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OVERVIEW OF FEDERAL RESERVE SYSTEM

1. BACKGROUND

The Federal Reserve System (FED or is the central banking system of

the United States. It was establish in 1913, with the enactment of the

Federal Reserve Act. By creating the Federal Reserve System, Congress

intended to eliminate the severe financial crisis that had periodically

swept the nation, especially the sort of financial panic that occurred in

1907. According to this Act, FED evolved over time into an independent

entity to attend to the nation’s credit and monetary needs without undue

influence from political pressure or situation. In keeping its

independence within the government, the system works without

appropriations from Congress.

The current structure of the system has three major components

established by the original act. The system consists of a Board of

Governors, twelve regional Federal Reserve Banks throughout the

nation and the member banks.

2. CHARACTERISTICS

The U.S Federal Reserve System has several features that distinguish it:

- Setting apart centralized authority into many divisions.

- Ownership and control by member banks

- Optional membership in the Fed of some banks

Federal Reserve System is a decentralized central bank. Its authority is

vested in the Board of Governors and the presidents of twelve

Regional Reserve banks (district banks).

FED is also considered to be an independent entity from government

because its decisions do not have to be ratified by the President or

anyone else in the executive branch of government. The System is,

however, subject to oversight by the U.S. Congress. It must work

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within the framework of the overall objectives of economic and

financial policy established by the government; therefore, the

description of the System as “independent within the government” is

more accurate. It is independent, moreover, because it finances its own

operation.

FED does not have right to solely approve or disapprove the monetary

policy or relevant legal issues. It must rely on the FOMC and district

banks to carry out the banking policies developed at the national level.

Especially, stocks are owned by the bank members, not the

Government. In the U.S only chartered banks, which only satisfy

required conditions, are accepted to join the Fed’s member banks.

3. FUNCTIONS

Serving Government

Federal Government’s Banker

The Fed maintains a checking account for the Treasury Department and

processes payments such as social security checks and IRS refunds.

Government Securities Auctions

The Fed serves as a financial agent for the Treasury Department and

other government agencies. The Fed sells, transfers, and redeems

government securities. Also, the Fed handles funds raised from selling

T-bills, T-notes, and Treasury bonds.

Issuing Currency

The district Federal Reserve Banks are responsible for issuing paper

currency, while the Department of the Treasury issues coins.

Serving Bank

Check Clearings

Check clearings is the process by which banks record whose account

gives up money, and whose account receives money when a customer

writes a check.

Supervising Lending Practices

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To ensure stability in the banking system, the Fed monitors bank

reserves throughout the system.

Lender of Last Resort

In case of economic emergency, commercial banks can borrow funds

from the Federal Reserve. The interest rate at which banks can borrow

money from the Fed is called the discount rate

Regulating the Banking System

The Fed generally coordinates all banking regulatory activities.

Reserves

Each financial institution that holds deposits for its customers must

report daily to the Fed about its reserves and activities.

The Fed uses these reserves to control how much money is in circulation

at any one time.

Bank Examinations

The Federal Reserve examines banks periodically to ensure that each

institution is obeying laws and regulations.

Examiners may also force banks to sell risky investments if their net

worth, or total assets minus total liabilities, falls too

Regulating the Money Supply

The Federal Reserve is best known for its role in regulating the money

supply. The Fed monitors the levels of M1 and M2 and compares these

measures of the money supply with the current demand for money.

Stabilizing the Economy

The Fed monitors the supply of and the demand for money in an effort

to keep inflation rates stable

4. THE STRUCTURE OF FEDERAL RESERVE SYSTEM

The Federal Reserve System was established by the Federal Reserve Act

in 1913 and began operating in 1914. It is an unusual mixture of public

and private elements.

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BOARD OF GOVERNORS(CHAIRMAN & VICE CHAIRMAN)

Thrift Institutions Advisory CouncilFederal Advisory CouncilConsumer Advisory CouncilAdvisory Committees

Federal Open Market Committee (FOMC)

FEDERAL RESERVE BANKS (12)

FEDERAL RESERVE BRANCHES

(25)Member Banks

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The structure of the Federal Reserve System is based on five

components: the Board of Governors of the Federal Reserve System, the

Federal Open Market Committee, the Federal Reserve Banks, member

banks, and advisory committees.

Figure 1 illustrates the organizational relationship of these components.

Figure 1: Federal Reserve Structure

4.1. BOARD OF GOVERNORS

The Board of Governors, frequently called the Federal Reserve Board,

represents the ultimate authority of the Federal Reserve System. Located

in Washington, D.C., the board consists of seven members, mostly

professional economists, appointed by the President of the United States

and confirmed by the Senate. Governors serve 14-year, staggered terms

to ensure stability and continuity over time. The chairman and vice-

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chairman are appointed to four-year terms and may be reappointed

subject to term limitations.

Responsibilities:

- Providing centralized authority.

- Establishing regulations.

- Supervising activities of the Federal Reserve Banks.

- Overseeing and approves merger applications.

- Controlling effectively the discount rate.

- Calculating Margin Requirements.

- Setting Reserve Requirements

4.2. FEDERAL OPEN MARKET COMMITTEE (FOMC)

The Federal Open Market Committee (FOMC) is the Fed's monetary

policy making body. The voting members of the FOMC are the Board of

Governors, the president of the Federal Reserve Bank of New York and

presidents of four other Reserve Banks, who serve on a rotating basis.

All Reserve Bank presidents participate in FOMC policy discussions.

The chairman of the Board of Governors chairs the FOMC. Hence,

FOMC is considered as an example of the interdependence built into the

Fed's structure. It combines the expertise of the Board of Governors and

the 12 Reserve Banks. Regional input from Reserve Bank directors and

advisory groups brings the private sector perspective to the FOMC and

provides grassroots input for monetary policy decisions. 

Responsibilities:

- Monitor District Economy.

- Convey regional economic perspectives to the Board of

Governors (Beige Book).

- Examine and Supervise banks.

- Lend to banks (Discount Window).

- Provide financial services to banks and the U.S. Treasury in the

region.

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- Recommend Discount Rate changes.

- Nine Board of Directors representing banks, business, and the

public

4.3. FEDERAL RESERVE BANKS (DISTRICT BANKS)

The Reserve Banks, also known as district banks, are nongovernmental

organizations, set up similarly to private corporations, but operated in

the public interest. The districts are headquartered in Boston, New York,

Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis,

Minneapolis, Kansas City, Dallas, and San Francisco. So far, there are

totally 25 Reserve bank branches.

Responsibilities:

- Clear checks

- Issue new currency

- Withdraw damaged currency from circulation

- Administer and make discount loans to banks in their districts

- Evaluate proposed mergers and applications for banks to expand

their activities

- Act as liaisons between the business community and the Federal

Reserve System amine bank holding companies and state-

chartered member banks

- Collect data on local business conditions

- Use their staffs of professional economists to research topics

related to the con-duct of monetary policy

4.4. MEMBER BANKS:

Member banks can be divided into three types according to which

governmental charters and whether or not they are members of FED:

(1) A state-chartered bank is a financial institution that receives its

charter from a state authority such as the Arkansas State Bank

Department. These banks are supervised jointly by their state

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chartering authority and either the Federal Deposit Insurance

Corporation (FDIC) or the Fed.

(2) A national bank is chartered issued by the Office of the

Comptroller of the Currency. This choice of state or national

charter for commercial banks is referred to as the "dual banking

system."

(3) A state nonmember banks is not chosen by FED because some of

mismatch with the standard requirements.

Responsibilities:

- As a member, each bank is required to hold stock in its respective

Reserve bank.

- Member banks also have to hold 3 percent of their capital as

stock in their Reserve Banks.

4.5. ADVISORY COUNCILS

(1) Federal Advisory Council (FAC), which is composed of twelve

representatives of the banking industry, consults with and advises the

Board on all matters within the Board's jurisdiction. The council

ordinarily meets four times a year, the minimum number of meetings

required by the Federal Reserve Act.

(2) Consumer Advisory Council also meets with the Board of Governors

at least four times each year. Composed of 30 members, the group

represents the interests of consumers and creditors. Its function is to

advise the Board of Governors on such matters related to the Fed's

authority in the areas of consumer and creditor laws.

(3) Advisory committees (one for each Reserve Bank) take a

responsibility for advising banks on matters of agriculture, small

business and labor. Every two years, the Board solicits the advice

and views of these committees by emails.

(4) Thrift Institutions Advisory Council, established in 1980 with the

Monetary Control Act, provides information related to issues and

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concerns of thrift institutions. The council is composed of

representatives from savings banks, savings and loan associations,

and credit unions. It meets at least four times every year.

ASSESSING THE FEDERAL RESERVE SYSTEM’S STRUCTURE

Independence from Political Influence

- The Fed controls its own budget, which is an important criterion for

central bank independence.

- It does occasionally come under political attack, especially when it

believes it must raise interest rates.

Decision Making by Committee

- The Fed meets this criterion for independence because the FOMC is

a committee.

- The chair may dominate policy decisions, but the fact that there are

12 voting members provides an important safeguard against arbitrary

action by a single individual.

Accountability and Transparency

- The FOMC releases huge amounts of information to the public.

- However, there is no regular press conference or real questioning of

the chair on the FOMC’s current policy stance.

- Moreover, some information is released well after the fact of the

meeting.

- Also, the Committee’s refusal to state its objectives clearly and

concisely hampers communication.

Policy Framework

- The Congress of the United States has set the Fed’s objectives, but

the statement is vague enough that the Fed can essentially set its own

goals.

- Many people have argued that the system should be replaced by one

in which the FOMC’s objectives are made clear and the Committee

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announce a specific numerical objective for consumer price inflation

over some horizon.

FEDERAL RESERVE SYSTEM (FED)

VS. EUROPEAN CENTRAL BANK (ECB)In world economy, nowadays, the Fed and the ECB are the most influential and

powerful central banks. Their decisions or issues can change the whole global

economy in different directions, maybe they lead to better or worse cases. Our

group thinks it is interesting to make a comparison of two important banks.

Although FED and ECB have not established in the same legal issue or

methodology, and history, they still have some similarities as same as some

major differences. In this part, we focus on the organizational structure, role in

the economy, and the monetary policy framework. Besides, the purpose of this

comparison is to give a brief overview of the history, structure, objectives, and

monetary policy strategies of The European Central Bank (ECB) and The

Federal Reserve System (Fed). Table 1 below is the brief description from

comparing two central banks.

FED (FEDERAL OF RESERVE

SYSTEM)

ECB (EUROPEAN SYSTEM OF

CENTRAL BANK)

ESTABLISHED YEAR 1914 1998

SUPERVISOR Board of Governors in control NCBs Governors in charge

DEC

ENTR

ALI

ZATI

ON

FED decentralizes its authority

into 12 Federal Reserve Banks,

each serving a specific region of

the country. The Board of

Governors (7 members), based in

Washington, DC, set up to

oversee the Fed System.

Governing Council, comprising 22

members: the ECB Executive

Board (6 members) and the

Governors of the 16 NCBs

(National Central Banks) of the

Euro system

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LEGAL TERM

- Governors (14 year terms)

- Chairman (4 year terms)

- Appointed by the US President

- Approved by the Congress

- All president and governing

council (8 year terms) y

- Appointed b National

governments

- Approved by the European

Parliament

INDEPENDENCE

FROM

POLITICAL

INFLUENCE

- Still report regularly to the

Congress

- Under the Federal Reserve Act

(1913)

- More independent than FED

- Lay under the Maastricht Treaty

MONETARY

POLICY

OBJECTIVES

Multiple objectives: to promote

maximum employment, price

stability, and moderate long-term

interest rates. Price stability not

defined, but widely viewed as 1-

2% comfort zone (skewed

toward upper portion) for core

PCE inflation

Price stability is the primary

objective as set in the Maastricht

Treaty. The ECB has quantified

this as medium-term inflation

goal of “below but close to 2%”.

MONETARY

POLICY

STRATEGY

Focus on economic forecasts;

rates adjusted to optimize

expected outcomes and minimize

risks of deviating from those

outcomes (factoring in costs of

those deviations).

Preference for gradualism unless

risks dictate more aggressive

action

Two pillar strategy:

- First pillar focuses on longer- on

shorter-term economic and price

developments (“economic

pillar”);

- Second pillar term inflation

outlook based on monetary

analysis

DECISION

MAKING

BODY

The decision-making authority is

hold by the FOMC. But it needs

to be ratified by the Chairman.

The main decision-making body is

Governing Council, which

formulate monetary policy.

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The 12 Reserve Banks

implement it.

The Executive Board is in charge

of implementing it.

MONETARY

POLICY TOOLS

(OPERATIONAL

POLICY)

Both use

similar tools

to implement

the monetary

policy

OPEN MARKET OPERATION

MA

IN

Repurchase Agreements

(Repos) on daily basis with

very short-term

maturity(sometime can

range from 1->90days)

Reserve transaction at weekly

auctions with maturities of two

weeksS

UB

Outright purchases or sales

of Government securities

(once a week)

Transaction with 3 months

maturities, conducted on monthly

basis

Non standard fine tuning

operations used various

instruments

STANDING FACILITIESOVERNIGHT LIQUIDITYDiscount Window Lending Marginal Lending Facility

The provision of overnight

adjustment credit at an interest

rate _ discount rate, which stay

at least 25-50 basis points below

the target for the federal funds

rate.

Overnight facility at an interest

rate _ marginal lending

rate(usually 100 basis points

above target refinancing rate)

DEPOSIT FACILITYRequired reserve balance and

excess balance have been paid

by the interest rate on required

reserve since 2008.

This rate ranges from 0 to ¼

percent.

Banks with excess reserve can

deposit them overnight at an

interest rate 100 basis points

below the target refinancing rate.

This rate has been used since

1999

RESERVE REQUIREMENT

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Reserve requirement is not used

to influence the inflation, but

used to stabilize the demand of

reserve. Based on two weeks

average balance on accounts

with unlimited checking

privileges.

- Called minimum reserve, which

based on the level of liabilities in

hand over a month.

- Remunerations, be at the average

of refinancing rate over the

period.

Table 1: Differences between FED and ECB

FEDERAL RESERVE SYSTEM: MONETARY POLICY BASICS

Monetary policy includes all the Federal Reserve actions that change the

money supply in order to influence the economy. Its purpose is to curb

inflation or to reduce economic stagnation or recession. Hence, it would

encompass various activities of the U.S. Treasury for those relating to

foreign exchange operations and the receipt and disposition of public

funds can affect the supply of money.

Thus, a more realistic definition of monetary policy is that it consists of

the directives, policies, pronouncements, and actions of the Federal

Reserve System that affect aggregate demand or national spending.

Among these, the dominant action consists of open market operations.

These involve the buying and selling of seasoned Treasury securities by

the Federal Reserve. When Treasury securities are purchased, the

Federal Reserve does so with newly created money. This money can

serve as reserves for the financial system and allows commercial banks

and other depository institutions to make new loans and investments,

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thereby expanding the money supply and aggregate demand. The

opposite happens when the Federal Reserve sells government securities

1. GOALS OF MONETARY POLICY

The goals of monetary policy are amended in the dual mandate in the

Federal Reserve Act, and other legislation indicates goals of policy:

(1) Price stability (by maximum purchasing power)

(2) Employment stability ( by maximum employment)

There are two factors to achieve the employment goal. First, low and

stable inflation rate retention maximizes the economy growth rate in

order to maximize the sustainable employment. Secondly, FED can

enhance this goal by timely adjustments in its policy stance to adapt the

economic changes.

By implementing effective monetary policy, the Fed can maintain stable

prices, thereby supporting conditions for long-term economic growth

and maximum employment. 

2. LIMITATIONS OF THE FED MONETARY POLICY

Monetary policy is not the only force that influences on national output,

unemployment, and prices. There are many forces go along with

aggregate demand and supply and the whole economy, such as:

Fiscal policy, which is undertaken by the Government, has an impact on

both demand and supply side. Although price stability is FED’s goal, it

is easy or affected by the changes of both fiscal policy and monetary

policy. Fiscal policy usually affects the economy through changes in

taxes, governmental spending and economic decisions or also political

mattes..

Many factors can be quietly unpredictable and influence the economy in

unforeseen point. On the demand side, for instance, the changes in

consumer and business confidence would lead to the changes in the

lending posture lending by the commercial bank or creditors. On the

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supply side, natural disasters, disruptions in the oil market… would

restraint the productivity growth.

Useful information is limited not only by lags in the construction and

availability of key data but also by later revisions, which can alter the

picture considerably.

The statutory goals of maximum employment and stable price

are easier to achieve if the public understands those goals and believes

that the FED will take effective measures to achieve them. Hence,

resident confidence for FED should maintain to achieve the better

results in implementing monetary policy.

3. GUIDES OF THE FED MONETARY POLICY RULE

The FED monetary policy rule has been calculated by a number of

elements and methods. In this part, discussion will focus on some

important of these:

3.1. THE TAYLOR RULE

The “Taylor rule,” named after the prominent economist John Taylor, is

another guide to assessing the proper stance of monetary policy. It

relates the setting of the federal funds rate to the primary objectives of

monetary policy—the extent to which inflation may be departing from

something approximating price stability and the extent to which output

and employment may be departing from their maximum sustainable

levels.

John Taylor noted that these characteristics of FOMC policy actions

could be summarized in a simple expression (original equation):

Where;

_ i is the nominal federal funds rate,

_ p is the inflation rate,

i p .5 p − p* .5y r*

1.5 p − p* .5y r * p*

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_ p* is the target inflation rate,

_ y is the percentage deviation of real gross domestic product

(GDP) from a target,

_ r* is an estimate of the “equilibrium” real federal funds rate.

Under this characterization:

- The funds rate is raised (lowered) when actual inflation exceeds

(falls short of),

- The long-run inflation objective and is raised (lowered) when

output exceeds (falls short of) a target level.

- In subsequent analyses this target has been interpreted as a measure

of “potential GDP.” When inflation and real GDP are on target,

then the policy setting of the real funds rate is the estimated

equilibrium value of the real rate.

To make this rule effective, however, data on the inflation rate and GDP

must be known to the FOMC. In practice, the equation can be specified

with lagged data on inflation and GDP. More generally the equation can

be written as follows:

Where;

pt–1 is the previous quarter’s PCE inflation rate measured on a year-over-

year basis,

yt –1 is the log of the previous quarter’s level of real GDP,

ytP

–1 is the log of potential real GDP as estimated by the Congressional

Budget Office.

Drawbacks of the Taylor Rule:

The level of short-term interest rates associated with achieving longer-

term goals, a key element in the formula, can vary over time in

unpredictable ways.

Moreover, the current rate of inflation and position of the economy in

relation to full employment are not known because of data lags and

it a pt −1 − p* 100bln y t −1 / y tP−1 r * p*

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difficulties in estimating the full-employment level of output, adding

another layer of uncertainty about the appropriate setting of policy.

3.2. FOREIGN EXCHANGE RATES

Exchange rate movements are an important channel through which

monetary policy affects the economy, and exchange rates tend to

respond promptly to a change in the federal funds rate. Moreover,

information on exchange rates, like information on interest rates, is

available continuously throughout the day.

Interpreting the meaning of movements in exchange rates, however, can

be difficult. A decline in the foreign exchange value of the dollar

monetary policy has become. But exchange rates respond to other

influences as well, notably developments abroad; so a weaker dollar on

foreign exchange markets could instead reflect higher interest rates

abroad, which make other currencies more attractive and have fewer

implications for the stance of U.S. monetary policy and the performance

of the U.S. economy. Conversely, a strengthening of the dollar on

foreign exchange markets could reflect a move to a more restrictive

monetary policy in the United States. But it also could reflect

expectations of a lower path for interest rates elsewhere or a heightened

perception of risk in foreign financial as-sets relative to U.S. assets.

Some have advocated taking the exchange rate guide a step further and

using monetary policy to stabilize the dollar’s value in terms of a

particular currency or in terms of a basket of currencies. However, there

is a great deal of uncertainty about which level of the exchange rate is

most consistent with the basic goals of monetary policy, and selecting

the wrong rate could lead to a protracted period of deflation and

economic slack or to an overheated economy. Also, attempting to

stabilize the ex-change rate in the face of a disturbance from abroad

would short-circuit the cushioning effect that the associated movement

in the exchange rate would have on the U.S. economy.

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3.3. POLICY ASYMMETRY

Policy bias exists because turning points in economic activity—peaks

and troughs of business cycles—are infrequent. Changes in economic

activity as measured by output and employment are highly persistent.

Given such persistence, once it becomes apparent that a cyclic peak

likely has occurred, the issue is never whether the Fed will raise the

target funds rate but whether and how much the Fed will cut the target

rate. Similarly, once it is apparent that an expansion is underway, the

solution is not whether the Fed will cut the target rate, but the extent and

timing of increases. Transitory and anomalous shocks to the data are

ordinarily rather easy to identify. Both Fed and market economists

develop estimates of these aberrations in the data shortly after they

occur. The principle of looking through aberrations is easy to state but

probably impossible to formalize with any precision.

Policymakers piece together a picture of the economy from a variety of

data, including anecdotal observations. When the various observations

fit together to provide a coherent picture, the Fed can adjust the intended

rate with some confidence. The market generally understands this

process, as it draws similar conclusions from the same data.

3.4. CRISIS MANAGEMENT

These rules are suspended when necessary to respond to a financial

crisis.

For examples of the Greenspan era are the stock market of 1987, the

combination of financial market events in late summer and early fall

1998 that culminated in the near failure of Long Term Capital

Management, crisis avoidance coming up to the century date change

at the end of 1999. In this case, the response was tailored to

circumstances unique event. Because markets had confidence in the

Federal Reserve, including confidence that extra provision of

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liquidity would be withdrawn before risking an inflation problem. In

the absence of such confidence, the Fed’s ability to respond would

be severely curtailed.

4. TRADITIONAL INSTRUMENTS (TOOLS) OF FEDERAL MONETARY

POLICY

Why does FED need tools to control or implement its policy?

Because the function of the central bank has grown and today, the Fed

primarily manages the growth of bank reserves and money supply in

order to allow a stable expansion of the economy.

To implement its primary task of controlling money supply, there are

three main tools the Fed uses to change bank reserves: 

(1) The target federal funds rate (FFR)

(2) The discount window lending (the primary credit rate)

(3) The Reserve Requirements

(1) THE TARGET FEDERAL FUNDS RATE AND THE OPEN MARKET

OPERATIONS

The target funds rate is the Federal Open Market Committee’s

primary policy instrument. On the other word, it is the interest

rate at which banks make overnight loans to each other. It is

sensitive to changes in the demand for and supply of reserves in

the banking system, thus provides a good indication of the

availability of credit in the economy. 

The Open Market Operations (OMO) plays a role of buying and

selling U.S. government securities to raise or lower the interest

rate. It means OMO change the amount money supply or money

base.

- This tool consists of Federal Reserve purchases and sales of

financial instruments, securities issued by the U.S.

Treasury, Federal agencies and government-sponsored

enterprises. Open market operations are carried out by the

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Domestic Trading Desk of the Federal Reserve Bank of

New York. The transactions are undertaken with primary

dealers.

- When the Fed wants to increase reserves, it buys securities

and pays for them by making a deposit to the account

maintained at the Fed by the primary dealer’s bank.

- When the Fed wants to reduce reserves, it sells securities

and collects from those accounts.  Trading securities, the

Fed influences the amount of bank reserves, which affects

the federal funds rate, or the overnight lending rate at

which banks borrow reserves from each other. 

(2) THE DISCOUNT WINDOW LENDING

The discount window lending is the Fed’s primary tool for

ensuring short-term financial stability, eliminating bank panics,

and preventing the sudden collapse of financial institutions in

financial difficulties.

The lending rate which the Fed charges banks for these loans is

the discount rate (officially the primary credit rate).

- Through its discount and credit operations, Reserve Banks

provide liquidity to banks to meet short-term needs stemming

from seasonal fluctuations in deposits or unexpected

withdrawals. Longer term liquidity may also be provided in

exceptional circumstances. In making these loans, the Fed

serves as a buffer against unexpected day-today fluctuations

in reserve demand and supply. This contributes to the

effective functioning of the banking system, alleviates

pressure in the reserves market and reduces the extent of

unexpected movements in the interest rates.

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- The Fed rarely uses the discount rate as a policy tool. As its

changes are strong signals of the Federal Reserves’ intentions

and no guarantee that banks will borrow.

- However, at times of market disruption, for instance, the

September 11, 2001, terrorist attacks, loans extended through

the discount window can supply a considerable volume of

Federal Reserve balances. This tool is also considered as

an important safeguard against bank runs. To sum up, it is the

lender of last resort, means making loans to banks when no

one else can or will.

(3) THE RESERVE REQUIREMENTS

Reserve requirements are the reserve assets depository institutions must

keep to “backing” transaction deposits. Reserve assets include vault cash

and deposits at Federal Reserve Banks. In short, the reserve requirement

is the percentage of deposits in demand deposit accounts that financial

institutions must set aside and hold in reserves.

The original purpose of this tool was to ensure banks were sound and to

reassure depositors that they could withdraw currency on demand. It is

lightly different from the current purpose. Today, the reserve

requirement is primarily to stabilize the demand for reserves and keep

the target federal funds rate close to the market rate.

Hence, in practice, if the Fed raises the reserve requirement, banks have

less money to lend, which restrains the growth of the money supply. On

the other hand, if the Fed lowers the reserve requirement, banks have

more money to lend and the money supply increases. The Fed rarely

changes the reserve requirement. In fact, it is the least-used monetary

policy tool because changes in the reserve requirement significantly

affect financial institution operations. Reserve requirement changes are

seen as a sign that monetary policy has swung strongly in a new

direction.

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THE CORRELATION OF MONETARY POLICY AND INFLATION

STABILIZATION

EASE (LOOSE)MONEY SUPPLY

TIGHT MONEY SUPPLY

METHOD

Buy government securities Sell government securities

Lower interest rate Higher interest rate

Lower reserve requirements rate

(RRR)

Increase reserve requirements

rate (RRR)

MACRO-

ECONOMY

More Money Supply in

circulation

(Money creation is set)

Less Money Supply in circulation

(Money back to Federal reserve)

EFFECTS

Stimulate economy Fight Inflation

More borrowing and lending Less borrowing and lending

ENCOURAGE INVESTMENT

SPENDING

DECLINE INVESTMENT

SPENDING

RESULT BOOSTING ECONOMIC

GROWTH

DELAY THE WHOLE

ECONOMY

CASE STUDY: FEDERAL RESERVE RESPONSES

TOWARD THE FINANCIAL CRISIS (2007-2009)

THE FINANCIAL CRISIS (2007): REVIEWING THE DISASTER

In near the end of 2007, the great financial crisis exploded in US, and

rapidly affected most of the global economy. In an interconnected

world, a seeming liquidity crisis can very quickly turn into a solvency

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crisis for financial institutions, a balance of payment crisis for sovereign

countries and a full-blown crisis of confidence for the entire world

Indeed, this explosion related to the Housing Market Bubbles Pop,

which has not been subject to pricing “bubbles” as the other assets

market. Most of people, investing in real estate, have not ever thought

about price declining of their house as the enormous amount of money

they have to pay to the transaction cost of purchasing, legal fees of

owning and maintaining costs for house blurred their analytical and

assessing vision. However, theoretically, the price of housing, like the

price of any good or service in a free market, is driven by supply and

demand. When demand increases and/or supply decreases, prices go up.

So, if there is a sudden or prolonged increase in demand, prices are sure

to rise.

The policy to keep away from the recession in 2001 was a wrong

decision. According to this, the federal funds rate was lowered 11 times

_ from 6.5% in 5/2001 to 1.75% in 12/2001. This action which created

the flood of liquidity in the economy made money cheaper. As result, it

was easy to become an attractive pitfall, which caused damage the

restless bankers and borrowers. This environment of easy credit and the

upward spiral of home prices made investments in higher yielding

subprime mortgages look like a new rush for gold. In 6/ 2003, interest

rates continued downing 1%, the lowest rate in 45 years. The whole

financial market resembled this rate.

But, every good item has a bad side, and several of these factors

started to emerge alongside one another. The trouble started when the

interest rates started rising and home ownership reached a saturation

point.6/ 2004, onward, the Fed raised rates so much that by 6/2006, the

Federal funds rate had reached5.25%.

Declines Begin: There were early signs of distress: by 2004, U.S.

homeownership had peaked at 70%; no one was interested in buying

houses. Then, during the last quarter of 2005, home prices started to fall,

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which led to a 40% decline in the U.S. Home Construction Index during

2006. This caused 2007 to start with bad news from multiple sources.

Every month, one subprime lender or another was filing for bankruptcy.

During February and March 2007, more than 25 subprime lenders filed

for bankruptcy, which was enough to start the tide. In April, well-known

New Century Financial also filed for bankruptcy.

Investments and the Public: Problems in the subprime market began

hitting the news, raising more people's curiosity. Horror stories started to

leak out. According to 2007 news reports, financial firms and hedge

funds owned more than $1 trillion in securities backed by these now-

failing subprime mortgages - enough to start a global financial tsunami

if more subprime borrowers started defaulting. By June, Bear Stearns

stopped redemptions in two of its hedge funds and Merrill Lynch seized

$800 million in assets from two Bear Stearns hedge funds. But even this

large move was only a small affair in comparison to what was to happen

in the months ahead.

August 2007: The Landslide Begins

The financial market could not solve the subprime crisis on its own and

the problems spread beyond the United States borders. The interbank

market froze completely, largely due to prevailing fear of the unknown

amidst banks. By that time, central banks and governments around the

world had started coming together to prevent further financial

catastrophe. It became apparent in August 2007 that the financial market

could not solve the subprime crisis on its own and the problems spread

beyond the United State's borders.

THE FEDERAL RESERVE’S RESPONSES TO THE CRISIS

In the national financial corruption, from 2007 to 2009, the Fed

announced many plans/ strategies to try to push long-term interest rates

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down. By reducing the supply of long-term interest rate Treasuries, the

Fed intends to force investors to accept lower rates of return on the ultra-

safe securities, or to move their money into a wide range of riskier

investments that could do more to promote growth. In this part, we will

pay attention to the Quantitative Easing (QE), the unconventional

monetary policy, is the Fed’s major policy to escape from the crisis.

The chart below will direct the changes in money supply from the very

beginning of the financial crisis (2007) to the points after applying the

QE policy in economy.

Figure 2: M2 vs. True money supply (2000-2010)

The figure 2 compares the year-over-year (YOY) growth rates of True

Money Supply (TMS - the blue line) and M2 (the red line). As at the end

of January the TMS yearly rate of change was down a few percent from

its high, but was still well into double digits and in the top quartile of its

10-year range. The M2 rate of change, however, was at a 10-year low.

As explained in previous commentaries, the large divergence over the

past year between these two monetary aggregates is primarily due to

declines in the nonmonetary components of M2 (the main non-monetary

components of M2 being money-market funds and time deposits). From

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the chart, the money aggregates (2000-2001) rate was low. But, after the

Fed enforced the “cheap money” rules, this rate soared rapidly. It was

the point that led to the greater crisis in 8/ than small-recession in 2001.

SUBSEQUENT BAILOUT IN 2008 (FOR FINANCIAL INSTITUTIONS)

The Treasury and the Federal Reserve began working on a $700 billion

bailout plan. Most of amounts was used to repurchase and invest to keep

some important financial institutions from bankruptcy.

- On Sept. 8, 2008, the U.S. Treasury seized control of mortgage

giants Fannie Mae and Freddie Mac and pledged a $200 billion cash

injection to help the companies cope with mortgage default losses.

- About a week later the government bailed out American

International Group Inc., or AIG, with $85 billion.

- The Fed refused to save Lehman Brothers and the company was

forced to file for bankruptcy. Some of the largest financial

institutions were on the verge of collapse as the mortgage market

melted down. As the crisis hit the global market, the credit freeze

spread.

- President George W. Bush signed the bailout plan into law October

3, 2008. 

- October 29, 2008, the Fed cut the key interest rate to 1 percent.

Expectation

The Fed’s chairman claimed the bailout was necessary to provide

stability in the economy and prevent disruption in the financial

system. The interest rate cut aimed to revive the economy, help

free up credit and make loans cheaper to consumers and

businesses.

Result:

The financial markets remained in turmoil for several months.

Credit remains tight to this day; although it loosened significantly

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compared to when lending nearly came to a halt during the

collapse period. Mortgage rates in figure 4 fell significantly after

the interest rate cut and amid expectations that the Fed would

start buying mortgage-backed securities.

Figure 4: Mortgage rates during the collapse and government bailout

REASONS FOR IMPLEMENTING UNCONVENTIONAL TOOLS

The size of the monetary policy funds rate shortfall has also caused

the Fed to expand its use of unconventional policy tools that change

the size and composition of its balance sheet.

- The Fed started to employ these balance sheet tools in late 2007

as unusual strains and dislocations in financial markets clogged

the flow of credit.

- Typically, changes in the funds rate affect other interest rates and

asset prices quite quickly.

- However, the economic stimulus from the Fed's cuts in the funds

rate was blunted by credit market dysfunction and illiquidity and

higher risk spreads. Accordingly, the Fed started to lend directly

to a broader range of counterparties and against a broader set of

collateral in order to enhance liquidity in critical financial

markets, improve the flow of credit to the economy, and restore

the full effect of the monetary policy interest rate easing.

Toward the end of 2008, the recession deepened with the prospect of a

substantial monetary policy funds rate shortfall.

- In response, the Fed expanded its balance sheet policies in order

to lower the cost and improve the availability of credit to

households and businesses.

- One key element of this expansion involves buying long-term

securities in the open market. The idea is that the funds rate and

other short-term interest rates fall to the zero lower bound; there

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may be considerable scope to lower long-term interest rates. The

FOMC has approved the purchase of longer-term Treasury

securities and the debt and mortgage-backed securities issued by

government-sponsored enterprises.

- These initiatives have helped reduce the cost of long-term

borrowing for households and businesses, especially by lowering

mortgage rates for home purchases and refinancing.

In terms of overall size, the Fed's balance sheet(B.S) has more than

doubled to just over $2 trillion.

- The increase in B.S. has likely only partially offset the funds rate

shortfall, and the FOMC has committed to further balance sheet

expansion by the end of this year.

- Looking ahead even further over the next few years, the size and

persistence of the monetary policy shortfall suggest that the Fed's

balance sheet will only slowly return to its pre-crisis level. This

gradual transition should be fairly straightforward, as most new

assets acquired by the Fed are either marketable securities or

loans with maturities of 90 days or less.

THE QUANTITATIVE EASING (QE) POLICY(UNCONVENTIONAL TOOLS)

The original definition of Quantitative easing (QE) is an

unconventional monetary policy used by central banks to stimulate the

national economy when conventional monetary policy has become

ineffective. A central bank buys financial assets to inject a pre-

determined quantity of money into the economy. This is distinguished

from the more usual policy of buying or selling government bonds to

keep market interest rates at a specified target value.

HOW THE FED APPLIED QE POLICY IN U.S.?

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2007-2008 FINANCIAL CRISIS

QE-1(Nov. 25, 2008)

END OF QE-1 (March 31, 2010)

QE-2(Nov. 3, 2010)

END OF QE-2 (June 30, 2011)

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It’s the electronic equivalent of starting up the Fed’s printing

presses to create money for buying financial assets in the market –

in this case long-term U.S. Treasury bonds. Buying bonds pushes

down their yields and the interest rates across the debt markets that

are closely tied to U.S. Treasury rates.

The chart in Figure 3 following is the timeline chart of from the money

infusion in the Fed’s monetary policy to rescue the national economy.

Figure 3: Timeline of FED implementing the money infusion

THE FIRST QUANTITATIVE EASING (QE-1) (NOV. 25, 2008 – MAR. 31, 2010)

The Fed initiated purchases of $500 billion in mortgage-backed

securities.

- It announced purchases of up to $100 billion in debt obligations of

mortgage giants Fannie Mae, Freddie Mac, Ginnie Mae and

Federal Home Loan Banks.

- The Fed cut the key interest rate to near zero, Dec. 16, 2008.

- In March 2009, the Fed expanded the mortgage buying program

and said it would purchase $750 billion more in mortgage-backed

securities.

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- The Fed also announced it would invest another $100 billion in

Fannie and Freddie debt and purchase up to $300 billion of longer-

term Treasury securities over a period of six months.

- The quantitative easing program, or QE1, concluded in the first

quarter of 2010, with a total of $1.25 trillion in purchases of

mortgage-backed securities and $175 billion of agency debt

purchases.

- After completing the purchase of $1.25 trillion in mortgage-backed

securities, $300 billion in Treasury bonds and $175 billion in

federal agency debt, the Fed ended QE1.

QE1 was initially open-ended. The Fed did not set an end date

for the program until about six months out, as it slowed the

buying pace.

Expectation:

- The Fed wanted to lower mortgage interest rates and increase the

availability of credit for homebuyers to help support the housing

market and improve financial market conditions.

- Many industry experts expected mortgage rates to rise after QE1

ended.

Result:

- Mortgage rates dropped significantly, to as low as 5 percent in

figure 4, about a year after QE1 started.

- Contrary to analysts' expectations, mortgage rates tumbled after the

program ended. See in Figure 5

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THE SECOND QUANTITATIVE EASING (QE-2) (NOV. 3, 2010 – JUN. 30, 2011)

The Fed continued to reinvest payments with the larger amount than the

first purchase on securities purchased during the QE-1 program.

- In second investment, it began the purchase of $600 billion of

longer-term Treasury securities.

- As the announcement, the Fed pushed the entire second budget into

$600 billion bond purchasing program.

QE-2 was conducted at an even pace, and the end date was

telegraphed from the start of the program.

Expectations:

- The Fed said QE-2 would help promote a stronger pace of

economic recovery.

Figure 4: Mortgage rate reacted during QE-1

Figure 5:

Mortgage rate

reacted after QE-

1 ended

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- Industrial observers expected QE-2 to keep mortgage rates low or

push the rates lower.

- Lower borrowing costs should help some homeowners refinance,

even if many others don’t qualify because of weak credit scores

or diminished home equity. It also should help businesses that

can qualify for loans through cheaper credit, though larger

corporations already can access money at cheap rates.

- The Fed figures that buying up government debt, in theory,

should push investors into riskier assets — such as stocks and

corporate bonds — and raise their value.

- It also will tend to weaken the dollar, helping U.S. exporters be

more competitive in overseas markets.

Results:

- Contrary to what was expected, mortgage rates spiked more than

half a percentage point in a little more than a month after QE-2

started. When the program ended, the 30-year fixed-rate

mortgage rate was about 30 basis points higher than it was when

QE-2 started.

- However, after the QE-2 ended, the mortgage rate was

dramatically tumbledown. See in Figure 7

Figure 6:

Mortgage

rate during

QE-2

Figure 7:

Mortgage

rate after

QE-2 ended

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THE RESULTS OF THE QUANTITATIVE EASING POLICIES

Through two rounds of pumping money into the U.S. economy, instead,

stabilizing the price and promoting employment rate should have been

paid more concern; the Fed was going too far from these two main

functions as a central bank. Pumping money into the market could not

help the every homeowners refinancing. By this way, the gap between

the poor and the rich is more severe and bigger than ever.

Although, the Fed’s starting points are based on the economic situations

and the household’s needs. But, its predictions might be no precisely

true as it should be.

UNEMPLOYMENT RATE (HIGH THAN PREDICTED)As shown in Figure 8, over the past two decades, the Fed has set the

federal funds rate, a key gauge of the stance of monetary policy, in a

fairly consistent relative to various economic indicators such as

unemployment and inflation. (Figure 8 shows the quarterly average

funds rate and unemployment rate, and the four-quarter inflation rate for

prices of core personal consumption expenditures.) During the current

and two previous recessions—around 1991, 2001, and 2008—the Fed

responded to large jumps in unemployment with aggressive cuts in the

funds rate. In addition, episodes of lower inflation also were generally

associated with a lower funds rate.

Figure 7:

Mortgage

rate after

QE-2 ended

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The unemployment rate is important as a gauge of joblessness. For this

reason, it's also a gauge of the economy's growth rate.

However, the unemployment rate is a lagging indicator. This means it

measures the effect of economic events, such as a recession, and so

occurs after one has already started. It also means the unemployment

rate will continue to rise even after the economy has started to recover.

The unemployment rate is another indicator used by the Federal Reserve

to determine the health of the economy when setting monetary policy.

Investors also use unemployment statistics to look at which sectors are

losing jobs faster. They can then determine which sector-specific mutual

funds to sell.

The year-over-year unemployment rate will tell you if unemployment is

worsening. If more people are looking for work, less people will be

buying, and the retail sector will decline. Also, if you are unemployed

yourself, it will tell you how much competition you have, and how much

leverage you might have in negotiating for a new position. As the

unemployment rate reaches 6-7%, the government gets concerned, and

tries to create jobs through stimulating the economy. It may also extend

or add benefits to help the unemployed.

After implementing the QE-1, Unemployment peaked at

10.2% in October 2009. It rose steadily from its low of 4.4% in

March 2007. It did not really become a concern until a year later

when it broke above 5% in March 2008. By then, the economy

had contracted., the unemployment rate rose rapidly, breaking

6.2% in August 2008, 7.2% by November 2008, 8.1% by

February 2009, and 9.4% three months later, finally reaching

10.2% in October, 2009.

Figure 8: Federal Funds rates, Unemployment rates, Inflations rates

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After the QE-2 enacted, although unemployment is projected

to range between 8.7-9.1% through 2011, according to the

Federal Reserve's June 2011 forecast. But, it will decline slowly,

falling to 7.5-8.7% in 2012, 6.5 - 8.3% in 2013. These forecasts

seem a little optimistic, since unemployment was still 9.1% as of

August 2011. (See in Figure 9)

Figure 9: Unemployment rate historical data from 1948 to 2012 Source: US Bureau Labor Statistics

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In its monthly survey of consumer confidence, the Conference Board asks their

respondents whether jobs are available, plentiful, or hard to get. The percentage

saying that “jobs are hard to get” (JHTG) is highly correlated with the

unemployment rate. In August, (Figure 10) it increased to 50% from 44.8% in

July. Its most recent low was 42.4% during April 2011. So the labor market has

actually been deteriorating every month for the past three months, according to

this measure. It gets worse: The latest reading is the highest since May 1983.

And that’s after the White House spent $880 billion aimed at creating 3.7

million jobs over the past two and a half years.

The main reason for this issue was an ineffective method “money

infusion” too much. It makes commodity price soar highly, reaches out

of consumers’ hands. Declining in retail sales, supply, CPI… gave an

impulse to downsize or dismiss workers. In addition, most businesses

slashed their payrolls in 2008 and 2009 and didn’t turn around and

rehire everyone they let go. Still, the high correlation between JHTG and

the jobless rate is unnerving given that the former is the highest in

almost three decades.

Commodity price (crucial part)

Figure 10: Unemployment rate vs. Jobs hard to get (1978-9/2011)Source: US Department of Labor and The Confidence Board

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The rise in commodity prices has directly increased the rate of inflation

while also adversely affecting consumer confidence and consumer

spending. It is shown clear in Figure 11, which indicated that the CPI

(consumer price index) was one of elements affecting the change in

retail sales. In figure 11, the retail sales had some good news from

economic recovery, commodity price still so high for consumer.

The basic facts are familiar. Oil prices have risen significantly, with the

spot price of West Texas Intermediate crude oil near $100 per barrel as

of the end of last week, up nearly 40 percent from a year ago.

Proportionally, prices of corn and wheat have risen even more, roughly

doubling over the past year. And prices of industrial metals have

increased notably as well, with aluminum and copper prices up about

one-third over the past 12 months. When the price of any product moves

sharply, the economist's first instinct is to look for changes in the supply

of or demand for that product. And indeed, the recent increase in

commodity prices appears largely to be the result of the same factors

that drove commodity prices higher throughout much of the past decade:

strong gains in global demand that have not been met with

commensurate increases in supply.

From 2002 to 2008, a period of sustained increases in commodity prices,

world economic activity registered its fastest pace of expansion in

decades, rising at an average rate of about 4-1/2 percent per year. This

impressive performance was led by the emerging and developing

economies, where real activity expanded at a remarkable 7 percent per

annum. The emerging market economies have likewise led the way in

the recovery from the global financial crisis: From 2008 to 2010, real

Figure 11: Real Retail Sales Source: Federal Reserve Board

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gross domestic product (GDP) rose cumulatively by about 10 percent in

the emerging market economies even as GDP was essentially

unchanged, on net, in the advanced economies.

Naturally, increased economic activity in emerging market economies

has increased global demand for raw materials. Moreover, the heavy

emphasis on industrial development in many emerging market

economies has led their growth to be particularly intensive in the use of

commodities, even as the consumption of commodities in advanced

economies has stabilized or declined. For example, world oil

consumption rose by 14 percent from 2000 to 2010; underlying this

overall trend, however, was a 40 percent increase in oil use in emerging

market economies and an outright decline of 4-1/2 percent in the

advanced economies. In particular, U.S. oil consumption was about 2-

1/2 percent lower in 2010 (Figure 12) than in 2000, with net imports of

oil down nearly 10 percent, even though U.S. real GDP rose by nearly

20 percent over that period.

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The value of the US Dollar and the price of Crude Oil are DIRECTLY

RELATED (as comparing two charts in Figure 12 and Figure 13) and anyone

that would deny that is either Liar, a Cheat, a Buffoon, an Idiot or a shill for the

Federal Reserve and Wall Street which makes a fortune when there is a lot of

Figure 12: Crude oil chart (May, 2010- May, 2011) Source: Finviz.com

Figure 13: US dollar chart (5/2010 – 5/2011)Source: Finviz.com

Figure 14: CRB Index (Commodity Price Index) (5/2010 – 5/2011)Source: Finviz.com

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volatility in the currency markets and thus they hate more than anything in the

world a stable US Dollar.

- Let’s have a close look in two charts in Figure 13 and Figure 14.

Notice in the above two charts of the US Dollar and the CRB Index

that when Bernanke, the Fed’s chairman, started talking about

cranking up the printing presses in June 2010 that the value of the

Dollar began falling and the prices of commodities started rising.

- Also, note that in Nov., 2010 that the value of the US Dollar rallied

for a few weeks and the CRB Index that tracks the prices for

commodities went down over the same timeframe.

- Next note at the beginning of 2011 that the value of the US Dollar

started to fall again the prices of commodities started to go up.

Finally, note that since early May that the value of the US Dollar has

stabilized in the 74 to 76 range that comm0odity prices have

stabilized as well and even started to come down as traders and

investors around the world .

So, as we know, he value of the US Dollar falls due to the out-of-

control “money printing” at the Fed, of course commodity

prices that are priced in Dollars would go up.  Something that

most everyone at the Federal Reserve forgot long ago, but then the

Fed and US Treasury were after something else when it comes to all

this money printing and devaluation of the US Dollar and that was

goosing the stock market in hopes that companies and the American

People would think that everything is now “fine and dandy,” the

economy is back on track and all of the unwashed masses will be

solved by the Fed.

THE FED’S BALANCE SHEET AFTER TWO QE

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The dollar might soar again. That is good as same as bad

news. It led to a flight away from counterparty risk and a flight

to quality. The US Dollar Index soared from a low of 71.99

during the summer of 2008 to a peak of 89.54 on March 4,

2009.

In figure 15, the Fed’s liabilities blew very high in the financial crisis

period (2007- 2009). And after ending the QE-2 (2011) again soar

quickly and higher than ever. Because the Fed’s monetary policy in

crisis basically injects money into market to avoid the financial

institution collapses, encourage risky investments, stimulus

manufacturing and consuming. To do these things, the first action is to

help borrowers lending money by easing credit (other name of QE). or

put money in the consumers’ hands to push them run the consuming

cycle. Purchasing Treasury securities and other long term securities are

to lower down the short-term rate and also Federal funds rate to make

money “flood” in market.

Figure 15: The Fed’s liabilitiesSource: Board of Governors of the FED

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But with the huge amount of debts, it may be a signal for new recession:

(1) Foreign official and international accounts deposited $102.8

billion at the Fed, up sharply from $57.6 billion at the start of the

year, and well above the previous high of $88.9 billion during the

week of January 7, 2009.

(2) The flight to quality is most apparent in the plunge in 10-year

government bond yields around the world to record lows. This

morning these yields are at 0.92% in Switzerland, 1.00% in Japan,

1.66% in Sweden, 1.71% in Germany, 1.89% in the US, 2.11% in

Canada, 2.19% in the UK, and 2.47% in France. On the other hand,

yields are much higher among the credit-challenged governments of

Spain (5.19%), Italy (5.44%), and Greece (18.56%).

(3) At the end of last week, the high yield spread in the US widened

to 651bps from 416bps at the beginning of the year. It is the widest

since November 30, 2009. This spread is an excellent leading

economic indicator and suggests that the outlook is deteriorating.

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