Federal Reserve Open Market Operations The Federal Reserve's operating strategy for implementing monetary policy involves interest rate targeting through open market operations. The Federal Reserve does not utilize reserve requirements or the discount rate as part of this strategy. Open market operations involves the buying and selling of securities in the open market, in order to influence reserve balances. By manipulating reserve balances, the Federal Reserve can control the price of reserves in the market. The price of reserves is known as the Federal Funds rate. The Federal Funds rate is the interest rate banks charge each other for lending and/or borrowing reserve balances. This paper will discuss how the Federal Reserve implements a strategy of interest rate targeting through open market operations.
Part I Introduction
The Federal Reserve Bank is the central bank of the United States. In 1913, Congress created the Federal Reserve System to provide stability to the financial and monetary system. The Federal Reserve Bank (from here on, referred to as the "FED") has four main functions. They conduct monetary policy by influencing money supply in the economy, in order to maintain full employment, price stability, and promote economic growth. They regulate and supervise banking institutions to ensure the safety and soundness of the U.S. financial and banking system. The FED also provides financial and banking services to the U.S. Government, the public, and to financial institutions. And lastly, the FED maintains stability in the financial system by reducing systemic risks that may arise in the markets.
The Federal Reserve System is made up of the Board of Governors and twelve regional Federal Reserve banks. The Board of Governors consists of seven members who are appointed by the President of The United States, and must be confirmed by the Senate. All seven governors are members of the Federal Open Market Committee (FOMC), and each vote on the conduct of open market operations. The network of twelve regional banks performs various functions, including; operating a nationwide payments system, distribution of currency and coin, supervising and regulating member banks, and serving as banker for the United States Treasury.
The Federal Open Market Committee (FOMC) is a major part of the Federal Reserve System. It is made up of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve Banks. The FOMC is responsible for making decisions about the conduct of open market operations in order to influence the monetary base.
Part II Monetary Policy
The Federal Reserve Act, signed into law by President Woodrow Wilson in 1913, spelled out the goals of monetary policy. It said that, when conducting monetary policy, the Federal Reserve System and the Federal Open Market Committee should strive "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."
The most important of these goals, of today's monetary policy, is price stability. When prices of goods and services rise (inflation), economic growth is slowed down. There is similar reaction to employment levels, as unemployment rates will increase. This also creates uncertainty in the economy, making it difficult for consumers, government, and businesses to make decisions about the future.
The Federal Reserve conducts Monetary Policy by affecting the money supply and interest rates. They have three tools they can use. The first tool is open market operations. Open market operations, is the most prevalent tool used in monetary policy today. Open market operations involves the buying and selling of U.S. government securities by the FED. When the FED buys or sells a security, it changes the amount of reserves. Open market operations will be discussed in further detail, later in this paper.
The second tool available to the FED is the Discount rate. The discount rate is the rate the FED charges depository institutions when they borrow reserves. By this, the FED can affect the quantity of loans or the price of loans (discount rate). In either case, when a bank takes out a discount loan from the FED, that bank's reserves will increase, thus increasing reserves in the Federal Reserve System. This tool also allows the FED to prevent financial panic as they are the lender of last resort.
The third tool is Reserve Requirements. This a requirement regarding the amount, or percentage, of funds banks, and other depository institutions, must hold in reserve against their deposits. "Currently, the reserve requirement equals 3 percent of the first $49.3 million of a bank's 'transaction deposits' (demand deposits and other checkable accounts) plus 1 percent of amounts beyond that." [Bennett & Hilton 1997] Reserve requirements are important in that they help ensure a stable and predictable demand for reserves. This increases the FED's control over short-term interest rates, namely the fed funds rate. As we will see, this requirement also helps in the conduct of open market operations.
Of the three tools described above, the tool used most often is open market operations. This is due to certain advantages open market operations over the other tools of monetary policy. First, open market operations is conducted at the initiative of the FED, which allows them to have complete control over the volume of activity. The second advantage is that open market operations can be specific and flexible, therefore can be used to any extent necessary. Another advantage is that open market operations are reversible in the event a mistake is made. Open market operations can also be implemented immediately, without delay. Since open market operations is so important in the Federal Reserve Bank's conduct of monetary policy, we will focus on open market operations further in this discussion.
Part III Strategies for Implementing Monetary Policy Through Open Market Operations
The FED's operating strategy for implementing monetary policy involves interest rate targeting through open market operations. This means that the FED targets the price of reserves, or the fed funds rate.
The challenge that the FED faces, is they wish to accomplish certain goals, such as price stability, full employment, and moderate long-term interest rates (economic growth), but they cannot directly influence those goals. Since monetary policy cannot directly affect the goals they strive for, they must develop a set of targets that affect the long-term goals.
After the FED decides it's long-term goals, they choose a set of intermediate targets to aim for. From year to year, the FED gauges the growth of the money supply using money aggregates, or various measures of the money supply, labeled as M1, M2, & M3.
Monetary policy tools, however, do not directly affect the money supply. They, therefore, choose another set of targets, which are more responsive to monetary policy tools. The Federal funds rate is monitored on a short-term basis. By targeting the price of reserves (Federal funds rate), the FED manipulates the supply of reserves.
This strategy has a domino effect. Each target must be accomplished in order to achieve the final goals of monetary policy. By controlling the Federal funds rate, and keeping it in line with the monetary policy directive, the FED has control over the supply of reserves. This allows them to set targets for the growth of the money supply. By influencing the money supply, they can achieve the long-term goals of monetary policy. If the FED feels they are off track of any target, they can conduct open market operations to make corrections.
Part IV Methods of Implementation of Monetary Policy
The FED conducts monetary policy through open market operations. The Federal Reserve Bank of New York is charged with the task of performing all open market operations activities.
What is open market operations? Simply put, it is the buying and selling of securities in the market, in order to influence reserves and the fed funds rate. In order for open market operations to work effectively, the assets traded must be able to be bought and sold quickly, and in any volume the FED deems necessary. These conditions require a highly active market. Therefore, U.S. government securities, which have the broadest and most active U.S. financial market, are the preferred asset. The FED currently conducts these trades with twenty-four primary dealers that actively trade in the U.S. government securities market (see Figure 1). If the FED analysts estimate that reserve supplies differ significantly from reserves demanded, the trading desk will add or remove reserves through open market operations to balance reserves supply with reserves demand. The open market operations trading desk seeks to manage reserve levels in a way that will steer the Federal funds rate to trade around the level agreed to by the FOMC. The trading desk staff adjusts supply of reserves to achieve a price, Federal funds rate.
When the FED seeks to undertake a particular operation, staff members of the Federal Reserve Bank of New York's trading desk send a message to all the primary dealers using the TRAPS system. TRAPS (Trading Room Automated Processing System), is linked to each of the primary dealers, and is the primary trading system the FED uses for open market operations. The message contains the type and maturity of the operation being performed. The dealers have several minutes to input their bids. Once the trading desk receives all the bids, they are arranged in order of the most attractively priced. Trades are then accepted up to the point where the desired amount to buy or sell is reached. Once each chosen bid has been accepted, the trading desk will notify each dealer, and notify them if their bid has been accepted or not.
If the FED analysts estimate that reserve shortages or excesses are expected to remain for a long period of time, the trading desk will make outright purchases or sales of securities. This has a long-term effect on reserve balances.
In contrast, if the FED analysts estimate the shortage or excess will be short-term in nature, they use temporary operations. These temporary transactions can be of two types. In a repurchase agreement (repo), the FED purchases securities with an agreement that the seller will repurchase them in the near future, anywhere from 1 to 15 days. This has the effect of adding to reserves temporarily. In a match sale-purchase transaction (reverse repo), the FED sells securities and the buyer agrees to sell them back at some future point in time. The effect of this transaction drains reserves temporarily.
When the FED buys securities from the market, reserves are increased, causing the price of reserves (Federal funds rate) to fall. Conversely, when the FED sells securities to the market, reserves are depleted, causing the Federal funds rate to increase.
Now that we understand how changes in reserve balances affect the price of reserves, or the Federal funds rate, we can discuss how the FED controls reserve balances to maintain the required Federal funds rate within a specified range. Since reserves are actively traded between banks, the FED must monitor the rates being used for those trades. When the FED sets the target Federal funds rate, they allow for a minimum and maximum level, or ceiling and floor rates. Let us assume the Federal funds target rate is 3.5%. As bank trading of reserves reaches 3.65%, the ceiling requirement, the FED will seek to temporarily increase reserves, buy securities from the market, in order to drive down the Federal funds rate back to the targeted level. Similarly, if reserves trading reaches 3.35%, the floor requirement, the FED will sell securities to the market in order to bring the Federal funds rate back up to the desired level (See Figure 2).
Part V Other factors affecting open market operations
The trading desk relies heavily on temporary reserve operations to deal with uncertainties in the market. An example of these uncertainties is the enormous drain on reserves during the holiday shopping season. Since consumers tend to carry more cash during this period, reserves are drained. To offset this drain on reserves, the FED buys securities, in order to bring reserves back to normal levels. After the holiday season passes, the FED will reverse their previous operations, and sell securities back to the market, to offset the increasing reserves due to consumers depositing more cash back into their bank accounts.
Another example is the movements in Treasury balances. Since the Federal Reserve Bank is the banker for the U.S. Treasury, they must monitor the Treasury's balances as tax receipts are deposited in the tax and loan accounts at commercial banks. These deposits increase reserves, and therefore, must be offset by the FED. Similarly, when the U.S. Treasury transfers balances from these tax and loan accounts, to their account with the FED, as they would do if they plan on spending the funds, reserves are depleted. The FED offsets this drain on reserves with temporary open market operations.
Changes in the Federal Reserve Float, also requires action by the FED using open market operations. Most households and businesses use checks drawn on their bank accounts to pay a major portion of their payments. The FED's national check clearing system facilitates the flow of checks around the country. The reserve bank credits the Bank's reserve account at the FED for checks deposited (or presented for collection), by the bank and debits its account for checks drawn on it and presented by other banks. When a presenting bank's reserve account is credited before a corresponding debit is made to the account of the bank on which the check is drawn, the two banks have credit simultaneously for the same reserves. This creates a reserve float. Float can vary widely on a weekly or monthly basis, and sometimes shows large increases when there is an interruption or delay in the normal check delivery process. An example of this is severe weather conditions. If the FED cannot make delivery of checks because their planes are grounded due to bad weather, there will be an increase in the Reserve Float.
Part VI Analysis of Open Market Operations
As the FED planned for the Y2K (year 2000) weekend, "the Federal Reserve Board voted to establish the Century Date Change Special Liquidity Facility (SLF) for lending to depository institutions from October 1, 1999 to April 7, 2000. The facility was designed to help ensure that banks with sound financial condition would have adequate liquidity to meet an unusual demand in the period around the century date change." [FRBNY Markets Group 2000] This facility was implemented using repurchase agreements totaling $141 billion that were outstanding over year-end. After year-end, these repurchase agreements matured, and by January 12, 2000, the balances were down to $63 billion, still far above the previous peak of $52 billion reached in April 1997. [FRBNY Markets Group 2000]
On September 11, 2001, a massive tragedy struck New York City in the heart of the financial district, as the World Trade Center collapsed due to a terrorist attack. This caused a large disruption in financial transactions and increased the demand for liquidity and bank lending for the FED. The FED responded by announcing the FED is open and the Discount Window is available. As you may recall from Part II, discount lending is one of the tools available for monetary policy. "Discount window loans soared instantly from around $200 million to a peak of about $45 billion on September 12 and later, as markets began to function better. Federal Reserve repurchase agreements soared from $25 billion to nearly $100 billion." [Meyer 2001] As previously stated, the FED buys securities when they transact in repurchase agreements. These transactions increased bank reserves by 300%. On September 11, 2001, the Federal funds rate was pegged at 3.5%. Since then, the FOMC has reduced the Federal funds target rate by another 1.75%, to 1.75%, including the most recent cut of 25 basis points on December 10, 2001.
We now see that there are many advantages to conducting open market operations. We see that the FED has complete control over the type and volume of open market operations. Open market operations are flexible, precise, and can be implemented immediately, without delay. Since open market operations are flexible, the FED can easily reverse any operation conducted in error. By using open market operations to maintain a targeted cost of Federal funds, the FED has the ability to meet it's operational, intermediate, and long-term goals. Federal funds rate targeting allows the FED to easily adjust reserve balances to make corrections, when certain factors beyond the FED's control, causes reserves to rise and fall. This is evidenced by response of the FED to the tragedy of September 11, 2001.
The Federal Reserve, has had so much success in their attempts to control the Federal Funds rate, they hardly need to act. As Meulendyke (1998) observes, "the Federal Funds rate has tended to move to the new preferred level as soon as the banks know the intended rate." Demiralp and Jorda (2001) called this the "announcement effect". By simply publicly announcing the FED's intended rate, the market will adjust toward that rate naturally, thus reducing the need for the FED's intervention.
However, the most challenging aspect of open market operations, as it relates to conducting monetary policy, is that information used to make decisions may not be accurate or hard to gather. A couple examples of this are changes in consumer's propensity to spend and save are not predictable, as are changes in consumer and business confidence. Cuts in short-term rates cannot make businesses invest in growth when sales are down, nor can they make consumers go out and spend when they are worried about their portfolios and jobs.
Part VII Conclusion
As we have discussed, the Federal Reserve's operating strategy for implementing monetary policy involves interest rate targeting through open market operations. By manipulating reserves balances, the FED is able to maintain control over the fluctuations in the trading of Federal funds. By achieving their short-term and medium-term targets, open market operations is able to affect the long-term goals of monetary policy; price stability, full employment, and economic growth.
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