Chapter 3: the Money Market and the Federal Reserve

Chapter 3: The Money Market and the Federal Reserve

The Fed attempts to fight the business cycle (conducts countercyclical policy) by influencing the amount of money that is circulating in the economy. The graph of the federal funds rate (below) will give us a feel for how active the Fed has been in this regard. Naturally, the Fed attempts to stimulate economic activity, as in fighting the recession of 2001 (shaded area) by ‘pumping money into the system’ via open market purchases. Conversely, beginning in June 2004, the Fed did the opposite, as they raised their target for the federal funds rate 17 times in a row by conducting open market sales.. In the space below, draw a picture of the Fed’s balance sheet and the balance sheet of the banking sector and allow the Fed to conduct open market purchases (expansionary monetary policy) as they did throughout 2001.

Note importantly that the Fed is injecting reserves into the banking system – the banks are selling some of their Government Securities (GS) to the Fed in return, the banks get (excess) reserves, reserves that can be lent out to the public. Note importantly that the intuition is as follows: The Fed buys interesting bearing assets from the banking sector that we call Government Securities and pays for them with non-interest bearing cash which to a bank, is classified as excess reserves. The banks that receive these excess reserves would like to get rid of these like a “hot potato.” That is, these reserves earn the banks zero in terms of interest, and there for, it is very costly to hold these excess reserves. To get rid of these reserves banks will eventually lower interest rates to stimulate borrowing activity.

The Fed conducts open market operations every business day – they guess where reserve demand is and supply the necessary reserves in hopes of hitting their Federal Funds Rates target! Sometimes they are wrong. When the federal funds rate is high, then the Fed underestimated reserve demand – that is, (actual) reserve demand was larger than they thought it would be. Conversely, if the federal funds rate is lower than target, they overestimated reserve demand. The Fed guesses what reserve demand will be every business day, and conducts the appropriate amount of open market operations in hopes of hitting the FF target as set by the FOMC.

In the space below using the information given, draw a reserve market diagram and depict what the Fed does every business day in hopes ‘hitting’ the federal fund rate target.

Note that this is actual data from the fall of 2007 and the federal funds rate target is 4.75%.

Oct Oct Oct Oct

8 9 10 11

4.77 4.91 4.52 4.75

Summary

The Fed tries to hit the target for the Federal Funds rate every business day by conducting open market operations – the buying and selling of Government Securities on the open market. This target is carefully chosen and is set in accordance with the Fed’s ultimate objectives of full employment, economic growth, and price stability.

The Discount Rate and Discount Rate Policy

A relatively recent and definitely a major change in the Fed’s discount rate policy:

The articles explain what the discount window is and how the policy regarding the discount window has changed. Be sure to understand exactly what the change implies for the upper (intra-day) limit of the federal funds rate.

May 17, 2002
/ ECONOMY
/ Fed Proposes a Big Change
In Its Emergency Lending
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON -- The Federal Reserve, trying to make its management of interest rates more effective, is overhauling the way it makes loans to commercial banks through its discount window.
The changes won't affect the stance of monetary policy. Under the proposed changes, the discount rate would be significantly higher than it is now but discount window credit would be granted with far less stringent conditions. This is meant to reduce the stigma and administrative burden of using the discount window, thus increasing its use.
The discount window used to be an important supplement to open-market operations: It was a way for the Fed to supply cash to banks and thus maintain its control over interest rates. But it has fallen into disuse, as banks have become better at managing their cash needs. Furthermore, because the Fed requires a bank to exhaust alternative sources of funds before granting the bank discount window credit, banks avoid the discount window for fear of suggesting to the market that they are in distress.
When the Sept. 11 terrorist attacks disrupted banks' access to the money markets, the Fed publicly announced the discount window was available in part to remove that stigma. That week, discount window loans topped $45 billion, a record. They typically fluctuate between $25 million and $300 million.
"There is an alleged stigma to the discount window and we intend to get rid of that," said Fed Governor Edward Gramlich.
By boosting use of direct loans to commercial banks, Fed officials hope they will prevent volatility in the important federal-funds rate due to temporary shortages of funds. The federal funds rate is the rate commercial banks charge on overnight loans to each other. Fed officials also hope to head off any loss of control over interest rates resulting from ongoing changes in the bank industry.
The discount rate is now 1.25%, a half-percentage point beneath the 1.75% federal-funds rate target. Under the proposal, on which the Fed is seeking comment, the discount rate would be initially set a full percentage point above the funds rate target, but that spread could then vary. The Fed would be able to cut the discount rate quickly in an emergency.
Furthermore, "primary" discount window credit would be granted to sound banks with few questions asked and without requiring a bank to first exhaust alternatives. By setting the discount rate above the funds rate, banks will be discouraged from using it as a routine funding source. Troubled banks will be eligible for more restrictive "secondary" credit at a discount rate charged half a percentage point above the primary discount rate.
But when the funds rate spikes above the Fed's intended target, banks are expected to turn to the discount window -- relieving the pressure on market rates. Such spikes were common in the early 1990s as hard-pressed banks sought ready cash but avoided the discount window. Today spikes are more often the result of temporary funding pressures, such as when banks are dressing up their balance sheets at quarter-end.
But the Fed also wants to prevent interest-rate volatility from rising because of changes in the bank industry. Banks are required to hold a portion of their deposits on reserve at the Fed, and the central bank manages interest rates by increasing or decreasing such reserves through open market operations. In recent years, required reserves have been dropping as money-market "sweep" accounts, which have no reserve requirements, spread. That trend could eventually make it harder for the Fed to target interest rates precisely. The new discount-window system could prevent that from happening.
Write to Greg Ip at 2
Updated May 17, 2002 8:53 p.m. EDT
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From Url: http://www.frbsf.org/education/activities/drecon/2004/0409.html

Ask Dr. Econ

I find definitions of the federal funds rate stating that it can be both above and below the discount rate. Which is correct? (September 2004)

Great question! The correct answer depends on the time period. Since January 2003, when the Federal Reserve System implemented a “penalty” discount rate policy, the discount rate has been about 1 percentage point, or 100 basis points, above the effective (market) federal funds rate. The fed funds rate is the interest rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans. The discount rate is the interest rate that Federal Reserve Banks charge when they make collateralized loans—usually overnight—to depository institutions.

The federal funds market
The fed funds rate and the discount rate are two of the tools the Federal Reserve uses to set U.S. monetary policy. Let’s start by describing the more important of these two short-term interest rates—the fed funds rate.

First, you should know that depository institutions are required by the Federal Reserve to keep a certain amount of their deposits as required reserves, in the form of vault cash or as electronic funds in reserve accounts with the Fed.1 Over the course of each day, as banks pay out and receive funds, they may end up with more (or fewer) funds than they need to meet their reserve requirement target. Banks with excess funds typically lend them overnight to other banks that are short on funds, rather than leaving those funds in their non-interest bearing reserve accounts at the Fed or as idle vault cash.

This interbank market is known as the federal funds market and the effective interest rate on daily transactions in this market is known as the federal funds rate. As of September 2004, U.S. commercial banks reported about $360 billion in daily average interbank loans, mostly federal funds loans—so you can see this is a very important market for banks to make short-term adjustments to their funding.

The Federal Reserve Bank of San Francisco publication, U.S. Monetary Policy: An Introduction describes how the fed funds market works:

The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.

Monetary policy and the fed funds rate
For monetary policy purposes, the Federal Reserve sets a target for the federal funds rate and maintains that target interest rate by buying and selling U.S. Treasury securities. When the Fed buys securities, bank reserves rise, and the fed funds rate tends to fall. When the Fed sells securities, bank reserves fall, and the fed funds rate tends to rise. Buying and selling securities, or open market operations, is the Fed’s primary tool for implementing monetary policy.

Borrowing from the Fed’s Discount Window
Additionally, banks may borrow funds directly from the discount window at their District Federal Reserve Bank to meet their reserve requirements. The discount rate is the interest rate that banks pay on this type of collateralized loan. On a daily average basis in September 2004, borrowing at the discount window averaged only $335 million a day, a tiny fraction of the $360 billion daily average for interbank loans during that month.

The following quote from the U.S. Monetary Policy: An Introduction, describes how the discount window works and the discount rate is set:

The Boards of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board… Since January 2003, the discount rate has been set 100 basis points above the funds rate target, though the difference between the two rates could vary in principle. Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives. At the same time, the (relatively) easy availability of reserves at this rate effectively places a ceiling on the funds rate.

Historical comparison: Which rate was higher?
Historically the federal funds rate has been both above and below the discount rate, although until 2003 the funds rate typically was above the discount rate. Until January 2003, it was possible for the effective fed funds rate to fall below the discount rate on occasion; however, normally the funds rate exceeded the discount rate. This relationship can be seen in the Chart 1, which plots both the interest rates and the difference between the two rates. The effective fed funds rate (in black) and the discount rate (in yellow before 2003 and red after 2002) compare the level of interest rates—note that since the January 2003 change in discount window policy the discount rate has exceeded the fed funds rate.

The line centered on zero in the chart is the difference between the two interest rates; it is calculated as the fed funds rate less the discount rate. Before 2003, the line showing the difference between the two interest rates (shown in orange) indicates that the funds rate typically was above the discount rate by a small margin. However, since the change to a “penalty” discount rate policy in January 2003, the funds rate (shown in pink) has been consistently below the discount rate.

Chart 1

Endnotes

1A bank’s reserve requirement is determined by a percentage the amount of deposits a bank has, so each bank’s reserve requirement is different. For current reserve requirements, please see Reserve Requirements of Depository Institutions at: http://www.federalreserve.gov/monetarypolicy/reservereq.htm.

References

Instruments of the Money Market. (1998) Federal Reserve Bank of Richmond. http://www.rich.frb.org/pubs/instruments/

Selected Interest Rates (H.15 Release). Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/releases/

U.S. Monetary Policy: An Introduction. (2004) Federal Reserve Bank of San Francisco.
http://www.frbsf.org/publications/federalreserve/monetary/index.html

In the space below, draw a reserve market diagram and depict how the relatively new discount rate policy effectively puts and upper bound on the federal funds rate.

Connecting the market for overnight reserves to the money market

Our objective is to understand both sides of the money market – money supply where the Fed plays a major role and money demand.