When Bernanke announces the federal funds rate target, the world listens. Everyone from the blue-collar American to the foreign multi-millionaire has a stake in his comments.
Many understand the significance of these rate changes but few know how they are enacted. After all, interest rates respond to the framework of supply and demand, right? Except for b-school students and economics enthusiasts, most people are oblivious to the behind-the-scenes action of manipulating short-term interest rates.
Monetary Policy’s 3 tools
The Fed has 3 tools at their disposal to manipulate the supply and demand of required reserves: the key component in the federal funds rate. Here’s a brief description:
Discount lending refers to loans conducted between the Fed and depository institutions performed at the discount rate. The discount rate offered depends on the type of loan and who it’s offered to. There are three: primary credit, secondary credit, and seasonal credit loans.
Primary credit loans, also known as adjustment credit loans, are offered to healthy banks at an unlimited quantity with rates 100 basis points above the fed funds rate target. Since financially sound banks are looking to pay the lowest rate, these loans only exist to provide a backup source of liquidity. Primary credit loans fulfill the Fed’s initial roles as lender of last resort. Secondary credit, which is given at 150 basis points above fed funds rate, is used by banks experiencing financial troubles. It prevents distressed banks from defaulting. The last type of discount loan services small and mid-sized banks that are challenged by seasonal liquidity difficulties. Seasonal credit loans serve banks operating in vacation and agricultural areas. The need for these types has been questioned in recent years
Reserve requirements are the least frequently used tool of the Fed. They are percentages of deposits that banks must hold as vault cash or on deposit at a Federal Reserve Bank. As of December 2006, the reserve requirement was 10% of checkable deposits. The Fed has the authority to adjust this rate in between an 8% and 14% range; in extreme cases it can be raised as high as 18%.
Open market operations refer to the central bank’s purchase or sale of securities in the open market. These securities include bonds such as T-bills from the US Treasury and other government agencies. Being the most liquid market, it can absorb the Fed’s volume of transactions without being disrupted by large price fluctuations. The decision making authority for open-market operations is the Federal Open Market Committee (FOMC) and the functions are performed by the NY Fed Bank.
A few key relationships
All interest rate movements are based on the laws of supply and demand. When Bernanke declares the fed funds rate target at 5.25%, banks can still lend to each other at any rate. It is important to differentiate between the target and the actual.
The fed funds rate is the actual overnight lending rate between banks used to maintain required reserve levels. On the other hand, the target is what the FOMC is setting as its policy goal. It is up to the Federal Reserve to use the three tools to keep these rates at the announced target. You may hear these two used interchangeably because the Fed does such a good job of keeping the actual close to its target. Let’s look at how they use them and which of the tools are most effective.
Changes in reserve requirements affect the demand for reserves such that a rise in requirements means that banks must hold more reserves. Therefore, the availability of money decreases, directly affecting the fed funds rate by making it higher. The inverse of this relationship holds true: a lowering of reserve requirements decreases the fed funds rate.
Historically, manipulating reserve requirements has proven infrequent for a number of reasons. Raising them can cause immediate liquidity problems for banks with low excess reserves. Not to mention, fluctuating reserve requirements would create uncertainty in the future for banks making their liquidity management more difficult. It is already hard for banks to forecast the amount of deposits they will have from day to day; it would prove even harder with the Fed switching the required reserve amounts frequently. Also, reserves prove to be an opportunity cost for banks as no interest is paid on them so, raising them proves incredibly unfavorable.
Although less static than reserve requirements, adjustment of the discount rate has no direct effect on the federal funds rate. Since the discount rate is always higher than the fed funds rate target, it proves useful as a ceiling preventing the fed funds rates from raising 1 percent higher than the target. As a result, an unexpectedly strong demand for reserves won’t drive the fed funds rate rates too high because healthy banks can always fall back on the discount window.
Open market operations prove to be the most effective and widely-used tool of the Fed. Each day, millions in transactions take place at the Fed Reserve Bank of New York based on the following relationship: open market purchases cause the fed funds rate to fall and vice versa. A purchase leads to an expansion of reserves as money is being injected into the economy in exchange for government securities. Using this simple relationship, traders at the Fed keep the actual rate at or near its target.
Open Market Operations: a detailed look
Each day, the trading desk at the Federal Reserve Bank of New York goes to work to maintain the target rate set by the FOMC. They start off by contacting primary dealers (government securities dealers who operate from commercial banks) to gauge market conditions for the day. During that time, they also contact the Treasury to survey the expected level of Treasury balances at the Fed in order to estimate the supply of reserves. Finds are compared with those of the Monetary Affair Division at the Board of Governors.
During this time, a course of action is developed along with the Division’s help. The plan is then presented to the Office of the Director and one of the four voting Reserve Bank presidents outside of New York to gain approval. Once it does, the plan turns into action with the trading desk using either of three types of transactions: repurchase agreement (repo) , matched sale-purchase transaction (reverse repo), and outright purchase and sale.
In repos, the Fed purchases securities with an agreement that the seller will repurchase them in a short period of time, anywhere from 1 to 15 days. Often referred to as a defensive operation, the position is short term because it’s attempting to counteract existing problems. Here is an example of the process. Either reserve supply falls or demand rises, and so the federal funds rate rises above the set target. Seen as a short-term issue, the trading desk engages in repurchase agreements pushing the fed funds rate closer to the target.
As with repos, reverse repos are short-term solutions categorized as defensive operations, too. However in reverse repos, the Fed sells securities and agrees to buy them back in the near future. These transactions are performed to drive up the fed funds rate placing it closer to the target because it is too low.
Outright purchases and sales have no stipulations for future resale/repurchase. They attempt to have a permanent impact on the supply of reserves and therefore are called dynamic operations. This is done to prevent any future problems before they happen.
So, why are open market operations the primary tool of the Fed? What advantages do they hold over the other tools? First, they are completely controlled by the Fed. With discount operations, the Fed can only adjust the discount rate but they have no control over the volume of discount loans. Second, they are flexible and precise and can be used to any extent; open market operations can achieve both small and large changes. Third, open market actions can be easily reversed. If it is found that purchasing actions have driven the fed funds rate too low, a correction can immediately be made with a sale. Fourth, open market operations are implemented quickly. There are no administrative delays where they need approval before action.
July, 13, 2007
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