The Fed and Monetary Policy

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• The Fed and Monetary Policy

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Federal Reserve System Third U. S. Central Bank

• A central bank is a bank for banks. Here is
  brief history.
• First Bank of the US (17911811) but after 20
  years the charter expired and was not renewed
• Second Bank of the US (18161836) but after 20
  years the charter again expired and was not
  renewed
• After a major banking crisis, Federal Reserve Act
  (1913) created the 3rd US Central Bank, the
  Federal Reserve system we have today. The
  purpose was to force banks and Fed to have enough
  reserves if there was a massive run on the bank.
  http//www.youtube.com/watch?v9V5OP-VmXgE
• Side Note 1913 was also the same year that the
  first income tax return was required. First
  return.

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Structure of the Federal Reserve System

• FIVE MAJOR COMPONENTS
• Member Commercial Banks
• 12 Fed District Banks
• 7 Members of Board of Governors
• 12 Open Market Committee (FOMC) Members
• Advisory Committees from private sector (Fed
  Advisory Council, Consumer Advisory Council,
  Thrift Inst. Advisory Council)

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1. Member Banks

• Nationally-chartered banks must be member banks
  (many used to have federal in their name, e.g.
  Commercial Federal Bank)
• State chartered banks may be member banks (many
  used have state in their name, e.g. First State
  Bank of Washington)
• Members banks purchase stock in Fed to become
  members, which pays a max dividend of 6.
• Must meet requirements (min. capital, etc. ) to
  be a member
• 35 of banks controlling 70 of all deposits are
  members

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Overview of Fed System

• Sets S/T
• interest rates

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Fed. Res. District Banks Branches
Districts created by dividing up the country in
roughly equal portions according to the
population in 1912-13
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2. Federal Reserve District Banks

• 12 districts (Fed. Res. Bank for WW is San
  Francisco, www.frbsf.org, and the branch is in
  Seattle)
• Districts divided by population in 1912
• District bank size related to economic wealth of
  district (NY Chicago are big NY considered
  most important)
• District banks owned by private member banks
• Functions clear checks, replace old currency,
  provide loans at discount window, do research.
• Megan Clubb, President of Baker Boyer Bank, is a
  board member for Fed Res Bank of San Francisco.
  http//www.bakerboyer.com/content/homepage

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3. Board of Governors (Fed. Res. Board)

• Headquarters in Wash. DC. See picture next pg.
• 7 members appointed by the U.S. president and
  confirmed by the Senate
• Each member serves a nonrenewable 14-year term
  (So how come Greenspan was on for 19 years,
  1987-2006?)
• U.S. President appoints one member to be chair
  whose 4-year term is renewable. Current chair
  Janet Yellen replaced Ben Bernanke as of 1/31/14.
• One governor is appointed by U.S. President to be
  VP for Supervision (Fin. Reform Act of 2010).
• Independence of Federal Reserve facilitated by
  staggered terms of Governors (1 term expires
  every even year) and having budget separate from
  Congress

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Central Bank Independence Around the World
Fed is supposed to be free from political and
bureaucratic pressure when it formulates policy
BUT the Fed is not immune from the desires of the
electorate.
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Federal Reserve Headquarters in Wash. DC
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The Feds Inner Sanctum
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The Fed Chair
Paul Volcker
Alan Greenspan
Ben Bernanke
CHAIRMEN (terms) Paul Volcker (1979-1987) Alan
Greenspan (1987-2006, 19 yrs!) Ben Bernanke
(2006-2014)Janet Yellen, (2/1/2014 - ??)
Janet Yellen
Chairman Power
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Board of Governors (cont.)

• Board of Governors has two main functions
• 1. Regulate commercial banks
• Supervise and regulate member banks and bank
  holding companies
• Oversight of 12 Fed district banks
• 2. Establish and effect monetary policy
• Direct control over three tools of monetary
  policy
• Set reserve requirements
• Approve discount rate set by district banks
• Sets the rate of interest paid on reserves at the
  Fed
• Indirect control of Federal Funds rate through
  open market operations
• All governors are members of the Federal Open
  Market Committee

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4. Fed Open Market Committee

• Scheduled to meet 8 times per year (or about
  every 6 weeks) Sometimes has unscheduled
  meetings in emergencies. Next meeting is?
  http//www.federalreserve.gov/monetarypolicy/fomcc
  alendars.htm
• 12 members
• 7 from the Board of Governors
• 1 President of the New York Fed
• 4 other district bank presidents on a rotating
  basis
• Other district bank presidents participate but do
  not vote on monetary policy matters

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FOMC (cont.)

• Monetary policy goals
• high employment
• price stability (Low inflation deemed most
  important goal)
• economic growth
• Forward decisions to NY Fed trading desk through
  policy directive, which sets target range for
  federal funds rate.
• The Beige Book a periodic report of economic
  conditions used by Fed in monetary policy
  decisions
• Megan Clubb, Baker Boyer Bank Presidenthelps
  create Beige Book for NW, who did abusiness
  colloquium Feb. 13, 2013
• http//coursecast.wallawalla.edu/Panopto/Pages/Vie
  wer/Default.aspx?idcad13e67-7e67-4226-8e5c-c61d3a
  15bd15

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Feds Influence on Economy

• Fed influences the money supply in order to
  achieve its goals of growth, price stability, and
  jobs.

Liquidity, Money Supply and Interest Rates
Goals of Growth Price Stability Jobs
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5. Advisory Committees

• Federal Advisory Council consists of one member
  from each Federal Reserve district who represents
  the banking industry. Meets with the Board of
  Governors in Washington, D.C., at least four
  times a year and makes recommendations about
  economic and banking issues.
• Consumer Advisory Council consists of 30 members
  who represent the financial institutions industry
  and its consumers.
• Thrift Institutions Advisory Council consists of
  12 members who represent savings banks, SLs, and
  credit unions.

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Advisory Committees (cont.)

• Consumer Financial Protection Bureau
• Established as a result of the Financial Reform
  Act of 2010.
• Responsible for regulating financial products and
  services, including online banking, certificates
  of deposit, and mortgages
• Republicans and Democrats fought over who should
  lead this Bureau

Current head Rich Cordray
Initial nomination Elizabeth Warren
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Seven Tools of Monetary Policy
3. Open Market Oper.
4. Interest on Required and Excess Reserve
Balances Held at Fed
TEMPORARY TOOLS In response to the
creditcrisis, the Fed created 8 newtools to
promote liquidity.Only 2 remain today7.
Overnight reverse purchaseagreements, and8.
Term Deposit Facility
Tools of Monetary Policy
5. Maturity Extension Program (expired fall/14)
2. Discount Rate
1. Reserve Req.
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TOOL1 Reserve Requirements

• Banks must maintain reserves as percent of
  deposits/liabilities, usually around 10 for
  larger banks
• http//www.federalreserve.gov/monetarypolicy/reser
  vereq.htm
• Purpose to have reserves if theres a run on
  the bank (Mary Poppins, Its a Wonderful Life,
  Bear Sterns, WaMu, IndyBank, etc.) This was the
  original purpose of the Fed. Reserve Act.
• Reserves are deposits at Fed plus vault cash.
• Fed sets reserve requirements, but this tool is
  used little as its too powerful (like a sledge
  hammer to swat a fly) because of the money
  multiplier effect
• The central bank of China recently lowered its
  reserve requirements to expand the nations money
  supply, since growth has tapered off recently.

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Run on Bank
Its a Wonderful Lifehttp//www.youtube.com/watch
?vlbwjS9iJ2Sw
Mary Poppins http//www.youtube.com/watch?vC6DGs3
qjRwQ
WaMu
IndymacBank, 2008http//www.youtube.com/watch?vI
VRgZ9LizZQ
1929
2008
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The Power of the Money MultiplierWith a reserve
requirement of 10, single deposit of 1 can
create 10 new dollars. Conversely, a single
withdrawal of 1 can reduce the money supply by
10
Increase in
Required reserves
Funds received from
deposits
held on
new deposits that
at banks
new deposits
can be lent out
100,000
10,000
90,000
90,000
9,000
81,000
81,000
8,100
72,900
Deposits created initial deposit / req. reserve
1 / .10 10 minus any leakage
a
a
a
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Limiting Factors to Deposit Expansion (Leakage)

• Banks may not lend all out
• Public may not re-deposit cash (grandpa stuffs
  his mattress)
• is converted to time deposits
• is transferred to a foreign bank
  account(maybe for payment of imports)
• is invested in the govt or taxes are paid

Hopefully not this kind of leakage!
The power of the money multiplier allows small
changes to influence economic activity in a large
way, both for good and for bad
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TOOL2 Discount Rate
NOTE technically, the name for the Discount Rate
changed in 2003 to the Primary Credit Loan
Lending Rate however, everyone still calls it
the Discount Rate.

• Banks might borrow from Fed at the discount
  window for 3 reasons(1) To meet short-term
  reserve deficiencies(2) Seasonal credit to
  banks, e.g. loans to banks in agricultural or
  tourist areas (farmers borrow and then pay back
  after harvest, or tourists comes only a certain
  time of year, or seasonal inventory for
  Christmas/Halloween)(3) Extended credit for
  longer-term liquidity problems at troubled banks

(NOTE it is usually cheaper for a bank to
borrow federal funds from other banks so the Fed
is meant to be used only as a last resort.
Borrowing from the Fed is usually a stigma like
spending money foolishly and then having to
borrow from dad). However, during the 2008
liquidity crisis, banks were lined up for miles
to borrow from the Fed.
You want to borrow 10? Sorry, but Im staying
out of the sub-prime loan business
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Discount Rate (cont.)

• Discount Rate Interest rate charged on loans
  made by Fed thru the discount window. Comes in 3
  forms
• (1) Primary credit, for any purpose of sound
  banks
• (2) Secondary credit, for banks not as sound
  (more risky)
• (3) Seasonal credit, for small banks needing S/T
  loans in ag or tourist areas.
• see www.frbdiscountwindow.org

Note For the first time in history, the Fed
opened the Discount Window to some non-commercial
banks in 2008. In addition, many non-bank
institutions (American Express, Morgan Stanley,
Goldman Sachs, etc.) rushed to create bank-like
holding companies so that they could borrow from
the Fed. Tim Geithner, Obamas Treasury
Secretary and then President of Fed Res Bank of
NY, said that none of these institutions would
have survived the liquidity crisis without the
Feds help. Congress is today howling for full
disclosure about exactly which institutions
borrowed from the Fed. See article.
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Discount Rate (cont.)

• Effect of changing rate
• Traditionally (before 2003)
• Lower discount rate More borrowed from Fed,
  bank reserves expand, money supply increases
• Raise discount rate less borrowed from Fed,
  bank reserves contract, money supply decrease
• Discount rate changes used serve as a signal for
  future changes in interest rates (especially
  federal funds rate)
• Today (post 2003)
• Discount rate simply changes in lock step
  (usually) with the federal funds target rate,
  thus no longer really serving as an effective
  tool of monetary policy. Usually at least 50bp
  higher than Fed. Fds. Rate. However, the Fed
  occasionally unhinges the two for short periods
  of time.

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TOOL 3 Open Market Operations

• FOMC uses Beige Book and other data to decide
  what the target federal funds rate should be
• Based on the target federal fund rate, FOMC sends
  a Policy Directives to the NY Fed Trading Desk
  (or Open Market Desk).
• The Trading Desk buys or sells Treasury
  securities in order to expand or contract the
  money supply
• Fed purchases (sells) securities, which increases
  (decreases) bank reserves (federal funds),
  thereby decreasing (increasing) the Fed. Fds.
  Rate

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Open Market Operations (cont.)

• The federal funds rate is not directly controlled
  by the FOMC but it is influenced by the FOMC
  this is why the Fed only sets a target range for
  the rate.
• Federal funds rate interest rate charged on S/T
  loans between banks, usually made in order to
  meet reserve requirements
• Federal funds rate is a benchmark rate for other
  S/T interest rates, such as on bank accounts,
  credit cards, etc.
• Fed purchase (sale) of securities results in an
  injection of additional funds into the bank
  system, lowering (raising) federal funds rate and
  other rates, because there are more (less) funds
  available for money market and bank lending

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Open Market Operations (cont.)
Open Market Operations in Response to the
Economy 20012003 The Fed frequently used open
market operations to reduce interest rates during
this period of weak economic conditions. 20042007
The Feds concern shifted from a weak economy
to high inflation as the economy improved. 2008
The Fed used open market operations to reduce
interest rates in an attempt to stimulate the
economy when economic conditions weakened due to
the credit crisis Today, with rates near zero,
the Feds open market operations are essentially
static and mute, replaced by quantitative easing
(QE) long-term bond buying.
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Money Supply

• M1 coin/currency, traveler checks, demand
  deposits (checking), NOW accounts, deposits at
  Fed
• M2 M1 plus savings, small time deposits
• M3 M2 plus large time deposits, repos
• See money stock measures (H.6) at
  http//www.federalreserve.gov/releases/h6/
• M1 is more volatile than M2 because peoples
  checking accounts go up with they get paid and
  down when they pay their bills but theres much
  less activity in savings accounts.

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TOOL 4 Interest on Required and Excess Reserve
Balances Held at Fed

• The Fed pays interest on required and excess
  reserve balances held at the Fed. The interest
  rates are determined by the Board of Governors,
  who can change the rates effect monetary policy.
  Interest rates are declared every Wednesday at
  430pm ET, when the reserve maintenance reports
  are due. Current rates are posted at
• http//www.federalreserve.gov/monetarypolicy/reqre
  sbalances.htm

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TOOL 5 Maturity Extension Program(ceased in
fall of 2014)

• The Fed sold 400 billion of shorter-term
  Treasury securities and used the proceeds to buy
  longer-term Treasury securities. This extended
  the average maturity of the securities in the
  Feds portfolio. By reducing the supply of
  longer-term Treasury securities in the market,
  this action put downward pressure on longer-term
  interest rates. The reduction in longer-term
  interest rates, in turn, contributed to a broad
  easing in financial market conditions that
  provided additional stimulus to support the
  economic recovery, especially the housing sector
  (at least in theory).

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TOOL 6-8 Credit Crisis Tools (temporary tools)

1. Traditionally, the Fed only lends to depository
   institutions (commercial banks). But during the
   2009 credit crisis, the Fed lent funds to many
   non-bank institutions. Earlier in 2008, the Fed
   had also lent funds to Bear Stearns, a
   non-depository institution. EXPIRED
2. Facilities created by the Fed to provide
   liquidity include
3. Primary Dealer Credit Facility overnight loans
   to bond dealers EXPIRED
4. Term Auction Facility banks can borrow for a
   fixed term EXPIRED
5. Term Securities Lending Facility dealers can
   swap mortgage-backed and other securities for
   loans (provided liquidity and lowered mortgages
   rates) EXPIRED
6. Commercial Paper Facilities (two different ones)
   created to restore liquidity in CP markets
   EXPIRED
7. Money Market Investor Facility provide
   liquidity to MM EXPIRED
8. Term Asset-Backed Securities Loan Facility
   provide liquidity for consumer and small business
   loans (credit cards, student loans, car loans,
   etc.) EXPIRED
9. Overnight Reverse Purchase Agreements helps
   control money supply affecting the federal funds
   rate. STILL HERE
10. Term Deposit Facility offers term deposits to
    banks thereby draining money supply and helping
    control the fed funds rate STILL HERE

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Using the Tools to Increases the Money Supply and
Decrease Interest Rates

• Increasing the money supply and lowering interest
  rates
• Open market purchase of Treasury securities via
  the Trading Desk in the secondary market
  increases money supply and lowers Federal Funds
  rate (this tool is used most frequently).
• Discount rate (usually in lock step with Federal
  Funds rate) will also be lowered, which might
  encourage borrowing at the discount window,
  increasing the money supply. Occasionally the
  Fed will change the Discount rate independently
  from the Fed Funds rate.
• Reserve requirements can be lowered, causing more
  money to be loaned out
• The interest rate paid on reserves held at the
  Fed can be lowered

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Using the Tools to Decrease the Money Supply and
Increase Interest Rates

• Decreasing the money supply to raise interest
  rates
• Open market sale of Treasury securities via the
  Trading Desk in the secondary market decreases
  money supply and raises federal funds rate (this
  tool is used most frequently).
• Discount rate (usually in lock step with Federal
  Funds rate) will also be raised which might
  discourage borrowing at the discount window,
  decreasing the money supply. Occasionally the Fed
  will change the Discount rate independently from
  the Fed Funds rate.
• Reserve requirements can be raised, causing less
  money to be loaned out
• The interest rate on reserves held at the Fed can
  be raised

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Playing the Fed Chair Game
Go to http//www.frbsf.org/education/activities/ch
airman/
Keep playing until you are reappointed!
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Global Monetary Policy

• Each country has its own central bank and most
  industrialized countries have banks with similar
  goals
• Since 1999, European Central Bank (in Frankfurt)
  works similar to the US Fed. Euro used in 23
  countries (Andorra, Austria, Belgium, Cyprus,
  Estonia, Finland, France, Germany, Greece,
  Ireland, Italy, Kosovo, Luxembourg, Malta,
  Monaco, Montenegro, Netherlands, Portugal, San
  Marino, Slovakia, Slovenia, Spain and Vatican
  City)
• Fed must consider conditions in other countries
  when looking at the U.S. economy
• Central banks try to work together but
  conflicting goals can make cooperation difficult
  at times

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Fed Power Bail-Outs

• The Fed gave loans to Bear Stearns, AIG and
  others in an attempt to prevent a meltdown. Do
  you think large financial institutions such as
  these should be rescued by the Fed?
• Many in Congress have argued (such as Ron Paul)
  that the Fed has too much power and that Congress
  should be involved in decision regarding the use
  of taxpayer funds to rescue institutions. Do you
  agree?

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Quantitative Easing QE 1, 2 and 3

• Quantitative Easing 1 refers to Fed purchasing
  1.45T mortgage-backed securities and 300B in
  L/T Treasuries from Mar/09 to mar/10, with the
  goal of holding down L/T rates to spur the
  mortgage market. This is similar to monetizing
  the debt. Many are critical of QE because it is
  like printing money and could eventually
  increase inflation and weaken the US dollar.
• Quantitative Easing 2 refers to the Feds bond
  buying from Nov/10 to June/11 (660 of L/T
  Treasuries).
• Quantitative Easing 3 refers to the Feds bond
  buying from Sept/12 to Oct/14 (originally 40B/mo
  of mortgage-backed securities, and 45B of L/T
  Treasuries revised to 35B and 40B in Jan/14 )
• See http//www.youtube.com/watch?vPTUY16CkS-k
• very controversial as it is essentially
  equivalent to the fed printing money which has
  caused the Feds balance sheet to burgeon

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Feds Balance Sheet has quadrupled since the 2008