Federal Reserve and the Tools of Monetary Policy

1. Federal Reserve and the Tools of Monetary Policy Continuation of Chapter 2 Kidwell, Blackwell, Whidbee and Sias Kidwell, et al., Chapter 2

2. Section 2.6 continued (12th edition)The Financial System Bailout Kidwell, et al., Chapter 2

3. Financial System Bailout • The Fed’s balance sheet was distorted by the financial crisis • The Fed undertook aggressive monetary action – buying Treasury and other securities – to stabilize the economy • “Lending to financial institutions” – this category reflects the large purchases of mortgage-backed (MBS) securities • MBS purchases supported the housing market but were significantly riskier than Treasury purchases Kidwell, et al., Chapter 2

4. Financial System Bailout • The purchases did lower interest rates to close to zero but the economy did not rebound. • Thus, the Fed began “Quantitative Easing” in 2009. • Purchasing even more bonds and creating more reserves • In the first round, the Fed purchased $1.75 trillion Treasury and MBS securities. • Economy still didn’t rebound • Interest rates were still low but financial institutions preferred to leave funds with Fed rather than lend out Kidwell, et al., Chapter 2

5. Financial System Bailout • 2010 – Second round of quantitative easing – QE2 • 2012 – Third round – QE3 • Fed is now looking to “shrink” the balance sheet but is finding it difficult to do this quickly. • https://www.wsj.com/articles/how-the-feds-unwinding-will-work-1505840459?cx_testId=17&cx_testVariant=cx&cx_artPos=0&cx_tag=related?cx_campaign=poptart&mod=cx_poptart#cxrecs_s • https://www.wsj.com/articles/how-the-feds-balance-sheet-unwind-will-ripple-through-banks-1505934565 Kidwell, et al., Chapter 2

6. Fed’s Balance Sheet – 2007 vs. 2015 Kidwell, et al., Chapter 2

7. 2.8 Federal Reserve Tools of Monetary Policy • Open Market Operations • Discount Rate • Reserve Requirements • Using these tools for monetary policy is discussed more completely in Chapter 3. • Here, we look at definitions and institutional implementation Kidwell, et al., Chapter 2

8. Open Market Operations • Most useful and therefore must important tool • Fed directly changes money supply by buying or selling US government securities on open secondary market— • Pays for “buys” by crediting new reserves to special bank accounts of selected dealers • Collects for sales by taking existing reserves back • Only the central bank can unilaterally create or retire money in this way Kidwell, et al., Chapter 2

9. Effects of Open Market Operations • Money supply changes immediately and dollar for dollar, making Open Market Operations flexible and precise. • Short-term interest rates are pressured upward when Fed sells and downward when it buys. • Easily done, little announcement effect, actions can be reversed quickly, reduces interest-rate volatility Kidwell, et al., Chapter 2

10. Control of Open Market Operations • FOMC decides whether, when, and how much to buy or sell. • FOMC meets 8 times a year. • The FOMC issues policy directives to Open Market Desk at FRB of New York. Kidwell, et al., Chapter 2

11. Operations of the Open Market Desk • Estimate the level of bank reserves necessary to support primary objectives plus • Estimate the level excess reserves that banks will hold minus • Estimate the level of discount window borrowing equals • Reserve Target to be supplied by the desk Kidwell, et al., Chapter 2

12. Meeting Reserve Targets • Day-to-day adjustments: Repos and Reverses on government securities • Permanent adjustments: Purchases of bills, notes, and bonds • A Repurchase Agreement (repos for short) are contracts involving the simultaneous sale and future repurchase of an asset - often Treasury securities • One firm's repo is another firm's reverse • A repo is, in effect, a collateralized loan • Used by the Fed and other institutions: Banks and other financial institutions, State and Local Governments, Government Securities Dealers. Kidwell, et al., Chapter 2

13. Discount Rate: Interest rate at which Fed lends to depository institutions • As Fed lends “at the window”, money supply increases. • Changes in discount rate theoretically affects incentives to borrow but banks do not necessarily respond to changes in discount rate. In addition, can be a short-term impact. • Banks in early 20th century relied on the discount window; now they have other choices for managing liquidity and they are wary of “discount window scrutiny.” • Today, changing discount rate is not a viable tool for conducting monetary policy. Discount rate is more of a signal than direct control: • Increase means Fed wants smaller money supply and higher rates; • Decrease means Fed wants larger money supply and lower rates. Kidwell, et al., Chapter 2

14. Reserve Requirements: Least-Used Tool of Monetary Policy • Depository institutions must reserve set percentage of certain types of deposits. • Most reserves are held at FRB for that district. • Reserves may also be held as vault cash. • Monetary Control Act of 1980 • subjects all US depository institutions to uniform reserve requirements; • sets limits within which Fed is to specify required reserve ratio. • Reserve requirements are a structural control. • Changes in reserve requirements have dramatic effects. • Reserve requirements are not useful for “fine-tuning.” Kidwell, et al., Chapter 2

15. Reserve Requirements Kidwell, et al., Chapter 2

16. Changes in Reserve Requirements Kidwell, et al., Chapter 2

17. Changes in Reserve Requirements • Exhibit 2.8: Initial reserve requirement k=.20 • $1000 in reserves can support $5000 in demand deposits. • Change k to k=.10 • Now the bank has $500 in excess reserves. The bank can loan out that $500 until its excess reserves are absorbed as required reserves. • Thus, the bank can have $10,000 in demand deposits and the money supply is increased • [DEP = RR / k = $1000 / .10 = $10,000 ] Kidwell, et al., Chapter 2

18. How Tools of Monetary Policy Affect the Money Supply Kidwell, et al., Chapter 2