Federal Reserve Study Notes

The Federal Reserve Overview

  • The Federal Reserve Act of 1913 charges the Fed
    • Goals: to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
  • The Fed's impact on employment and prices is significant but
    • The mechanisms used are not entirely perfect and difficult to fine-tune.
    • The channels through which the Fed impacts real economic activity remain uncertain.
    • Described as a blunt instrument.
    • Currently, the only significant mechanism in play due to the paralysis of fiscal policy.

Monetary Base Control

  • The Fed controls the monetary base (sometimes referred to as M0 or BM):
    • Components: Currency in circulation + bank reserves at the Fed.
  • The Fed employs three main conventional tools to conduct monetary policy:
    1. Reserve requirements
    2. Open market operations
    3. Federal discount window
  • All three tools significantly affect the level of bank reserves within the system.

Reserve Requirements

  • The U.S. banking system operates under a fractional reserve system:
    • This system requires banks to maintain a certain percentage of deposits as cash or reserves held with the Fed.
  • Changes in reserve requirements:
    • March 2020: Reserve requirements set to 0%.
    • Prior to COVID, there was a "low reserve tranche" (currently $645.8 million) where requirements were 3%; anything above was at 10%.
  • Since 2008, the Fed has paid interest on reserves:
    • Current interest rate on reserves: 4.15%.
  • **Misconception in Deposits Creation:
    • Deposits are not created solely from deposits by savers; most deposits are created when banks issue loans.**

Reserve Creation Example

  • Example Scenario: Person X seeks to borrow $100,000 from Bank of America (BofA).
    • BofA does not provide cash direct to Person X but creates an electronic account holding the amount, thereby creating a deposit.
    • In BofA's balance sheet:
    • Loan ($100,000) is categorized as an Asset.
    • The corresponding deposit ($100,000) is categorized as a Liability.
    • BofA is required to keep a percentage of the deposit as a reserve requirement.
    • If BofA lacks sufficient existing funds to meet this reserve requirement,
    • They need to borrow the needed amount to back the newly created deposit.

Open Market Operations

  • The federal funds rate is defined as:
    • The interest rate at which banks borrow and lend reserves to each other overnight.
  • The federal funds rate is aimed to be controlled by the Fed:
    • It is the most fundamental interest rate within the economy.
    • Not directly decided by the Fed but determined by the balance of borrowing and lending reserves.
    • The Fed manipulates the rate by altering the overall amount of bank reserves through open market operations.

Operations Detail

  • The Federal Reserve Bank of New York manages a trading desk that executes:
    • Permanent Open Market Operations:
    • Involving purchasing or selling Treasury securities.
    • Selling Treasuries drains reserves, while purchasing Treasuries increases reserves.
    • Temporary Open Market Operations:
    • Conducts repos (repurchase agreements) or reverse repos.
      • Reverse Repo: Fed lends Treasuries against cash, draining reserves.
      • Repo: Fed lends cash against Treasuries or agency MBS, increasing reserves.

Interest Rate Graphs and Trends

  • Graph 1: Showing upper target rates and effective federal funds over the years.
  • Graph 2: Annual inflation relative to federal funds rates over decades.
  • Graph 3: Quantitative easing sequence - showing amounts held of Treasuries and MBS in billions over time frame from 2005 to 2025.

Discount Window

  • Banks can borrow reserves directly from the Fed via the discount window, which serves as a lender of last resort.
  • Types of credit available from the Fed:
    • Primary credit: Available to sound financial institutions at 25 basis points above the federal funds rate.
    • Secondary credit: Available to troubled institutions at 75 basis points over the federal funds rate, typically short-term.
  • There is a negative stigma associated with accessing the discount window making banks reluctant to use it.

Rules versus Discretion in Monetary Policy

  • Discussion of Monetary Policy: Focused on rules vs discretion:
    • Discretion: The Fed sets policy as deemed necessary and can adjust as needed.
    • Rules: The Fed establishes fixed rules for monetary policy that are not deviated from.
  • Kydland and Prescott (1977) make the argument:
    • Discretion is time-inconsistent.
    • For instance, institutions politically promise not to rescue failing financial institutions yet do so inevitably.
  • In Kydland and Prescott (1977)’s paradigm, rules lead to time-consistent outcomes due to credibility but may impose significant losses on economic players under certain scenarios.

Further Theoretical Perspectives

  • Friedman (1960) contended that an algorithm could replace the Fed's role due to inappropriate information and methods.
  • Taylor (1993) established the Taylor rule:
    • It indicates a trade-off between the Fed’s two mandates: employment and inflation targeting.
    • The aim is to achieve the natural interest rate ($r^*$) and the Non-Accelerating Inflation Rate of Unemployment (NAIRU).
    • Strongly aligned with the Phillips Curve, though its relevance seems compromised in recent discussions.

Taylor Rule Formula

  • Plain version of the Taylor rule:extFedFunds=extπ+r∗+extαπ(extπ−π<em>)+extαy(y−y</em>)ext{Fed Funds} = ext{π} + r^* + ext{α}π( ext{π} - π^<em>) + ext{α}y(y - y^</em>)
    • Where:
    • π = current inflation rate
    • π* = targeted inflation rate
    • r* = target real interest rate
    • y = unemployment rate
    • y* = natural rate of unemployment.
  • Specific Taylor Rule Application:
    ext{Fed Funds} = ext{PCEPI} + 2 ext{%} + 0.5 ( ext{PCEPI} - 2 ext{ %}) + 0.5( ext{UNRATE} - 4.0 ext{ %})

Quantitative Easing (QE)

  • The Financial Crisis (2008-2009) prompted the Fed to confront the zero-rate structure, moving to non-conventional monetary policy.
  • QE Definition: Buying securities on the fixed income market; primarily Treasuries and Agency MBS, with some corporate bonds acquired during the COVID crisis.
  • The Fed can nearly unconstrainedly expand its balance sheet.

QE Mechanics

  • In the QE process:
    • The Fed purchases securities from a bank and generates excess reserves in the bank's account at the Fed.
    • Misconception about Lending:
    • Banks do not lend out of excess reserves; excess reserves can be withdrawn only as currency.
    • Having excess reserves does support lending because it eliminates the need for banks to source fractional reserves for new deposits.

Implications of QE

  • QE enables direct influence over the yield curve:
    • The Fed decides which maturities to acquire, thereby impacting the slope of the yield curve (flattening or steepening it).
  • A notable downside: The federal funds rate has become nonbinding due to the large volume of excess reserves.
  • Future interest rate policies may need to be conducted through the interest on reserves and reverse repo rates.

References

  • Friedman, Milton. 1960. A Program for Monetary Stability. Ravenio Books.
  • Kydland, Finn E, and Edward C Prescott. 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans." Journal of Political Economy, vol. 85, no. 3, pp. 473–91.
  • Taylor, John B. 1993. "Discretion Versus Policy Rules in Practice." In Carnegie-Rochester Conference Series on Public Policy, 39:195–214. Elsevier.