The Federal Reserve

1
The Federal Reserve

• By
• A.V. Vedpuriswar

Feb 10, 2008
2
Introduction

• The Federal Reserve ( The Fed) is the central
  bank of the US.
• It is widely considered to be the most
  influential central bank in the world.
• The Fed is quite independent.
• Unlike other central banks it is a network of 12
  District Federal Reserve Banks.
• There are six / seven members of the Board of
  Governors of the Federal Reserve System who are
  nominated by the President and confirmed by the
  Senate.
• A full term is fourteen years. One term begins
  every two years, on February 1 of even-numbered
  years. A member who serves a full term may not be
  reappointed.
• The president of the Federal Reserve Bank of New
  York serves continuously, while the presidents of
  the other reserve banks rotate in their service
  of one-year terms.
• Ben S. Bernanke is the current Chairman while
  Donald L. Kohn is the Vice Chairman

3
Monetary policy tools

• The Federal Reserve controls the three tools of
  monetary policy
• Reserve requirements
• Open market operations
• The discount rate

4
FOMC

• The  Federal Open Market Committee (FOMC) is the
  branch of the Federal Reserve Board that
  determines the direction of monetary policy.
• The FOMC consists of twelve members the seven
  members of the Board of Governors of the Federal
  Reserve System the president of the Federal
  Reserve Bank of New York and four of the
  remaining eleven Reserve Bank presidents, who
  serve one-year terms on a rotating basis.
• The FOMC meets eight times per year to set key
  interest rates, such as the discount rate, and to
  decide whether to increase or decrease the money
  supply.
•  The meetings of the committee, which are secret,
  are the subject of much speculation on Wall
  Street.
• Recent press releases illustrate how the FOMC
  takes decisions.

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FOMC Press Release Dated January 30, 2008

• The Federal Open Market Committee decided today
  to lower its target for the federal funds rate 50
  basis points to 3 percent.
• Financial markets remain under considerable
  stress, and credit has tightened further for some
  businesses and households. 
• Moreover, recent information indicates a
  deepening of the housing contraction as well as
  some softening in labor markets.
• The Committee expects inflation to moderate in
  coming quarters, but it will be necessary to
  continue to monitor inflation developments
  carefully.
• Todays policy action, combined with those taken
  earlier, should help to promote moderate growth
  over time and to mitigate the risks to economic
  activity. 
• However, downside risks to growth remain. 
• The Committee will continue to assess the effects
  of financial and other developments on economic
  prospects and will act in a timely manner as
  needed to address those risks.

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• Voting for the FOMC monetary policy action were
  Ben S. Bernanke, Chairman Timothy F. Geithner,
  Vice Chairman Donald L. Kohn Randall S.
  Kroszner Frederic S. Mishkin Sandra Pianalto
  Charles I. Plosser Gary H. Stern and Kevin M.
  Warsh. 
• Voting against was Richard W. Fisher, who
  preferred no change in the target for the federal
  funds rate at this meeting.
• In a related action, the Board of Governors
  unanimously approved a 50-basis-point decrease in
  the discount rate to 3-1/2 percent. 
• In taking this action, the Board approved the
  requests submitted by the Boards of Directors of
  the Federal Reserve Banks of Boston, New York,
  Philadelphia, Cleveland, Atlanta, Chicago, St.
  Louis, Kansas City, and San Francisco

7
Recent FOMC statements (Click for all statements)
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Federal Funds rate

• The interest rate at which a depository
  institution lends immediately available funds to
  another depository institution overnight.
• This is what news reports are referring to when
  they talk about the Fed changing interest rates.
• In fact, the FOMC sets a target for this rate,
  but not the actual rate itself (because it is
  determined by the open market).
• The short end of the yield curve moves up and
  down more than the long end.
• Monetary policy works with a lag.
• So anticipation is important.
• In 1998, the Fed lowered the rate from 5.5 to
  4.75.
• Between June 1999 and May 2000, the rate went up
  from 4.75 to 6.5.
• During 2001 and 2002, the Fed brought down the
  rate from 6.5 to 1.
• In the past 14 weeks, the Fed has cut rates by
  225 basis points from 5.25 to 3.

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Discount rate

• The discount rate is the rate that Federal
  Reserve Banks lend to member banks on a temporary
  basis.
• This helps the banks maintain the appropriate
  level of reserves.
• The central bank adjusts the supply of currency
  within national borders by adjusting the bank
  rate.
• When the central bank reduces the bank rate, it
  increases the attractiveness for commercial banks
  to borrow, thus increasing the money supply.
• When the central bank increases the bank rate, it
  decreases the attractiveness for commercial banks
  to borrow, consequently decreasing the money
  supply
• Each Federal Reserve Bank sets the discount rate
  for its own region subject to approval from the
  Federal Reserve Board in Washington.
• This type of borrowing from the Fed is
  fairly limited. 
• Institutions will often seek other means of
  meeting short-term liquidity needs.

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Discount windows

• The Federal Reserve Banks offer three discount
  window programs to depository institutions
• primary credit - loans are extended for a very
  short term (usually overnight) to depository
  institutions in generally sound financial
  condition. This is what is generally meant by the
  term discount rate
• secondary credit - Depository institutions that
  are not eligible for primary credit may apply for
  secondary credit to meet short-term liquidity
  needs or to resolve severe financial difficulties
• seasonal credit is extended to relatively small
  depository institutions that have recurring
  intra-year fluctuations in funding needs, such as
  banks in agricultural or seasonal resort
  communities

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Reserve ratio

• Commercial Banks make money by lending out the
  money received from depositors.
• The Fed requires commercial banks to hold a
  certain amount of these deposits as reserves
• Reserves are vault cash or deposits at the
  Federal Reserve
• Required Reserve Ratio (rr)
• Required Reserves rr x Deposits
• Max increase in money supply New money /Reserve
  ratio

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Open market operations

• The Fed adjusts money supply through buying and
  selling government securities.
• For example, to tighten the money supply, or
  decrease the amount of money available in the
  banking system, the Fed sells government
  securities.
• To loosen money supply, it may buy securities.
• A repo is a temporary measure.
• It involves the sale (now) and repurchase (later)
  of securities instead of an outright purchase.

13
Board of Governors Model

• For every 100 basis points cut in Fed funds rate,
  GDP will change by
• 0.6 at the end of 1 year
• 1.7 at the end of two years

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The Beige book

• Made public in 1983, the Summary of Commentary on
  Current Economic Conditions by Federal Reserve
  District, or Beige Book, rather than being filled
  with raw data, takes a more conversational
  approach.
• The book has 12 regional reports from each of the
  member Fed district banks, and one national
  summary.. 
• This is the first chance investors have to see
  how the Fed draws logical and intuitive
  conclusions from the raw data presented in other
  indicator releases.
• The Beige Book is published eight times per year,
  just before each of the  FOMC meetings.

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• The Beige Book aims to give to give a broad
  overview of the economy, bringing many variables
  and indicators into the mix.
• Discussion will be about things such as labor
  markets, wage and price pressures, retail and
  ecommerce activity and manufacturing output.
• Investors can see comments that are
  forward-looking
• The Beige Book will contain comments that look to
  predict trends and anticipate changes over the
  next few months or quarters.
• Investors and Fed watchers look to the Beige Book
  to gain insight into the next FOMC meeting. 

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• Is there language that shows fear about
  inflation?
• Do the reports suggest that the economy needs a
  financial boost to continue growing?
• To read the Beige Book effectively, one must
  become accustomed to "Fed speak.
• Occasionally, the Beige Book will give evidence
  that may contradict what a previous indicator has
  presented the Employment Report may suggest that
  there is slack in the labor market, while Beige
  Book reports may give anecdotal evidence that
  wage pressures are forming, or that certain
  specific labor markets are tight.

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• The last thing the Fed wants to do with its words
  is corner itself into a pre-supposed policy
  decision prior to the next FOMC meeting.
• Investors won't ever see a definitive statement
  about the Fed going one way or the other with 
  monetary policy , but there may be valuable clues
  in the Beige Book .
• The Fed directors and their staffs will try to
  obtain an economic pulse that can't be found in
  any other indicator's report.
• They will interview business leaders, bank
  presidents, members of other Fed boards and
  hundreds of other informal networks before
  writing the reports that will be compiled in the
  Beige Book.

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M1, M2, M3

• M1 currency in circulation, demand, checkable
  deposits, non bank travellers checks.
• M2 M1 savings deposits, small denomination
  time deposits, retail money market mutual funds.
• M3 M2 institutional money funds, large
  denomination time deposits, repurchase
  agreements, Eurodollars.
• M3 is no longer used.

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Economic indicators

• The Fed looks at various indicators while setting
  policy.
• There is a complete economic calendar of events
  and data releases which are closely monitored by
  analysts and the Fed.
• See next slide.

20
The Economic Calendar ( Click for full years
calendar)
21
US Economy Various indicators (Click for full
PDF file)