Lecture 7 - The Federal Reserve System

The Federal Reserve System (the central bank of the US)

The Federal Reserve System was created by Congress in 1913.

Federal Open Market Committee FOMC, consists of 7 members of the Board of Governors (14 year terms, appointed by the president and confirmed by the senate) and the presidents of 5 of the 12 Federal Reserve District Banks. The NY district is always on the FOMC because they run two important operations: The Open Market Desk and the Foreign Market Desk.

They meet eight times a year (about every 6 weeks) and make decisions regarding the conduct of open market operations, which influence the monetary base. Statements and minutes from their meetings are posted on the web.

Primary responsibility includes controlling inflation or stable price as well as stabilizing economic activity: Humphrey Hawkins Act of 1978

Fed attempts to achieve low inflation by controlling the money supply and short-term interest rates: setting M or i but not both independently.

The Fed's Balance Sheet

Assets:
Securities: US Treasury bonds
Discount loans
Gold and SDR (special drawing rights from IMF)
Coin (Treasury currency held by the Fed)
Cash in the process of collection
Fed's other assets such as foreign currencies, foreign govt bonds, real estates.

Liabilities:
Federal reserve notes outstanding (currency held by the public)
Bank deposits (reserves)
US Treasury deposits
Foreign and other deposits
Other liabilities

Open Market Operations

The Fed increases or decreases the monetary base by selling or buying Treasury bonds through open market operations.

Expansionary monetary policy = open market purchase of Treasury bonds
Contractionary monetary policy = open market sale of Treasury bonds

Open market purchase from a bank has the same effect as purchase from an individual

Fed
Assets +10k bond
liability +10k cash

Individual
assets: -10k bond, +10k cash

What really happens?

After the Fed decides to cut interest rates, they call the open market operations desk (VP of NY fed). They call 30 major bond dealers and tell them that the Fed wants to buy bonds. They keep buying bonds until the interest rate reaches their target. They continue to intervene to keep the interest rate where they want it. They get market feedback every morning, meet around 10 to plan their strategy. After their meeting, they execute their plan and take the afternoon off.

Reserve Requirements

As of Dec 2006, the reserve requirement on demand deposits was 0% on the first 8.5 million, 3% on those between 8.5 million and 45.8 million and 10% on those in excess of 45.8 million.

If the Fed reduces the reserve requirement, then the money stock will rise and vice versa.

However, the Fed rarely changes this because it would require significant alterations in banks' portfolios, so it would be disruptive if it changes frequently.

Discount Rate

Suppose that a bank finds itself temporarily with fewer reserves than those required by the Fed. Instead of forcing the banks to reduce loans or investments, the Fed could lend money to the bank to meet the required reserve ratios, and charge interest on the loan. The process is called borrowing at the discount window and the interest rate is called the discount rate.

Two ways to use this tool: change the discount rate or limit how much they can borrow at the given discount rate. today this is used mostly to help or discipline a particular bank.

Banks have developed their own way to meet their reserve requirements. Rather than borrowing from the Fed (and possibly being subject to increased scrutiny), banks short of reserves can borrow from other banks that have excess reserves. This market for reserves is called the "Federal Funds Markets" and the interest rate charged is called the "Federal Funds Rate" - interbank loan interest rate. (counterpart in London, LIBOR (London interbank offered rate)).

Fed's Activity during credit crisis of 2007-08

Fed cut interest rates seven times to 2% (as of May 12, 008) from 5.25% in September 2007. With rescue of Bear Stearns in mid-March, Fed started lending to prime dealers and investment banks against collateral of martgage-backed securities. Fear of financial market meltdown easing.

2 functions of the Fed:
(1) Monetary policy: change the size of money supply (i.e., federal funds rate) - expansion & contraction of Fed's balance sheet

Three important assets:
1. Securities held outright (system of open market account SOMA - entirely Treasury securities $703bn out of $898bn total assets of Fed)
2. Securities held under repo agreement (treasuries, GSE-agency bonds and agency MBS, $77bn)
3. Discount window lending ($60bn)

(2) Lender of last resort (liquidity and financial stability): To promote liquid and functioning markets, Fed can change the composition of Fed's balance sheet, not the size. Take out of favor assets into its balance in exchange for Fed liabilities.

Examples: (i) TAF (term auction facility - discount window): Fed lent funds to depository institutions against a broad range of collateral that the borrowing institutions have pledged to the Fed ($100bn for 28 or 35 days in March 2008). To offset the increase in the balance sheet, Fed has had to reduce Treasuries under SOMA.

(ii) TSLF (term securities lending facility): Under the new facility, the 20 primary dealers will be allowed to exchange mortgages (GSE agency mortgages or private label RMBS) for Treasuries that the Fed holds in the SOMA ($200bn for 28 days).

(iii) Expansion of term repos: On March 7 Fed announced an intention to ...

Hyperinflation

Hyperinflation is defined to be inflation that exceeds 50% per month, which is just over 1% per day.

Why central banks in countries having hyperinflation chose to print so much money in the first place?

Govt can finance its spending mainly through 3 ways:
1. tax revenues
2. borrowing from the public: issuing govt bonds
3. seigniorage: monetary finance. simlpy print more money to finance the spending

Most hyperinflation begins with...

Primary budget deficit = G-T
Total budget deficit = G-T-i x D_-1(interest payments on existing debt outstanding)

D-D_-1 is the new issues of govt bonds.

(i) who buys bonds? D = D^{Central bank} + D^public
(ii) D = M^h - B^CB/e + D^public
see derivation

The Central Bank Independence and Politics

Rapid increase in money supply can produce high inflation that destabilizes the economy.

Controlling the money supply is the crucial job of the central bank.

Yet the central bank faces many powerful political forces that put continued pressures on it to extend cheap credits, or to help finance a large budget deficit. Thus it may be hard for the Central Bank to resist these political pressures unless it has some institutional independence from the government executive and legislative branches.

Therefore, in the pursuit of low inflation, there are advantages to having an independent Central Bank. Also, an independent Central Bank may possess greater credibility once it commits to lower inflation, compared to a Central Bank that is heavily under the influence of elected policymakers.

Data (graph, page 23) shows inverse relationship between avg inflation and index of central-bank independence among major countries. I.e. lower independence is associated with higher inflation.