the public understand and address financial services issues that affect low- and moderate-income people and geographic regions. Government Services. As discussed, the Federal Reserve serves as the commercial bank for the U.S. Treasury (U.S. government). Each year government agencies and departments deposit and withdraw billions of dollars from U.S. Treasury operating accounts held by Federal Reserve Banks. For example, it is the Federal Reserve Banks that receive depos- its relating to federal unemployment taxes, individual income taxes withheld by payroll deduction, and so on. Further, some of these deposits are not protected by deposit insur- ance and must be fully collateralized at all times. It is the Federal Reserve Banks that hold collateral put up by government agencies. Finally, Federal Reserve Banks are responsible for the operation of the U.S. savings bond scheme, the issuance of Treasury securities, and other government-sponsored securities (e.g., Fannie Mae, Freddie Mac—see Chapter 7). Federal Reserve Banks issue and redeem savings bonds and Treasury securities, deliver government securities to investors, provide for a wire transfer system for these securities (the Fedwire), and make periodic payments of interest and principal on these securities. New Currency Issue. Federal Reserve Banks are responsible for the collection and replacement of currency (paper and coin) from circulation. They also distribute new cur- rency to meet the public’s need for cash. For example, at the end of 1999 the Fed increased the printing of currency to meet the estimated $697 billion demand for currency result- ing from the Y2K scare, in which it was feared that computers worldwide (incapable of recognizing the year 2000) would cease to function on January 1, 2000. Afraid that bank accounts would be lost, depositors withdrew funds in record amounts. More recently, beginning in 2011, there was talk of the Treasury minting a $1 trillion platinum coin as a way of addressing the U.S. debt ceiling crisis. A few, otherwise intended, sentences in the 1997 Omnibus Consolidated Appropriations Act allowed such a minting as long as the coin was platinum. Advocates argued that minting the $1 trillion coin to pay off some of  Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 103 the national debt was a better option than the continued fighting by political leaders over raising the U.S. debt ceiling. However, talk of this solution was relatively short-lived, as in January 2013 the Federal Reserve announced that if the Treasury did mint the coin and present it for payment, the Fed would not accept it. Check Clearing. The Federal Reserve System operates a central check clearing system for U.S. banks, routing interbank checks to depository institutions on which they are written and transferring the appropriate funds from one bank to another. All depository institutions have accounts with the Federal Reserve Bank in their district for this purpose. Table 4–2 shows the number and value of checks collected by the Federal Reserve Banks from 1920 through 2018. The number of checks cleared through the system peaked in 1990, with 18.60 billion checks cleared. For several reasons, this fell to 4.74 billion by 2018. Industry consolida- tion and greater use of electronic products has resulted in a reduction in the number of checks written and thus cleared through the Federal Reserve System. Further, in October 2004, the Check 21 Act, enacted by the Congress and the Federal Reserve, allowed banks to destroy checks after taking a digital image that is then processed electronically. The act begins the process of moving to a paperless environment. Check 21 authorizes the use of a substitute check (Image Replacement Document) for settlement. The new law is designed to encourage the adoption of electronic check imaging. It was prompted partly by the Sep- tember 11 attacks, which grounded the cargo airplanes that flew 42 billion checks a year around the United States, threatening to disrupt the financial system. The switch to elec- tronic processing of checks has saved as much as $3 billion a year for the banking industry. For customers, the implications are mixed. Because checks are processed much more quickly, check writers have lost the “float” of several days between the time checks are deposited and when they are debited from the account. Wire Transfer Services. The Federal Reserve Banks and their member banks are linked electronically through the Federal Reserve Communications System. This network allows these institutions to transfer funds and securities nationwide in a matter of minutes. Two elec- tronic (wire) transfer systems are operated by the Federal Reserve: Fedwire and the Auto- mated Clearinghouse (ACH). Fedwire is a network linking more than 5,300 domestic banks with the Federal Reserve System (however, use of the Fedwire service is highly concentrated among the top 10 participants in terms of volume). Banks use this network to make deposit TABLE 4–2 Number and Value of Checks and Electronic Transactions Processed by the Federal Reserve Checks Cleared Fedwire Transactions Processed ACH Transactions Processed Value Value Value Number (in trillions Number (in trillions Number (in trillions Year (in billions) of dollars) (in billions) of dollars) (in billions) of dollars) 1920 0.42 $ 0.15 0.50 $ 0.03 n/a n/a 1930 0.91 0.32 2.00 0.20 n/a n/a 1940 1.18 0.28 0.80 0.09 n/a n/a 1950 1.96 0.86 1.00 0.51 n/a n/a 1960 3.42 1.15 3.00 2.43 n/a n/a 1970 7.16 3.33 7.00 12.33 n/a n/a 1980 15.72 8.04 43.00 78.59 n/a n/a 1990 18.60 12.52 62.56 199.07 0.92 $4.17 2000 16.99 13.85 108.31 379.76 3.81 11.62 2005 12.23 15.69 132.44 518.55 7.34 12.80 2010 7.71 8.83 125.13 608.33 10.23 16.94 2015 5.45 8.11 142.76 834.63 12.30 20.57 2018 4.74 8.49 158.43 716.21 14.69 25.86 Source: Federal Reserve Website, “Payment Systems,” December 2019, https://www.federalreserve.gov/paymentsystems.htm 104 Part 1 Introduction and Overview of Financial Markets and loan payments, to transfer book entry securities among themselves, and to act as payment agents on behalf of large corporate customers.6 Fedwire transfers are typically large dollar payments (averaging $4.52 million per transaction in 2018). The ACH was developed jointly by the private sector and the Federal Reserve System in the early 1970s and has evolved as a nationwide method to electronically process credit and debit transfers of funds. Table 4–2 shows the number and dollar value of Fedwire and ACH transactions processed by Federal Reserve Banks from 1920 through 2018. In contrast to the falling volume of checks cleared by the Federal Reserve, electronic Fedwire and ACH transactions processed have grown sig- nificantly in recent years. Research Services. Each Federal Reserve Bank has a staff of professional economists who gather, analyze, and interpret economic data and developments in the banking sec- tor as well as the overall economy. These research projects are often used in the conduct of monetary policy by the Federal Reserve. Research papers are freely accessible to the public, are of very high quality, and are quite readable. This makes them one of the best resources for economists, investors, FI managers, and any other individual interested in the operations and performance of the financial system. Balance Sheet of the Federal Reserve Table 4–3 shows the balance sheet for the Federal Reserve System for various years from 2007 through 2018. The conduct of monetary policy by the Federal Reserve involves changes in the assets and liabilities of the Federal Reserve System, which are reflected TABLE 4–3 Balance Sheet of the Federal Reserve (in billions of dollars) Percentage of Assets 2007 2008 2010 2013 2016 2018 Total, 2018 U.S. official reserve assets $ 34.2 $ 35.7 $ 37.0 $ 34.5 $ 30.5 $ 31.80 0.8% SDR certificates 2.2 2.2 5.2 5.2 5.2 5.20 0.1 Treasury currency 38.7 38.7 43.5 45.0 47.6 49.80 1.2 Federal Reserve float −0.0 −1.5 −1.4 −0.6 −0.0 −0.80 0.0 Interbank loans 48.6 559.7 0.2 0.0 0.1 0.10 0.0 Security repurchase agreements 46.5 80.0 0.0 0.0 0.0 0.00 0.0 U.S. Treasury securities 740.6 475.9 1,021.5 1,796.0 2,461.6 2,338.00 55.2 U.S. government agency securities 0.0 19.7 1,139.6 1,143.4 1,780.4 1,644.60 38.8 Miscellaneous assets 40.5 1,060.2 207.6 220.3 216.8 167.40 4.0 Total assets $951.3 $2,270.6 $2,453.2 $3,243.8 $4,542.2 $4,236.00 100.0% Liabilities and Equity Depository institution reserves $ 20.8 $ 860.0 $ 968.1 $1,790.4 $1,977.2 $1,556.00 36.7% Vault cash of commercial banks 55.0 57.7 52.7 59.7 74.2 82.00 1.9 Deposits due to federal government 16.4 365.7 340.9 79.4 333.7 402.40 9.5 Deposits due to government agencies 1.7 21.1 13.5 20.2 31.1 38.50 0.9 Currency outside banks 773.9 832.2 930.0 1,117.3 1,350.8 1,637.20 38.6 Security repurchase agreements 44.0 88.4 59.7 105.5 712.4 304.00 7.2 Miscellaneous liabilities 2.5 3.4 35.3 16.2 23.3 81.70 1.9 Federal Reserve Bank stock 18.5 21.1 26.5 27.6 29.5 32.30 0.8 Equity 18.5 21.0 26.5 27.5 10.0 101.90 2.4 Total liabilities and equity $951.3 $2,270.6 $2,453.2 $3,243.8 $4,542.2 $4,236.00 100.0% Source: Federal Reserve Board, “Financial Accounts of the United States - Z.1,” Monetary Authority, December 2019, p. L.109, https:// www.federalreserve.gov 6. A second major wire transfer service is the Clearing House Interbank Payments System (CHIPS). CHIPS operates as a private network, independent of the Federal Reserve. At the core of the CHIPS system are approximately 50 large U.S. and foreign banks acting as correspondent banks for smaller domestic and international banks in clearing mostly international transactions in dollars.  Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 105 in the Federal Reserve System’s balance sheet. The Federal Reserve’s balance sheet has expanded and contracted over time. During the 2007–2008 financial crisis and subsequent recession, total assets increased significantly from $951 billion in 2007 to $4.5 trillion in 2016, representing 377 percent growth. Then, reflecting the FOMC’s balance sheet normalization program that took place between October 2017 and August 2019, total assets declined to $4.2 trillion in 2018, and $3.7 trillion in August 2019. Beginning in September 2019, total assets started to increase. Liabilities. The major liabilities on the Fed’s balance sheet are currency in circulation reserves and reserves (depository institution reserve balances in accounts at Federal Reserve Banks Depository institutions’ plus vault cash on hand at commercial banks). Their sum is often referred to as the Fed’s vault cash plus reserves monetary base or money base. We can represent these as follows: deposited at Federal Reserves—depository institution reserve balances at the Fed plus vault cash. Reserve Banks. Money base—currency in circulation plus reserves. monetary base For example, in November 2019 the monetary base totaled $3.32 trillion, of which $1.39 Currency in circulation trillion was reserves and $1.93 trillion was currency in circulation. As we show below, and reserves (depository changes in these accounts are the major determinants of the size of the nation’s money institution reserves and supply—increases (decreases) in either or both of these balances (e.g., currency in circula- vault cash of commercial tion or reserves) will lead to an increase (decrease) in the money supply (see below for a banks) held by the Federal definition of the U.S. money supply). Reserve. Also referred to as money base. Reserve Deposits. One of the largest liabilities on the Federal Reserve’s balance sheet (36.7 percent of total liabilities and equity) is depository institution reserves. All banks hold reserve accounts at their local Federal Reserve Bank. These reserve holdings are used to settle accounts between depository institutions when checks and wire transfers are cleared (see above). Reserve accounts also influence the size of the money supply (as described below). required reserves Total reserves can be classified into two categories: (1) required reserves (reserves Reserves the Federal that the Fed requires banks to hold by law) and (2) excess reserves (additional reserves over Reserve requires banks to and above required reserves) that banks choose to hold themselves. Required reserves are hold. reserves banks must hold by law to back a portion of their customer transaction accounts (deposits). For example, the Federal Reserve currently requires up to 10 cents of every excess reserves dollar of transaction deposit accounts at U.S. commercial banks to be backed with reserves Additional reserves banks (see Chapter 13). Thus, required reserves expand or contract with the level of transaction choose to hold. deposits and with the required reserve ratio set by the Federal Reserve Board. Because these deposits earn little interest, banks try to keep excess reserves to a minimum. Excess reserves, on the other hand, may be lent by banks to other banks that do not have sufficient reserves on hand to meet their required levels. As the Federal Reserve implements monetary policy, it uses the market for excess reserves. For example, in the fall of 2008, the Federal Reserve implemented several mea- sures to provide liquidity to financial markets that had frozen up as a result of the financial crisis. The liquidity facilities introduced by the Federal Reserve in response to the crisis created a large quantity of excess reserves at depository institutions (DIs). Specifically, in October 2008 the Federal Reserve began paying interest on excess reserves for the first time.7 Further, during the financial crisis, the Fed set the interest rate it paid on excess reserves equal to its target for the federal funds rate (see below). This policy essentially removed the opportunity cost of holding reserves. That is, the interest banks earned by holding excess reserves was approximately equal to what was previously earned by lending to other FIs. As a result, banks drastically increased their holdings of excess reserves at Federal Reserve Banks. Because the U.S. economy was slow to recover from the financial crisis, the Fed kept the fed funds rate at historic lows into 2016. Thus, banks continued to 7. On October 1, 2008, the Board of Governors amended its rules governing the payment of interest on excess reserves so that the interest rate on excess balances was set at 25 basis points. 106 Part 1 Introduction and Overview of Financial Markets hold large amounts of excess reserves. Note in Table 4–3 that depository institution reserves were 36.7 percent of total liabilities and equity of the Fed in 2018, slightly lower than 37.9 percent in 2008. This in turn was up from 2.2 percent in 2007, prior to the start of the financial crisis. Some observers claim that the large increase in excess reserves implied that many of the policies introduced by the Federal Reserve in response to the financial crisis were ineffective. Rather than promoting the flow of credit to firms and households, critics argued that the increase in excess reserves indicated that the money lent to banks and other FIs by the Federal Reserve in late 2008 and 2009 was simply sitting idle in banks’ reserve accounts. Many asked why banks were choosing to hold so many reserves instead of lending them out, and some claimed that banks’ lending of their excess reserves was crucial for resolving the credit crisis. In this case, the Fed’s lending policy generated a large quantity of excess reserves without changing banks’ incentives to lend to firms and households. Thus, the total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not necessarily affected by private banks’ lending decisions. Currency Outside Banks. Another large liability, in terms of percentage of total lia- bilities and equity, of the Federal Reserve System is currency in circulation (38.6 percent of total liabilities and equity in 2018). At the top of each Federal Reserve note ($1 bill, $5 bill, $10 bill, etc.) is the seal of the Federal Reserve Bank that issued it. Federal Reserve notes are basically IOUs from the issuing Federal Reserve Bank to the bearer. In the United States, Federal Reserve notes are recognized as the principal medium of exchange and therefore function as money (see Chapter 1). Assets. The major assets on the Federal Reserve’s balance sheet are Treasury and gov- ernment agency (i.e., Fannie Mae, Freddie Mac) securities, Treasury currency, and gold and foreign exchange. While interbank loans (loans to domestic banks) are quite a small portion of the Federal Reserve’s assets, they play an important role in implementing mon- etary policy (see below). Treasury Securities. Treasury securities (55.2 percent of total assets in 2018) are the largest asset on the Fed’s balance sheet. They represent the Fed’s holdings of securities issued by the U.S. Treasury (U.S. government). The Fed’s open market operations involve the buying and selling of these securities. An increase (decrease) in Treasury securities held by the Fed leads to an increase (decrease) in the money supply. U.S. Government Agency Securities. U.S. government agency securities are the second-largest asset account on the Fed’s balance sheet (38.8 percent of total assets in 2018). However, in 2007 this account was 0.0 percent of total assets. This account grew as ? the Fed took steps to improve credit market liquidity and support the mortgage and housing D O YO U markets during the financial crisis by buying mortgage-backed securities (MBS) backed by U N D E R STA N D Fannie Mae, Freddie Mac, and Ginnie Mae. Under the MBS purchase program, the FOMC 1. What the main called for the purchase of up to $1.25 trillion of agency MBS. The purchase activity began functions of Federal on January 5, 2009, and continued through March 2010. Thus, the Fed expanded its role as Reserve Banks are? purchaser/guarantor of assets in the financial markets. 2. What the main responsibilities of the Gold and Foreign Exchange and Treasury Currency. The Federal Reserve holds Federal Reserve Board Treasury gold certificates that are redeemable at the U.S. Treasury for gold. The Fed also are? holds small amounts of Treasury-issued coinage and foreign-denominated assets to assist 3. How the FOMC in foreign currency transactions or currency swap agreements with the central banks of implements monetary policy? other nations. 4. What the main assets and liabilities of the Interbank Loans. As mentioned earlier, depository institutions in need of additional Federal Reserve are? funds can borrow at the Federal Reserve’s discount window (discussed in detail below). The interest rate or discount rate charged on these loans is often lower than other interest  Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 107 rates in the short-term money markets (see Chapter 5). As we discuss below, in January 2003 the Fed implemented changes to its discount window lending policy that increased the cost of discount window borrowing but eased the requirements on which depository institutions can borrow. As part of this change, the discount window rate was increased so that it would be higher than the fed funds rate. As a result, (discount) interbank loans are normally a relatively small portion of the Fed’s total assets. Miscellaneous Assets. Generally, miscellaneous assets are a small portion of the Fed’s total assets (e.g., 4.0 percent in 2018). However, during the financial crisis, the Fed undertook a number of measures to support various sectors of the financial markets. For example, as mentioned above (and below), during the financial crisis, the Fed provided AIG with a loan to prevent its failure; lent funds (for the first time ever) through its discount window to brokers and dealers; and committed over $1 trillion of loans to support the commercial paper market. These temporary programs were recorded as miscellaneous assets and, as a result, this item rose to 46.7 percent of total assets in 2008. MONETARY POLICY TOOLS LG 4-3 In the previous section of this chapter, we referred briefly to tools or instruments that the Federal Reserve uses to implement its monetary policy. These included open market oper- ations, the discount rate, and reserve requirements. In this section, we explore the tools or instruments used by the Fed to implement its monetary policy strategy.8 Figure 4–2 illus- trates the monetary policy implementation process that we will be discussing in more detail below. Regardless of the tool the Federal Reserve uses to implement monetary pol- icy, the major link by which monetary policy impacts the macroeconomy occurs through the Federal Reserve influencing the market for bank reserves (required and excess reserves held as depository institution reserve balances in accounts at Federal Reserve Banks plus the vault cash on hand of commercial banks). Specifically, the Federal Reserve’s monetary policy seeks to influence either the demand for, or supply of, excess reserves at depository institutions and in turn the money supply and the level of interest rates. As we describe in Figure 4–2 Federal Reserve Monetary Policy Activities Discount Window Federal Open Market Loans Reserve Operations Repayment Total Reserves Securities Drains in the Sales Extensions Reserves Banking System Drain Securities Add Reserves Purchases Reserves Add Reserves Trade Reserves Banks with Banks That Excess Reserves Want Reserves Source: Federal Reserve Board website, “Purposes & Functions,” www.federalreserve.gov 8. In addition to the tools described here, the Fed (as well as the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency) can indirectly affect the money supply by signaling to bankers to tighten or loosen credit availability. Further, changes in other types of regulations such as capital requirements can affect the money sup- ply. Finally, the U.S. Congress and the U.S. Treasury can use fiscal policy (the use of government expenditure and reve- nue collection through taxation) to affect the level of aggregate demand in the economy to achieve economic objectives. 108 Part 1 Introduction and Overview of Financial Markets the next section, a change in excess reserves resulting from the implementation of mone- tary policy triggers a sequence of events that affect such economic factors as short-term interest rates, long-term interest rates, foreign exchange rates, the amount of money and credit in the economy, and ultimately the levels of employment, output, and prices. Some of the specific economic variables the Federal Reserve works to affect as it implements monetary policy are listed in Table 4–4. These economic variables are referred to as the index of leading indicators. A leading indicator is a measurable economic factor that changes before the economy starts to follow a particular pattern or trend, and, as such, can be used to predict future economic trends. Depository institutions trade excess reserves held at their local Federal Reserve Banks among themselves. Banks with excess reserves—whose reserves exceed their required reserves—have an incentive to lend these funds (generally overnight) to banks in need of reserves since excess reserves held in the vault or on deposit at the Federal Reserve earn little or no interest. The rate of interest (or price) on these interbank transactions is a fed funds rate benchmark interest rate, called the federal funds rate or fed funds rate, which is used in The interest rate on short- the United States to guide monetary policy. The fed funds rate is a function of the supply term funds transferred and demand for federal funds among banks and the effects of the Fed’s trading through between financial institu- the FOMC. tions, usually for a period Further, the Financial Services Regulatory Relief Act of 2006 authorized the of one day. Federal Reserve to pay interest on reserve balances held by depository institutions effec- tive October 1, 2011. Because of the severity of the financial crisis and the need by the Fed to have as many tools available to fight off the crisis, the Emergency Economic Stabilization Act of 2008 moved the effective date to October 1, 2008. The interest rate on required reserves (IORR) is determined by the Fed and is intended to eliminate effec- tively the implicit tax that reserve requirements used to impose on depository institu- tions (see Chapter 13). The interest rate on excess reserves (IOER) is also determined by the board and gives the Federal Reserve an additional tool for the conduct of monetary policy. Specifically, during monetary policy normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjust- ing the IOER rate. For example, as indicated in the minutes of the March 2015 FOMC meeting, the Federal Reserve intended to set the IOER rate equal to the top of the target range for the federal funds rate (which was 0.25 percent to 0.50 percent). Thus, as of December 2015, the IOER rate was set at 0.50 percent. As the target range of federal funds rate increased nine times from December 2015 to December 2018, IOER rate was raised nine times from 0.50 percent to 2.40 percent to influence overnight fed funds to trade around the policy target rate or within the target rate range. In implementing monetary policy, the Federal Reserve can take one of two basic approaches to affect the market for banks’ excess reserves: (1) it can target the quantity of reserves in the market based on the FOMC’s objectives for the growth in the mon- etary base (the sum of currency in circulation and reserves) and, in turn, the money supply (see below), or (2) it can target the interest rate on those reserves (the fed funds rate). The actual approach used by the Federal Reserve has varied according to considerations TABLE 4–4 List of Leading Economic Indicators Average number of weekly hours worked by manufacturing workers Average number of initial applications for unemployment insurance Number of manufacturers’ new orders for consumer goods and materials Speed of delivery of new merchandise to vendors from suppliers Number of new orders for capital goods unrelated to defense Number of new building permits for residential buildings S&P 500 stock index Inflation-adjusted monetary supply (M2) Spread between long- and short-term interest rates Consumer sentiment Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 109 such as the need to combat inflation or the desire to encourage sustainable economic growth (we discuss the various approaches below). Since 1993, the FOMC has implemented monetary policy mainly by targeting interest rates (mainly using the fed funds rate as a target). As mentioned earlier, to reduce the effects of an economic slowdown in the United States, the Fed decreased the fed funds rate 11 times in 2001. This was done to soften the effects of the collapse of the dot-com bubble and the September 2001 terrorist attacks, as well as to combat the perceived risk of deflation. Even into August 2003 the FOMC took the unusual step of foreshadowing its future policy course by announcing that the histori- cally low interest rates could be maintained for a considerable period. Although the FOMC did not specify the length of the considerable period, it was not until the summer of 2004 that the Fed increased the fed funds rate (initially by 0.25 percent). It has been argued that this lowering of interest rates was a contributing factor to the rise in housing prices. From 2000 to 2003, the Federal Reserve lowered the fed funds target from 6.5 percent to 1.0 percent. The Fed believed that interest rates could be lowered safely primarily because the rate of inflation was low. However, some have argued that the Fed’s interest rate pol- icy during the early 2000s was misguided, because measured inflation in those years was below true inflation, which led to a monetary policy that contributed to the housing bub- ble. Low interest rates and the increased liquidity provided by the central bank resulted in a rapid expansion in mortgage financing as demand for residential mortgages rose dramati- cally, especially among those who had previously been excluded from participating in the market because of their poor credit ratings. The Fed then raised the fed funds rate significantly between July 2004 and August 2006; it increased the rate by 0.25 percent for 17 straight meetings. As a result, the fed funds rate rose from a 46-year low of 1 percent in July 2004 to 5.25 percent in August 2006. This contributed to an increase in one-year and five-year adjustable-rate mortgage (ARM) rates and triggered resets of rates on existing ARMs, making ARM interest payments more expensive for homeowners. This also may have contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing. Then, on December 16, 2008, as the U.S. economy faced a severe financial crisis and fell into its deepest recession since the Great Depression, the Fed, in a historic move, unexpectedly announced that it would drop its target fed funds rate to a range between 0 and one-quarter of 1 percent and lowered its discount window rate (see below) to one- half percent, the lowest level since the 1940s (see the In the News box in this section). The overall reduction in the federal funds rate between late 2007 and December 2008 was dramatic, going from 5.26 percent in September 2007 to a range of 0 percent to 0.25 percent as of December 16, 2008. The rate remained at these historically low levels into 2010, and in June 2010 the Fed announced that the fed funds rate would remain at these levels for an “extended period.” It was not until the spring and summer of 2013 that the Fed mentioned the end of these low interest rates and the tightening of monetary policy. And even then, the Fed repeatedly stated that the end of its monetary easing actions would not come until the very slow economic growth picked up. It was not until December 2015 that the Fed eventually raised interest rates (for the first time in 10 years). Since December 2015, the Fed raised interest rates by 0.25 percent nine times through December 2018 to reach target fed funds rate of between 2.25 percent and 2.50 percent. During the FOMC meeting that took place on July 31, 2019, the participants favored a reduction in the target range for the fed funds rate due to deceleration in economic activity, concerns about the outlook for inflation, and risks and uncertainties associated with global economic outlook and international trade. As a result, the Fed left the target fed funds rate unchanged but decreased the target range from 2.25–2.50 percent to 2.00–2.25 percent starting from August 1, 2019. During the early morning hours on September 17, 2019, bids in the fed funds mar- ket reached as high as 5 percent, well above the target range of 2.00–2.25 percent. The fed funds rate trading at above the target range has not occurred since the 2008 financial crisis. Similarly, the rate of borrowing money in the repurchase agreement, or, repo, market reached as high as 10 percent, compared with just over 2 percent in the days prior. The spike in IN THE NEWS Fed Cuts Rates to Record Low In an effort to prevent a worsening U.S. Treasury debt. According to the increased economic disruption recession, in December of 2008 the Fed, “The focus of the commit- and confusion that accompanied the U.S. Federal Reserve made the tee’s policy going forward will be to the failure of Lehman Brothers in unprecedented decision to cut its support the functioning of financial September of 2008. benchmark interest rates to as low markets and stimulate the economy In the fall of 2008, the Fed also as zero. According to a Fed spokes- through open market operations and injected huge amounts of money person, “The Federal Reserve will other measures that sustain the size into credit markets, increasing employ all available tools to promote of the Federal Reserve’s balance the size of its balance sheet from the resumption of sustainable eco- sheet at a high level.” $887 billion to $2.2 trillion over nomic growth and to preserve price In an article from Reuters, just three months. According to Ian stability.” In a historic move, the Fed Michael Woolfolk, senior currency Shephardson, chief U.S. economist lowered its target for the benchmark strategist at the Bank of New York- for High Frequency Economics in federal funds rates from 1.0 percent Mellon in New York, said, “It’s a Valhalla, New York, the decision “is to a record low range of zero to highly unorthodox and creative a reflection of an utterly desolate 0.25 percent. step. We think it’s the best possible economic picture, which will persist The Fed also mentioned that it move for the U.S. consumer and for the foreseeable future as the was considering additional ways for the financial market.” Even with wrenching adjustment in household to support and boost the faltering a large and varied number of new finances continues.” economy, including expanding a initiatives planned to encourage Source: Mark Felsenthal, “Fed plan to purchase large amounts lending by banks, as of late 2008, Cuts Rates to Record Low,” Reuters, of debt issued or guaranteed by U.S. authorities had been unable to December 16, 2008, http://www government-sponsored mortgage stop the recession from worsening..reuters.com/article/us-usa-fed-preview- agencies and purchasing longer-term They increased their efforts after idUSN1550484520081216. overnight lending rates was caused by a string of coincidental events, including corporate tax payments and Treasury sales, according to analysts and investors. But those events only had such startling effect because banks were already operating close to the minimum level of reserves they want to hold. After the 2008 crisis, the Fed’s massive bond-buying programs led to a huge increase in reserves in the system. But that has gone into reverse as the central bank tightened monetary policy in the past couple of years. The Fed’s reversal has forced the U.S. Treasury to sell more bonds to banks and investors. That reduces the amount of money in the financial system because primary dealers buy the bonds using reserves. The Fed believed there was still spare capacity of $200 billion to $300 billion in reserves before money would get too tight and overnight funding problems would appear, according to Mor- gan Stanley analysts. However, the combination in of corporate tax payments and Treasury issuance in mid-September showed that cushion may not have existed. To respond to this crunch in overnight funding markets, the Fed injected billions of dollars into the repo market for the first time in more than a decade. These operations are ongoing, having been both widened in scope, to include two-week lending as well as overnight repo, and increased in size. The Fed is also buying Treasuries again, expanding its balance sheet by an extra $60 billion a month in a bid to build up banks’ reserves and www.newyorkfed.org increase the amount of cash in the financial system more permanently. Federal Reserve Open Market Operations Board Trading Desk Unit of the Federal Reserve As mentioned earlier, open market operations are the Federal Reserves’s purchases or sales Bank of New York through of securities in the U.S. Treasury securities market. When a targeted monetary aggregate which open market opera- or interest rate level is determined by the FOMC, it is forwarded to the Federal Reserve tions are conducted. Board Trading Desk at the Federal Reserve Bank of New York (FRBNY) through a 110  Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 111 policy directive statement called the policy directive. The manager of the Trading Desk uses the policy Statement sent to the Fed- directive to instruct traders on the daily amount of open market purchases or sales to trans- eral Reserve Board Trading act. These transactions take place on an over-the-counter market in which traders are linked Desk from the FOMC that to each other electronically (see Chapter 5). specifies the daily amount To determine a day’s activity for open market operations, the staff at the FRBNY of open market purchases begins each day with a review of developments in the fed funds market since the previous or sales to transact. day and a determination of the actual amount of reserves in the banking system the previ- ous day. The staff also reviews forecasts of short-term factors that may affect the supply and demand of reserves on that day. With this information, the staff decides the level of transactions needed to obtain the desired fed funds rate. The process is completed with a daily conference call to the Monetary Affairs Division at the Board of Governors and one of the four voting Reserve Bank presidents (outside of New York) to discuss the FRBNY plans for the day’s open market operations. Once a plan is approved, the Trading Desk is instructed to execute the day’s transactions. Open market operations are particularly important because they are the primary deter- minant of changes in bank excess reserves in the banking system and thus directly impact the size of the money supply and/or the level of interest rates (e.g., the fed funds rate). When the Federal Reserve purchases securities, it pays for the securities by either writing a check on itself or directly transferring funds (by wire transfer) into the seller’s account. Either way, the Fed credits the reserve deposit account of the bank that sells it (the Fed) the securities. This transaction increases the bank’s excess reserve levels. When the Fed sells securities, it either collects checks received as payment or receives wire transfers of funds from these agents (such as banks) using funds from their accounts at the Federal Reserve Banks to purchase securities. This reduces the balance of the reserve account of a bank that purchases securities. Thus, when the Federal Reserve sells (purchases) securities in the open market, it decreases (increases) banks’ (reserve account) deposits at the Fed. EXAMPLE 4–1 Purchases of Securities by the Federal Reserve Suppose the FOMC instructs the FRBNY Trading Desk to purchase $500 million of Trea- sury securities. Traders at the FRBNY call primary government securities dealers of major commercial and investment banks (such as Goldman Sachs and Morgan Stanley),9 who provide a list of securities they have available for sale, including the denomination, matu- rity, and the price on each security. FRBNY traders seek to purchase the target number of securities (at the desired maturities and lowest possible price) until they have purchased the $500 million. The FRBNY then notifies its government bond department to receive and pay the sellers for the securities it has purchased. The securities dealer sellers (such as banks) in turn deposit these payments in their accounts held at their local Federal Reserve Bank. As a result of these purchases, the Treasury securities account balance of the Federal Reserve System is increased by $500 million and the total reserve accounts maintained by these banks and dealers at the Fed are increased by $500 million. We illustrate these changes to the Federal Reserve’s balance sheet in Table 4–5. In addition, there is also an impact on commercial bank balance sheets. Total reserves (assets) of commercial banks will increase by $500 million due to the purchase of securities by the Fed, and demand deposits (liabilities) of the securities dealers (those who sold the securities) at their banks will increase by $500 million.10 We also show the changes to commercial banks’ balance sheets in Table 4–5. 9. As of December 2019, there were 24 primary securities dealers trading, on average, $1.27 trillion of securities per day. 10. In reality, not all of the $500 million will generally be deposited in demand deposit accounts of commercial banks, and commercial banks will not generally hold all of the $500 million in reserve accounts of Federal Reserve Banks. We relax these simplifying assumptions and look at the effect on total reserves and the monetary base later in the chapter. 112 Part 1 Introduction and Overview of Financial Markets TABLE 4–5 Purchase of Securities in the Open Market Change in Federal Reserve’s Balance Sheet Assets Liabilities Treasury securities + $500m Reserve account of + $500m securities dealers’ banks Change in Commercial Bank Balance Sheets Assets Liabilities Reserve accounts + $500m Securities dealers’ demand + $500m at Federal Reserve deposit accounts at banks Note the Federal Reserve’s purchase of Treasury securities has increased the total sup- ply of bank reserves in the financial system. This in turn increases the ability of banks to make new loans and create new deposits. For example, in March 2009 the Federal Reserve announced that it would buy $300 billion of long-term Treasury securities over the next six months in order to try and get credit flowing to the financial markets. This program was eventually referred to as the Fed’s Quantitative Easing 1 (QE1) program. The Fed gener- ally conducts open market operations using short-term Treasury bills (to set the fed funds rate) and generally does not intervene in long-term Treasury markets (allowing the market to set long-term rates). In fact, the Fed had not purchased long-term Treasury securities since the 1960s. In November 2010, the Fed followed up its QE1 program with QE2, in which it purchased $600 billion of long-term Treasury securities between November 2010 and June 2011. In September 2012 the Fed announced the beginning of QE3, an open-ended program involving the purchase of $40 billion of Treasury securities per month. QE3 ended in Octo- ber 2014. The results of the QE programs can be seen on the Federal Reserve’s balance sheet in Table 4–3. Treasury securities totaled $2.46 trillion in 2016, up 232 percent from $741 billion in 2007, while depository institution reserves were $1.98 trillion in 2016, up 9,406 percent from $21 billion in 2007. The message to the financial markets from these actions was that the Fed was willing to do whatever was necessary to stabilize the economy until it had sufficiently recovered from the financial crisis. From October 2017 to August 2019, the Fed undertook a balance sheet normalization program, which reduced the Fed’s holding of U.S. Treasury securities to $2.34 trillion in 2018 from $2.46 trillion in 2016 (see Figure 4–3). EXAMPLE 4–2 Sale of Securities by the Federal Reserve Suppose the FOMC instructs the FRBNY Trading Desk to sell $500 million of se