Institutions Ch 4 (Done)

Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview

• Central banks determine, implement, and control the monetary policy in their home countries

• The Federal Reserve (the Fed) is the central bank of the United States

  • Founded by Congress under Federal Reserve Act of 1913

  • Independent central bank

  • Duties incorporate four major functions:

    1. Conducting monetary policy

    2. Supervising and regulating depository institutions

    3. Maintaining the stability of the financial system

    4. Providing payment and other financial services to the U.S. government, the public, financial institutions, and foreign official institutions

Central banks

_____________ determine, implement, and control the monetary policy in their home countries

Federal Reserve (the Fed)

The ______________________ is the central bank of the United States

• Founded by Congress under Federal Reserve Act of 1913

• Independent central bank

• Duties incorporate four major functions:

1. Conducting monetary policy

2. Supervising and regulating depository institutions

3. Maintaining the stability of the financial system

4. Providing payment and other financial services to the U.S. government, the public, financial institutions, and foreign official institutions

12 Federal Reserve Banks in cities throughout the U.S.

• Each acts as a depository institution for the banks in its district

• Operate under general supervision of the Board of Governors

• Each has its own 9-member board of directors

• Nationally chartered banks are required to become members of the FRS

7-member Board of Governors in Washington, D.C.

• Each member appointed by the president of the U.S. and must be confirmed by the Senate

• Members serve a nonrenewable, 14-year term

• Primary responsibilities are the formulation and conduct of monetary policy and the supervision and regulation of banks

Federal Reserve Districts

Federal Open Market Committee (FOMC)

FOMC is the major monetary policy-making body of the Federal Reserve System

• Required to meet at least four times each year in Washington, D.C., but typically meet more often

• Main responsibilities are to formulate policies to promote full employment, economic growth, price stability, an da sustainable pattern of international trade

• Set guidelines regarding open market operations, the purchase and sale of U.S. government and federal agency securities, as the main policy tool to achieve monetary targets

• Beige Book summarizes information on current economic conditions by Federal Reserve district

FOMC

________ is the major monetary policy-making body of the Federal Reserve System

promote full employment, economic growth, price stability, an the sustainable pattern of international trade

(FOMC) - Main responsibilities are to formulate policies to ____________________________________________________________.

open market operations

Set guidelines regarding ____________________, the purchase and sale of U.S. government and federal agency securities, as the main policy tool to achieve monetary targets

Functions Performed by Federal Reserve Banks (FRBs)

1. Assistance in the conduct of monetary policy

   • Set and change the discount rate

   • Loans transacted through each FRBs discount window

2. Supervision and regulation

   • Each FRB has supervisory and regulatory authority over the activities of state-chartered member banks and bank holding companies located in their districts

3. Consumer protection and community affairs

   • Possess authority to implement federal laws intended to protect consumers in credit and other financial transactions

4. Government services

   • Serves as the commercial bank for the U.S. Treasury 

Assistance in the conduct of monetary policy

• Set and change the discount rate

• Loans transacted through each FRBs discount window

Supervision and regulation

• Each FRB (Federal Reserve Banks) has supervisory and regulatory authority over the activities of state-chartered member banks and bank holding companies located in their districts

Consumer protection and community affairs

• Possess authority to implement federal laws intended to protect consumers in credit and other financial transactions

Government services

• Serves as the commercial bank for the U.S. Treasury

Functions Performed by Federal Reserve Banks (FRBs) (Continued)

5. New currency issue

   • Responsible for the collection and replacement of currency (paper and coin) from circulation 

6. Check clearing

   • Operates a central check clearing system for U.S. banks, routing interbank checks to DIs on which they are written and transferring the appropriate funds from one bank to another 

7. Wire transfer services

   • FRBs and member banks are linked electronically through the Federal Reserve Communications System

8. Research services

   • Each FRB uses professional economics to conduct research

New currency issue

• Responsible for the collection and replacement of currency (paper and coin) from circulation 

Check clearing

• Operates a central check clearing system for U.S. banks, routing interbank checks to DIs on which they are written and transferring the appropriate funds from one bank to another 

Wire transfer services

• FRBs and member banks are linked electronically through the Federal Reserve Communications System

Research services

• Each FRB uses professional economics to conduct research

Balance Sheet of the Federal Reserve

• Liabilities

  • Major liabilities on the Fed’s balance sheet are currency in circulation and reserves, the sum of which is referred to as the Fed’s monetary base or money base

  • Total reserves can be classified into two categories:

    • Required reserves are those the Fed requires banks to hold by law

    • Excess reserves are additional over and above required reserves

• Assets

  • Major assets are Treasury and government agency (i.e., Fannie Mae, Freddie Mac) securities, Treasury currency, and gold and foreign exchange

  • Interbank loans are a small portion of total assets, but they plan an important role in implementing monetary policy

Balance Sheet of the Federal Reserve (Liabilities)

• Major liabilities on the Fed’s balance sheet are currency in circulation and reserves, the sum of which is referred to as the Fed’s monetary base or money base

• Total reserves can be classified into two categories:

  • Required reserves are those the Fed requires banks to hold by law

  • Excess reserves are additional over and above required reserves

reserves | monetary base or money base

Major liabilities on the Fed’s balance sheet are currency in circulation and _________, the sum of which is referred to as the Fed’s ________________________.

Total reserves can be classified into two categories:

• Required reserves are those the Fed requires banks to hold by law

• Excess reserves are additional over and above required reserves

Required reserves

____________________ are those the Fed requires banks to hold by law

Excess reserves

_______________ are additional over and above required reserves

Balance Sheet of the Federal Reserve (Assets)

• Major assets are Treasury and government agency (i.e., Fannie Mae, Freddie Mac) securities, Treasury currency, and gold and foreign exchange

• Interbank loans are a small portion of total assets, but they plan an important role in implementing monetary policy

Federal Reserve uses the following to implement monetary policy:

• Open market operations

• Discount rate

• Reserve requirements

Major link by which monetary policy impacts the macroeconomy occurs through the Federal Reserve influencing the market for bank reserves

Federal Reserve’s monetary policy seeks to influence either the demand for, or supply of, excess reserves at depository institutions and in turn the money supply and the level of interest rates

Federal Reserve Monetary Policy Activities

Depository institutions trade excess reserves held at their local Federal Reserve Banks among themselves

• Rate of interest (or price) on these interbank transactions is a benchmark interest rate, called the fed funds rate

Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve to pay interest on reserve balances

• Interest on excess reserves (IOER) and required reserves (IORR)

Federal Reserve can take one of two basic approaches to affect the market for banks’ excess reserves

1. Target the quantity of reserves in the market 

2. Target the interest rate on those reserves (the fed funds rate) 

Open market operations

• When a targeted monetary aggregate or interest rate level is determined by the FOMC, it is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York (FRBNY) through a statement called the policy directive

• Manager of Trading Desk uses policy directive to instruct traders on daily amount of open market purchases or sales to transact

Federal Reserve Board Trading Desk | policy directive

When a targeted monetary aggregate or interest rate level is determined by the FOMC, it is forwarded to the ________________________________ at the Federal Reserve Bank of New York (FRBNY) through a statement called the ________________.

Open market operations are the primary determinant of changes in bank excess reserves in the banking system

• Directly impact the size of the money supply and/or the level of interest rates (e.g., the fed funds rate)

Treasury securities

Open market operations are primarily conducted using ______________, but others can be used as well

Federal Reserve’s Balance Sheet and Large-Scale Asset Purchases

Recall, the discount rate is the rate of interest Federal Reserve Banks charge on loans to FIs in their district

• Raising the discount rate signals a desire to see a tightening of monetary conditions and higher interest rates in general

• Lowering the discount rate signals a desire to see more expansionary monetary conditions and lower interest rates in general

Federal Reserve has rarely used the discount rate as a monetary policy tool for the following reasons:

1. It is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes 

2. Because of its “signaling” importance, a discount rate change often has great effects on the financial markets 

Various U.S. Interest Rates

Historically, discount window lending was limited to depository institutions (DIs) with severe liquidity needs

• Fed made changes to discount window lending that increased the cost of borrowing but eased the terms in January 2003

(Not tested but should learn for self) Three lending programs are now offered through the Fed’s discount window:

• Primary credit is available to generally sound DIs 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 meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution 

• Seasonal credit is available to DIs that can demonstrate a clear pattern of recurring intrayearly swings in funding needs

Reserve requirements determine the minimum amount of reserve assets that DIs must maintain by law to back transaction deposit accounts held as liabilities on their balance sheets

• Requirement is usually set as a ratio of transaction accounts

• Very rarely used by the Federal Reserve as a monetary policy tool

Reserve Requirements (Reserve Ratios) Choices in increase vs Decrease

A(n) decrease (increase) in the reserve requirement ratio means that DIs may hold fewer (must hold more) reserves against their transaction accounts, allowing them to lend out a greater (smaller) percentage of their deposits and increasing (decreasing) credit availability in the economy

• Decrease in the reserve requirement results in a multiplier increase in the supply of bank deposits and thus the money supply 

  • Multiplier effect:

• Increase in the reserve requirement results in a multiple contraction in deposits and a decrease in the money supply

  • Multiplier effect:

The Process of Monetary Policy Implementation

Expansionary Activities

• Open market purchases of securities

  • All else constant, reserve accounts of banks increase

• Discount rate decreases

  • All else constant, interest rates in the economy decrease

• Reserve requirement ratio decreases 

  • All else constant, bank reserves increase

Contractionary Activities

• Open market sales of securities

  • All else constant, reserve accounts of banks decrease

• Discount rate increases

  • All else constant, interest rates in the open market increase

• Reserve requirement ratio increases 

  • All else constant, bank reserves decrease

The Impact of Monetary Policy on Various Economic Variables

Federal Reserve can successfully target only one of these two variables (money supply or interest rates) at any one moment

• If the money supply is the target variable used to implement monetary policy, interest rates must be allowed to fluctuate relatively freely 

• If an interest rate (e.g., fed funds rate) is the target, bank reserves and the money supply must be allowed to fluctuate relatively freely

Federal Reserve Monetary Policy Targets

• Fed announced that it would use interest rates—the federal funds rate—as the main target variable to conduct monetary policy in 1993

  • Guiding principle used by the Fed to set short-term interest rates is the Taylor rule, which states short-term interest rates should be determined by three conditions:

1. Where actual inflation is relative to the Fed’s targeted level 

2. The extent to which the economy is above or below its full employment level 

3. What short-term interest rates should be to achieve full employment

monthly FOMC meeting

Under the current regime, the Fed simply announces whether the federal funds rate target has been increased, decreased, or left unchanged after every ____________________.

Central banks guide the monetary policy in virtually all countries

Independence of a central bank generally means that the bank is free from pressure from politicians who may attempt to enhance economic activity in the short term at the expense of long-term economic growth

Other independent central banks, like the Federal Reserve:

• European Central Bank (ECB) is the central bank for the EU

• Bank of England is the central bank of the UK

Banks with less independence:

• People’s Bank of China

• Reserve Bank of India

• Central Bank of Brazil

Systemwide Rescue Programs Employed during the Financial Crisis (2008)

1. Expansion of retail deposit insurance was widely used during the crisis to ensure continued access to deposit funding

2. Capital injections by central governments were the main mechanism used to directly support bank balance sheets

3. Debt guarantees allowed banks to maintain access to reasonably priced, medium-term funding. 

   • They also reduced liquidity risk and lowered overall borrowing costs for banks 

4. Asset purchases/guarantees removed distressed assets from bank balance sheets

Expansion of retail deposit insurance

_________________________ was widely used during the crisis to ensure continued access to deposit funding (Ex: FDIC insurance increased from $125k to $250k)

Capital injections

__________________ by central governments were the main mechanism used to directly support bank balance sheets (Ex: 2008 Central bank went to commercial banks and bought up their assets [ex: mortgages, securities, bonds, etc] to provide liquidity to the banks)

Debt guarantees

___________________ allowed banks to maintain access to reasonably priced, medium-term funding. 

• They also reduced liquidity risk and lowered overall borrowing costs for banks

Asset purchases/guarantees

_________________________ removed distressed assets from bank balance sheets

While the worst of the financial crisis subsided in the U.S. in the last half of 2009, throughout the spring of 2010 Greece struggled with a severe debt crisis

• Problems in the Greek bond market then spread to other European nations with fiscal problems, such as Portugal, Spain, and Italy 

• In August 2018, Greece exited the third bailout program 

• In total, Greece now owes the EU and IMF roughly $330 billion, part of a public debt that has climbed to 180 percent of GDP

Challenges to central banks became even bigger in June 2016 when the people of the United Kingdom voted to leave the EU after 43 years (i.e., Brexit)

• The pound fell more than 11 percent to its lowest point since 1985

• The DJIA dropped 610.32 points, or 3.4 percent

• The Stoxx Europe 600 index fell 7 percent, its steepest drop since 2008

• Japan’s Nikkei Stock Average declined 7.9 percent

Bank of England (BoE) unveiled a four-point plan to prevent a post-Brexit recession

• In August 2016, the BoE cut interest rates for the first time in more than seven years to a new record low of 0.25 percent