The Federal Reserve

By

A.V. Vedpuriswar

Feb 10, 2008

Introduction

The Federal Reserve ( The Fed) is the central bank of the US. It is widely considered to be the most influential central bank in the world. The Fed is quite independent. Unlike other central banks it is a network of 12 District Federal Reserve

Banks. There are six / seven members of the Board of Governors of the Federal

Reserve System who are nominated by the President and confirmed by the Senate.

A full term is fourteen years. One term begins every two years, on February 1 of even-numbered years. A member who serves a full term may not be reappointed.

The president of the Federal Reserve Bank of New York serves continuously, while the presidents of the other reserve banks rotate in their service of one-year terms.

Ben S. Bernanke is the current Chairman while Donald L. Kohn is the Vice Chairman

Monetary policy tools

The Federal Reserve controls the three tools of monetary policy:

Reserve requirements Open market operations The discount rate

FOMC The  Federal Open Market Committee (FOMC) is the

branch of the Federal Reserve Board that determines the direction of monetary policy.

The FOMC consists of twelve members; the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.

The FOMC meets eight times per year to set key interest rates, such as the discount rate, and to decide whether to increase or decrease the money supply.

 The meetings of the committee, which are secret, are the subject of much speculation on Wall Street.

Recent press releases illustrate how the FOMC takes decisions.

FOMC Press Release Dated January 30, 2008

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. 

Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. 

However, downside risks to growth remain.  The Committee will continue to assess the effects of financial and

other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. 

Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3-1/2 percent. 

In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco

Recent FOMC statements (Click for all statements)

Press Release

Release Date: January 30, 2008

For immediate release

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco.

2008 Monetary Policy Releases

Federal Funds rate The interest rate at which a depository institution lends immediately

available funds to another depository institution overnight. This is what news reports are referring to when they talk about the Fed

changing interest rates. In fact, the FOMC sets a target for this rate, but not the actual rate itself

(because it is determined by the open market). The short end of the yield curve moves up and down more than the long

end. Monetary policy works with a lag. So anticipation is important. In 1998, the Fed lowered the rate from 5.5 to 4.75%. Between June 1999 and May 2000, the rate went up from 4.75 to 6.5%. During 2001 and 2002, the Fed brought down the rate from 6.5% to 1%. In the past 14 weeks, the Fed has cut rates by 225 basis points from

5.25% to 3%.

Discount rate The discount rate is the rate that Federal Reserve Banks lend to

member banks on a temporary basis. This helps the banks maintain the appropriate level of reserves. The central bank adjusts the supply of currency within national

borders by adjusting the bank rate. When the central bank reduces the bank rate, it increases the

attractiveness for commercial banks to borrow, thus increasing the money supply.

When the central bank increases the bank rate, it decreases the attractiveness for commercial banks to borrow, consequently decreasing the money supply

Each Federal Reserve Bank sets the discount rate for its own region subject to approval from the Federal Reserve Board in Washington.

This type of borrowing from the Fed is fairly limited.  Institutions will often seek other means of meeting short-term

liquidity needs.

Discount windows

The Federal Reserve Banks offer three discount window programs to depository institutions:

primary credit - loans are extended for a very short term (usually overnight) to depository institutions in generally sound financial condition. This is what is generally meant by the term discount rate

secondary credit - Depository institutions that are not eligible for primary credit may apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties

seasonal credit is extended to relatively small depository institutions that have recurring intra-year fluctuations in funding needs, such as banks in agricultural or seasonal resort communities

Reserve ratio

Commercial Banks make money by lending out the money received from depositors.

The Fed requires commercial banks to hold a certain amount of these deposits as reserves:

Reserves are vault cash or deposits at the Federal Reserve

Required Reserve Ratio (rr) Required Reserves = rr x Deposits Max increase in money supply = New money /Reserve

ratio

Open market operations

The Fed adjusts money supply through buying and selling government securities.

For example, to tighten the money supply, or decrease the amount of money available in the banking system, the Fed sells government securities.

To loosen money supply, it may buy securities. A repo is a temporary measure. It involves the sale (now) and repurchase (later) of

securities instead of an outright purchase.

Board of Governors Model

For every 100 basis points cut in Fed funds rate, GDP will change by 0.6% at the end of 1 year 1.7% at the end of two years

The Beige book

Made public in 1983, the Summary of Commentary on Current Economic Conditions by Federal Reserve District, or Beige Book, rather than being filled with raw data, takes a more conversational approach.

The book has 12 regional reports from each of the member Fed district banks, and one national summary.. 

This is the first chance investors have to see how the Fed draws logical and intuitive conclusions from the raw data presented in other indicator releases.

The Beige Book is published eight times per year, just before each of the  FOMC meetings.

The Beige Book aims to give to give a broad overview of the economy, bringing many variables and indicators into the mix.

Discussion will be about things such as labor markets, wage and price pressures, retail and ecommerce activity and manufacturing output.

Investors can see comments that are forward-looking The Beige Book will contain comments that look to

predict trends and anticipate changes over the next few months or quarters.

Investors and Fed watchers look to the Beige Book to gain insight into the next FOMC meeting. 

Is there language that shows fear about inflation? Do the reports suggest that the economy needs a

financial boost to continue growing? To read the Beige Book effectively, one must become

accustomed to "Fed speak“. Occasionally, the Beige Book will give evidence that

may contradict what a previous indicator has presented; the Employment Report may suggest that there is slack in the labor market, while Beige Book reports may give anecdotal evidence that wage pressures are forming, or that certain specific labor markets are tight.

The last thing the Fed wants to do with its words is corner itself into a pre-supposed policy decision prior to the next FOMC meeting.

Investors won't ever see a definitive statement about the Fed going one way or the other with  monetary policy , but there may be valuable clues in the Beige Book .

The Fed directors and their staffs will try to obtain an economic pulse that can't be found in any other indicator's report.

They will interview business leaders, bank presidents, members of other Fed boards and hundreds of other informal networks before writing the reports that will be compiled in the Beige Book.

M1, M2, M3

M1: currency in circulation, demand, checkable deposits, non bank travellers’ checks.

M2 : M1 + savings deposits, small denomination time deposits, retail money market mutual funds.

M3 : M2 + institutional money funds, large denomination time deposits, repurchase agreements, Eurodollars.

M3 is no longer used.

Economic indicators

The Fed looks at various indicators while setting policy.

There is a complete economic calendar of events and data releases which are closely monitored by analysts and the Fed.

See next slide.

The Economic Calendar ( Click for full year’s calendar)

US Economy: Various indicators (Click for full PDF file)