Topic 3 Central Banks (The Fed) and their role in Fixed Income Markets

1. Topic 3 Central Banks (The Fed) and their role in Fixed Income Markets

2. Objectives of Central Banks • The Federal Reserve is responsible for the country’s monetary policy. The Federal Reserve Act spells out the goals of the monetary policy as follows — to promote effectively the goals of: ■ Maximum employment (economic growth) ■ Stable prices (low to moderate inflation) ■ Moderate long-term interest rates • Is there a conflict??? • There is a potential tension between maximizing employment and stabilizing prices; for example, a rapid growth may be result in inflation.

3. Global Central Banks ■European Central Bank (for the Euro-zone) ■ Bank of Japan. ■ Peoples Bank of China ■ Bank of England ■ Reserve Bank of India ■ Reserve Bank of Australia All Central Banks tend to have the same basic objective: price stability, and very low unemployment. Some may have explicit mandate to prevent asset price bubbles.

4. Tools of Global Central Banks & Coordination • All central banks have similar tools to achieve their stated goals. Focus on the Fed/US market. • Credit channels in different countries differ, and hence the approach pursued by one central bank might differ from another to reflect such differences. • All central banks coordinate their actions in periods of crisis (such as Y2K, 2007-2008 credit crisis, etc.)

5. Tools of Central Banks The Fed relies on three major policy tools to execute its monetary policy under normal conditions. They are: • Open market operations, • Discount window, and • Reserve requirements.

6. Open Market OperationsTarget Fed Funds Rates • One of the mechanisms the Fed uses is to announce a rate known as the target Fed funds rate . • By announcing this rate and using its policies to keep the short-term interest rates close to the announced target rate, the Fed attempts to influence interest rates and hence the cost of credit in the economy.

7. Open Market Operations The open market operations can be either temporary or more permanent . In a permanent open market operation, the Fed buys and sells U.S. Treasury securities by trading with primary dealers, who are dealers with a direct phone line to the Fed, to participate in certain open market operations. When the Fed sells securities, it is draining reserves by taking out cash from the economy. Since depository institutions are required to maintain a certain amount of reserves, the draining of reserves increases the rate at which banks with deficit reserves may be able to borrow reserves from banks that have a surplus. Thus, this draining action tends to push the Fed funds rates up.

8. Fed executes open market operations the “Primaries”

9. Open Market Operations - Repo auctions This tool (repo auctions) allows the Fed to monitor and act on a daily basis as needed to respond to the demand for reserves in the economy and keep the short-term rates at the desired levels (namely, close to the target rate of interest).

10. Effective and Target Fed funds rates The effective Fed funds rate is the volume-weighted Fed funds rates at which reserves are lent and borrowed in reality. Note that the Fed, has, by and large, kept the effective Fed funds rates very close to the target Fed funds rates.

11. Tools – Discount Window The discount window of the Federal Reserve is where the central bank lends funds to depository institutions as a “ lender of last resort. ” The Federal Reserve Bank of New York reported that the Reserve banks lent $45.5 billion to depository institutions on September 12, 2001, the record for a single day. The Fed took this extraordinary action to calm the financial markets on the day following the attack on the World Trade Center.

12. Tools – Discount Window Prior to 2003, the credit from the discount window was offered at a discount to the target Fed funds rate and was rarely availed by financial institutions for fear of the loss of reputation. The very act of a bank borrowing from the discount window may mark that bank as a “ problem bank, ” leading other banks to curtail their exposure to that bank. Hence a rational bank might never want to be seen at the discount window to borrow cash. This is sometimes referred to as the stigma effect .

13. Tools – Discount Window Effective January 2003, the Fed has introduced (a) primary and (b) secondary credit programs. Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee’s target rate for federal funds. Secondary credit is available to depository institutions not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate.

14. Discount window and the rates.

15. Tools – Discount Window No Stigma effect during the crisis!

16. Tools – Reserve Requirements The Fed can change the reserve requirements, a term that refers to the percentage of deposits that a depository institution must maintain either as cash or on deposit at a Federal Reserve Bank. Reserve requirements represent a cost to the banks. In recent times, the central bank has imposed a 10% reserve requirement on transaction deposits and none on time deposits. More recently, the Fed has begun to pay interest on reserves.

17. Tools – Reserve Requirements By paying interest on excess reserves Fed is seeking to help banks build capital. Source: “Domestic Open Market Operations”, report prepared for the FOMC by the Markets group of the Federal Reserve Bank of New York, January 2009.

18. Topic3 - Conclusions/Main insights • The central bank of a country is the custodian of a country’s monetary policy. In Europe ECB, assumes this role for a collection of countries. • Central bank is also responsible for emergency liquidity provision. • The tools that central banks use include a) discount window (or standing facilities), b) repo auctions, c) reserve policies, d) interest on reserves, etc. • Central banks may also coordinate with each other when the crisis develop an international dimension – dollar shortage in non-dollar markets, etc.