Chapter Eighteen

1. Chapter Eighteen

2. Introduction • There are three interest rates: • The federal funds rate, • The discount rate, and • The deposit rate. • These are the primary tools of monetary policy during normal times. • In a financial crisis, central banks may also adjust the size and composition of their balance sheet.

3. Introduction • Interest rates play a central role in all of our lives. • They are the cost of borrowing and the reward for lending. • Higher rates restrict growth of credit. • The business press is constantly speculating about whether the FOMC will change its target.

4. Introduction • Between September 2007 and December 2008, the FOMC lowered its target for the federal funds rate 10 times. • This was the first time since the 1930s that the Fed hit the zero bound on the nominal federal funds rate. • Banks can always hold cash paying zero interest. • They will never choose to lend their reserves at a negative nominal rate. • The nominal policy rate therefore faces a zero bound: it will never fall below zero.

5. Introduction • Even setting the federal fund rate target at essentially zero wasn’t enough to stabilize the economy. • The crisis had undermined the willingness and ability of major financial intermediaries to lend. • In this environment the Fed moved to substitute itself for dysfunctional intermediaries and markets. • This significantly altered the Fed’s balance sheet.

7. Introduction • To steady the financial system and the economy after the crisis, the Fed utilized its three principal conventional policy tools: • The federal funds rate target, • The rate for discount window lending, and • The deposit rate. • They did so to the fullest extent possible to support economic activity.

8. Introduction • Policymakers then proceeded to develop and use a variety of unconventional policy tools including: • Commitments to keep interest rates low over time, and • Massive purchases of risky assets in thin, fragile markets. • These unconventional measures added meaningfully to the conventional actions.

9. Introduction • In this chapter we will: • See how the Fed uses its policy tools, both conventional and unconventional to achieve economic stability. • See that those tools are quite similar to those of other central banks. • Focus on three links: • Between the central bank’s balance sheet and its policy tools; • Between the policy tools and monetary policy objectives; and • Between monetary policy and the real economy.

10. The Federal Reserve’s Conventional Policy Toolbox • In looking at day-to-day monetary policy, it is essential that we understand the institutional structure of the central bank and financial markets. • We will begin with the Fed and financial markets in the U.S. • In the next section, we will look at the ECB’s operating procedures to see how they differ.

11. The Federal Reserve’s Conventional Policy Toolbox • The Fed has four conventional monetary policy tools, also known as monetary policy instruments: • The target federal funds rate, • The discount rate, • The deposit rate, and • The reserve requirement. • Each of these tools are related to several of the central bank’s functions and objectives.

12. The Federal Reserve’s Conventional Policy Toolbox

13. The Target Federal Fund Rate and Open Market Operations • The target federal fund rate is the FOMC’s primary policy instrument. • The federal funds rate is the rate at which banks lend reserves to each other over night. • It is determined in the market and not controlled by the Fed. • We will distinguish between the target federal funds rate set by the FOMC and the market federal funds rate, at which transactions between banks take place.

14. The Target Federal Fund Rate and Open Market Operations • On any given day, banks target the level of reserves they would like to hold at the close of business. • That may leave them with more or less reserves than they want. • This gives rise to a market for reserves. • Some banks can lend out excess reserves. • Some banks will borrow to cover a shortfall.

15. The Target Federal Fund Rate and Open Market Operations • Without this market, banks would need to hold substantial quantities of excess reserves as insurance against shortfalls. • These transactions are all bilateral agreements between two banks. • Loans are unsecured so the borrowing bank must be credit worthy in the eyes of the lending bank.

16. The Target Federal Fund Rate and Open Market Operations • If the Fed wanted to, it could force the market federal funds rate to equal the target rate. • However, policymakers believe that the federal funds market provides valuable information about the health of specific banks. • So the Fed allows the federal funds rate to fluctuate around its target in a channel or corridor defined by the discount rate and the deposit rate.

17. The Target Federal Fund Rate and Open Market Operations • When the federal fund rate climbs to the discount rate, banks may borrow from the Fed at the discount rate. • When the market federal funds rate falls to the deposit rate, banks can deposit their excess reserves at the Fed at the deposit rate. • The Fed can adjust the width of the so-called channel around the target federal funds rate.

18. The Target Federal Fund Rate and Open Market Operations • The Fed targets an interest rate at the same time that it wants to allow an interbank lending market to flourish. • Instead of fixing the interest rate, the Fed controls the federal funds rate by manipulating the quantity of reserves. • The Fed does this by using open market operations.

19. The Target Federal Fund Rate and Open Market Operations • We can use a standard supply-and-demand graph to analyze the market in which banks borrow and lend reserves. • The demand curve for reserves is downward sloping. • However, when the federal funds rate in the market drops to the deposit rate, banks are willing to hold any amount of reserves supplied beyond this level. • So the demand curve turns flat.

20. The Target Federal Fund Rate and Open Market Operations • Keeping the market federal funds rate at the target means balancing supply and demand for reserves at that target rate. • The staff of the Open Market Trading Desk does this by: • Estimating the demand for reserves at the target rate each morning, and • Supplying that quantity for the day. • This means the daily supply for reserves is vertical until the market federal funds rate reaches the discount rate.

21. The Target Federal Fund Rate and Open Market Operations

22. The Target Federal Fund Rate and Open Market Operations • Within a day, the federal funds rate can fluctuate in a range from the deposit rate to the discount rate. • As the reserve demand shifts, the Fed staff will use open market operations to shift the daily reserve supply curve to accommodate the change. • This ensures that the market federal funds rate stays near the target.

23. The Target Federal Fund Rate and Open Market Operations • An increase in reserve demand is met by an open market purchase. • The vertical portion of reserve supply shifts to the left to keep the federal funds rate at the target level.

24. The Target Federal Fund Rate and Open Market Operations • We can compare the FOMC’s target rate with the market rate over the last two decades. • We can see how well the Fed’s staff has met its objective. • Figure 18.4 plots both the target federal funds rate and the market federal fund rate beginning in 1992.

25. The Target Federal Fund Rate and Open Market Operations • We can see that the market rate was close to the target on most days after 2000. • Changes in the reserve accounting rules in 1998 and improvements in information systems made it easier for the Open Market Trading Desk to estimate reserve demand. • The use of the discount rate as a daily cap on the funds rate after 2002 appears to have stabilized the market rate even further. • The 2007-2009 crisis introduced new targeting errors.

26. The Target Federal Fund Rate and Open Market Operations

27. The Federal Funds Rate is the overnight lending rate. • Long-term interest rates = average of expected short-term interest rates + the risk premium. • When the expected future path of the federal funds rate changes, long-term interest rates we all care about change.

28. Discount Lending, the Lender of Last Resort, and Crisis Management • By controlling the quantity of loans it makes, a central bank can control: • The size of reserves, • The size of the monetary base, and ultimately • Interest rates. • However, lending by the Federal Reserve Banks to commercial banks, called discount lending, is usually small aside from crisis periods.

29. Discount Lending, the Lender of Last Resort, and Crisis Management • Yet, discount lending is the Fed’s primary tool for: • Ensuring short-term financial stability, • Eliminating bank panics, and • Preventing the sudden collapse of institutions that are experiencing financial difficulties. • Recall that crises were the primary impetus for the creation of the Federal Reserve in the first place.

30. Discount Lending, the Lender of Last Resort, and Crisis Management • The idea was that some central government authority should be capable of providing funds to sound banks to keep them from failing during financial panics. • The central bank is therefore the lender of last resort: • Making loans to banks when no none else will or can.

31. Discount Lending, the Lender of Last Resort, and Crisis Management • But, a bank is supposed to show that it is sound to get a loan in a crisis. • This means having assets the central bank will take as collateral. • A bank that does not have assets it can use as collateral for a discount loan is a bank that should probably fail.

32. Discount Lending, the Lender of Last Resort, and Crisis Management • For most of its history, the Fed loaned reserves to banks at a rate below the target federal fund rate. • Borrowing from the Fed was cheaper than borrowing from another bank. • But no one borrowed. • The Fed required banks to exhaust all other sources of funding before they applied for a loan.

33. Discount Lending, the Lender of Last Resort, and Crisis Management • Banks that used discount loans regularly faced the possibility of being denied loans in the future. • These rules created quite a disincentive to borrow from the Fed. • By severely discouraging banks from borrowing, the Fed destabilized the interbank market for reserves causing some of the upward spikes in Figure 18.4.

34. Discount Lending, the Lender of Last Resort, and Crisis Management • Because of this in 2002, officials instituted the discount lending procedures in place today. • The current discount lending procedures: • Provide a mechanism for stabilizing the financial system, and • Help the Fed meet its interest-rate stability objective.

35. Discount Lending, the Lender of Last Resort, and Crisis Management • The Fed makes three types of loans: • Primary credit, • Secondary credit, and • Seasonal credit. • The Fed controls the interest rate on these loans. • The banks decide how much to borrow.

36. Primary Credit • Primary credit is extended on a very short-term basis, usually overnight, to institutions that the Fed’s bank supervisors deem to be sound. • Banks seeking to borrow much post acceptable collateral. • The interest rate on primary credit is set at a spread above the federal fund target rate called the primary discount rate.

37. Primary Credit • Primary credit is designed to provide additional reserves at times when the open market staff’s forecasts are off and so that the day’s reserve supply falls short. • The market federal funds rate will rise above the FOMC’s target. • Providing a facility through which banks can borrow at a penalty rate above the target puts a cap on the market federal funds rate.

38. Primary Credit • The system is designed both: • To provide liquidity in times of crisis, ensuring financial stability, and • To keep reserve shortages from causing spikes in the market federal funds rate. • By restricting the range over which the market federal funds rate can move, this system helps to maintain interest-rate stability.

39. Secondary Credit • Secondary credit is available to institutions that are not sufficiently sound to qualify for primary credit. • The secondary discount rate is set about he primary discount rate. • There are two reason a bank might seek secondary credit: • A temporary shortfall of reserves, or • They cannot borrow from anyone else.

40. Secondary Credit • By borrowing in the secondary credit market, a bank signals that it is in trouble. • Secondary credit is for banks that are experiencing longer-term problems that they need some time to work out. • Before the Fed makes the loan, it has to believe that there is a good chance the bank will be able to survive.

41. Seasonal Credit • Seasonal credit is used primarily by small agricultural banks in the Midwest to help in managing the cyclical nature of farmers’ loans and deposits. • Historically, these banks had poor access to national money markets. • In recent years, however, there has been a move to eliminate seasonal credit. • There seems little justification for the practice as they now have easy access to longer-term loans from large commercial banks.

42. Reserve Requirements • Since 1935, the Federal Reserve Board has had the authority to set the reserve requirements. • These are the minimum level of reserves banks must hold either as vault cash or on deposit at the Fed. • Changes in the reserve requirement affect the money multiplier and the quantity of money and credit circulating in the economy. • However, the reserve requirement turns out not to be very useful.

43. Reserve Requirements • The reserve requirement is applied to two-week average balances in account with unlimited checking privileges--transaction deposits. • This period ends every second Monday. • The reserves a bank must hold are also averaged over a two-week period, called the maintenance period. • This begins on the third Thursday after the end of the computation period.

44. Reserve Requirements • This means that the banks and the Fed both know exactly what level of reserves every bank is required to hold during given maintenance period well before the period starts. • All banks have 16 days to figure out their deposit balances before they even need to start holding reserves. • This procedure is called lagged-reserve accounting, and it makes the demand for reserves more predictable.

45. Reserve Requirements • In 1980, the Monetary Control Act changed the rules slightly so that the Fed can now set the reserve requirement ratio between 8 and 14 percent of these transactions deposits. • Now that interest is paid on reserves, it is not so costly to the banks. • To help small banks, the law specifies a graduated reserve requirement similar to graduated income taxes.

46. Reserve Requirements • In the beginning, reserves were required to ensure banks were sound and to reassure depositors that they could withdraw currency on demand. • Today the reserve requirement exists primarily: • To stabilize the demand for reserves, and • To help the Fed to maintain the market federal funds rate close to target.

47. Reserve Requirements • Before August 1998, the computation and maintenance periods overlapped. • Banks had to manage their deposits and reserves at the same time. • The result was a volatile market federal funds rate. • Since the summer of 1998, things have calmed down quite a bit.

48. Numerous innovations have reduced the demand for the monetary base. • As the demand for the reserves disappears, will monetary policy go with it? • There are other countries who have eliminated reserve requirements entirely, but retain monetary policy control. • Australia, Canada, and New Zealand, for example.

49. They do it through what is called a “channel” or “corridor” system that involves setting not only a target interest rate, but also a lending and deposit rate: just as the Fed and the ECB do. • Banks in need of funds will never be willing to pay more than the central bank’s lending rate, and • Those that have excess funds will never be willing to lend at a rate below the central bank’s deposit rate. • This will continue to give monetary policymakers a tool to influence the economy.