Financial Markets and Institutions: Functions of the Fed

The Federal Reserve System and Monetary Policy

Chapter Objectives

• To describe the organizational structure of the Federal Reserve (Fed).
• To describe how the Fed influences monetary policy.
• To explain how the Fed revised its lending role in response to the credit crisis.
• To explain how monetary policy is used in other countries.

Overview of the Federal Reserve's Role

• As the central bank of the United States, the Fed's primary responsibility is to conduct national monetary policy.
• Goals of Monetary Policy: To achieve full employment and price stability (low or zero inflation) in the United States.
• Impact on Interest Rates: The Fed's monetary policy significantly affects interest rates, which in turn influences:
  • Cost of borrowing by households: Directly impacts consumer spending and debt.
  • Cost of borrowing by businesses: Influences how much businesses are willing to borrow to support or expand operations, affecting investment and economic growth.

Organizational Structure of the Fed

Federal Reserve District Banks

• There are $12$ Federal Reserve district banks across the U.S. (refer to Exhibit 4.1 for locations).
• The New York Fed is considered the most important district bank.
• Membership for Commercial Banks: Commercial banks become members by purchasing stock in their respective Federal Reserve district bank.
  • This stock pays a maximum dividend of $6\%$ annually.
• Directorate: Each Fed district bank has $9$ directors.
• Functions: These banks facilitate operations within the banking system by:
  • Clearing checks.
  • Replacing old currency.
  • Providing loans to depository institutions in need of funds, through the discount window.
• Activity Review: An activity not performed by Fed district banks is acting as an intermediary to match up lenders and borrowers in the stock market.

Member Banks

• Commercial banks can choose to become member banks if they meet specific requirements set by the Board of Governors.
• All national banks are legally required to be members of the Fed.

Board of Governors

• Comprised of seven members.
• Appointment: Each member is appointed by the U.S. President.
• Term: Members serve a nonrenewable $14$-year term.
• Federal Reserve Chairman: One of the seven board members is selected by the President to serve as the Federal Reserve Chairman for a $4$-year renewable term.
• Vice Chairman for Supervision: One board member is designated as the Vice Chairman for Supervision, as mandated by the Financial Reform Act of $2010$.

Federal Open Market Committee (FOMC)

• Composition: Consists of the seven members of the Board of Governors plus the presidents of five Fed district banks.
  • The President of the New York district bank is a permanent member.
  • The other four district bank presidents serve on a rotating basis from the remaining $11$ Fed district banks.
• Term Length: Members of the FOMC do not all serve $14$-year nonrenewable terms; specifically, the Fed district bank presidents' terms on the FOMC are rotating, not the same as the Board of Governors' appointments.

Advisory Committees

• Federal Advisory Council:
  • Composed of one member from each Federal Reserve district, representing the banking industry.
  • Meets with the Board of Governors at least four times a year in Washington, D.C.
  • Provides recommendations on economic and banking issues.
• Consumer Advisory Council: Consists of $30$ members representing both financial institutions and their consumers.
• Thrift Institutions Advisory Council: Comprises $12$ members representing savings banks, S&Ls (savings & loan associations), and credit unions.

Integration of Federal Reserve Components

• Advisory committees provide counsel to the Board of Governors.
• The Board of Governors oversees the operational activities of the district banks.
• (Refer to Exhibit 4.2 for a visual representation of these relationships).

Consumer Financial Protection Bureau

• Establishment: Created as a direct result of the Financial Reform Act of $2010$.
• Responsibility: Tasked with regulating financial products and services, which include online banking, certificates of deposit (CDs), and mortgages.

How the Fed Controls the Money Supply

Open Market Operations

• Frequency: The FOMC meets eight times a year.
• Objectives: Sets targets for money supply growth and interest rate levels, and subsequently implements monetary policy.
• Process:
  • Pre-meeting Economic Report (Beige Book): A consolidated report of regional economic conditions from each of the $12$ districts is prepared.
  • Economic Presentations: Members receive data and trends on key economic indicators such as wages, consumer prices, unemployment, GDP, business inventories, foreign exchange rates, interest rates, and financial market conditions.
  • FOMC Decisions: Each member can offer recommendations regarding the federal funds rate target (refer to Exhibit 4.3 for historical trends).
  • FOMC Statement: A summary of the committee's conclusions is released to the public.
  • Minutes of FOMC Meeting: Detailed minutes are provided to the public and made accessible on Federal Reserve websites.

Role of the Fed's Trading Desk (Open Market Desk)

• Location: Situated at the New York Fed.
• Policy Implementation: If a change in monetary policy is decided by the FOMC, the decision is conveyed to the Trading Desk via a policy directive.
• Mechanisms for Influencing the Federal Funds Rate:
  • Fed purchases of securities (to lower federal funds rate): Traders buy Treasury securities from securities dealers. This increases the bank account balances of the dealers, thereby increasing the supply of funds in the banking system and pushing down the federal funds rate.
  • Fed sales of securities (to increase federal funds rate): Traders sell government securities to government securities dealers. As dealers pay for these securities, their bank balances decrease, leading to a decrease in the supply of funds in the banking system and pushing up the federal funds rate.
    • Question Answer: When open market operations are used to reduce bank funds, the yield on debt instruments increases (due to higher interest rates).
  • Fed trading of repurchase agreements (repos): The Fed purchases Treasury securities from government securities dealers with an agreement to sell them back at a specified date in the near future. This is a temporary injection of funds.

Control of Money Supply Measures ($M1$, $M2$)

• Optimal Form of Money: An optimal money supply measure should:
  1. Be controllable by the Fed.
  2. Have a predictable impact on economic variables when adjusted by the Fed.
• Definitions: (Refer to Exhibit 4.4 for a comparison).
  • $M1$: Includes currency held by the public and checking deposits (e.g., demand deposits, NOW accounts, automatic transfer balances) at depository institutions.
  • $M2$: Includes everything in $M1$ as well as savings accounts, small time deposits, Money Market Deposit Accounts (MMDAs), and some other items.
  • $M3$: Includes everything in $M2$ in addition to large time deposits and other items (less commonly used now).

Consideration of Technical Factors

• The manager of the Trading Desk incorporates expected impacts of technical factors, such as currency in circulation and Federal Reserve float, into trading instructions to maintain precise control over the money supply.

Dynamic versus Defensive Open Market Operations

• Dynamic Operations: Implemented to intentionally increase or decrease the overall level of funds in the financial system to achieve specific monetary policy goals.
• Defensive Operations: Conducted to offset the impact of other conditions or temporary factors that might affect the level of funds, thereby maintaining the desired level of reserves.

How Fed Operations Affect All Interest Rates

• Even though most interest rates are determined by market forces, the Fed exerts significant influence by controlling the supply of loanable funds through its operations.
• Open Market Operations in Response to the Economy:
  • $2001-2003$: The Fed aggressively used open market operations to reduce interest rates to stimulate the weak economy.
  • $2004-2007$: As the economy improved, the Fed's concern shifted to high inflation, leading to operations aimed at increasing interest rates.
  • $2008$ (and through $2012$): In response to the credit crisis and weakening economic conditions, the Fed again used open market operations to reduce interest rates in an attempt to stimulate the economy. Economic conditions remained weak through $2012$.

Adjusting the Reserve Requirement Ratio

• Definition: The Reserve Requirement is the proportion of a bank's deposit accounts that must be held as required reserves or funds held in reserve.
  • Historically, this ratio has typically been set between $8\%$ and $12\%$ of transaction accounts.
• Impact:
  • Reducing the Reserve Requirement: Increases the proportion of a bank's deposits that can be lent out. A lower reserve requirement leads to a greater lending capacity for depository institutions.
  • Impact on Money Growth: Leakages (e.g., households holding cash, banks holding excess reserves) can occur, causing the money multiplier effect to be less than expected (refer to Exhibit 4.5).
• Responsibility: The Board of Governors is directly responsible for setting reserve requirements.

Adjusting the Fed's Loan Rate

• Before $2003$ (Discount Rate): The Fed set its loan rate (then called the