The Fed’s Tool Kit*

The recent crisis in financial markets growing out of the subprime mortgage mess generated calls for the Federal Reserve to "ease" monetary policy. What most people had in mind by easing was a reduction in the Fed's target federal funds rate from the 5.25 percent level that had prevailed for over a year. Instead, the Fed responded, at least initially, by reducing its "discount" rate from 6.25 percent to 5.75 percent and liberalizing collateral requirements and length of borrowing at the Fed's "Discount Window."  This is a good time to review the contents of the Fed's tool kit-it's three tools of monetary policy: open market operations and the Fed Funds rate; the discount window and the discount rate; and reserve requirements.

Open Market Operations and the Federal Funds Rate

Banks and other depository institutions are required to keep a percentage of their deposit liabilities as "reserves," either on deposit at the Fed or in vault cash.  The Fed's reserve requirement, the third tool of monetary policy even though it rarely changes, is, at the margin, 10 percent of deposits.  This means that each dollar of reserves in the banking system supports $10 of deposit liabilities, which are part of the money supply.  Banks must meet their reserve requirements over a two-week "maintenance" period.

At any given time, some banks will have more reserves than currently needed to fund their loans and investments and still meet their reserve requirement while others will have a need for more reserves. This has resulted in an inter-bank market in reserve deposits at the Fed-the Federal Funds market-where banks with excess reserves  lend (sell) reserves to banks with a potential reserve deficiency. The interest rate that clears this market daily is the Federal Funds rate. Upward pressure on the Federal Funds rate suggests a scarcity of reserves in the banking system.  Downward pressure suggests that reserves are plentiful.

The Federal Reserve normally conducts monetary policy by buying and selling (primarily) government securities with the motive of injecting new reserves into this market or withdrawing reserves from it, thus giving the banking system a greater or lesser ability to make loans and create new deposits that are used by the public as money.  The important part of these open market operations is the rate of reserve and money-creation they generate. Ideally, the nation's money supply should grow over time at about the same rate as the economy's potential to grow in real terms. With money creation and economic activity growing at about the same rate, the inflation rate should not rise.

While money growth is most important in its impact on the economy, as a short-term operating procedure, the Fed in recent years has based its operations on its "target" for the Fed Funds rate.  It buys securities to push the rate down toward the target and sells them to push it up. The decision about the level of the target rate will be is made by the Federal Open Market Committee (FOMC), composed of the Fed Governors and Presidents of the Reserve Banks.  The FOMC, in 17 consecutive meetings in just over two years beginning in June 2004, raised its target Fed Funds rate from 1 percent to 5.25 percent, where it has been for more than a year now, in an effort to prevent or offset inflationary pressures.

The Discount Rate and the Lender of Last Resort

When the Fed was established back in 1913-14, bank loans were typically in the form of "discounts" where the borrower signed a note for $100 but received only $94 in cash.  One of the intended roles of the Fed was to enable banks, when they had a need for liquidity, to "re-discount" those discounts, or customer notes, at the Fed.  The Fed charges an interest rate that came to be known as the "re-discount" rate.  Over time, the "re" was dropped, and the interest rate the Fed charges to borrowing banks became the "discount" rate.

Banks could also get funds (become more liquid) by borrowing reserve deposits from each other in the Federal Funds Market.  But the reserves gained by one bank would be lost by another.  Normally, that is not a problem, but is a good way to distribute reserves among the banks as needed for loan and investment growth.  But during times of stress, reflected by a shortage of liquidity in many banks, the whole banking system needed new reserves, hence the Fed's Discount Window.  New reserves borrowed from the Fed do not come at the expense of other banks.  They are new reserves to the borrowing bank as well as new reserves to the banking system as a whole.  This distinction is extremely important in times of stress.

Another important distinction between the Fed supplying new reserves to banks through open market operations vs. the discount window is that the former is a general injection, initiated by the Fed, while the latter is initiated by the borrowing bank in need of liquidity-a shotgun approach vs. a rifle approach.  For this reason, borrowing at the discount window is probably a better option for crisis management since the reserves are more likely to end up where they are needed.

In the modern era, large banks receive and pay out millions and billions of dollars throughout the day.  In normal times, the banker doesn't worry much as he pays out money whether he will receive the funds he has coming.  In times of stress, however, they do worry, and they are motivated to slow the outgoing payments to make sure they are fully matched by incoming payments. This behavior among banks is, of course, self defeating and causes the very problem it seeks to protect against.

The Fed's discount window is well suited to break this log jam, or freeze up, but it may also require a little Fed jawboning.  Following 9/11 and during the recent crisis, the Fed urged large banks, particularly, to keep the money flowing and use the discount window to make up any daily shortfalls that might result.

A Bothersome Technicality

My description of open market operations above was accurate, but it doesn't match up very will with the contemporary jargon surrounding recent events.  When the Fed wants to "ease" monetary or liquidity conditions, it purchases (normally) government securities in the open market.  This expands bank reserves and the money supply initially by the amount of the purchase.  Further multiple expansion of deposit money will ensue, other things equal, because each dollar of new bank reserves will support about $10 in deposits-which are used as money-in our example above.

Think of the previous paragraph as a description of a "permanent" injection of reserves and money.  More temporary, day-to-day injections are done with "repos" or "repurchase agreements." For example, the New York Fed, acting on behalf of the System, will offer to purchase government securities from dealer banks and sell them back the next day for a specified price that determines the repo interest rate.  The bank, for a day, or more, gives up an earning asset, in exchange for reserve balances that count toward its required reserves. If the Fed wishes to withdraw funds from the banking system temporarily, it might do a "reverse repurchase agreement," by selling securities to banks for a day with a reversal of the transaction the next day.

If you have found the press discussion-and my own-of repos confusing, part of the reason is that the nomenclature that has evolve is backwards. When people say the Fed injected reserves into the banking system with a repo, it really is a repo from the banks' point of view since it is the banks who agree to repurchase the securities. When the Fed withdraws liquidity by selling securities for a day and agreeing to buy them back the next day, it's a repo from the Fed's viewpoint, but it's usually called a reverse repo.  Go figure. (Hint: the language used usually is from the banks viewpoint.)

What Fed Has Done So Far

As an example of the real world use of its policy tools, the New York Fed, on Thursday, August 9, injected $12b of reserves with a 14 day repo plus another 1 day repo for only one day.  The next day it injected $3 billion in reserves for 3 days (Friday, Saturday and Sunday) and $2 more.

Several pendants on financial television, who were not familiar with the discount rate, got in the habit of adding all these sums up to get the total reserves added to the banking system.  They failed to subtract from the cumulative total when a previous repo expired, causing reserves to decline.  The total or reserves retained in the banking system was, therefore, less than the sum of the initial injections.

The big news on Friday, August 17, however, was an early-morning announcement by the Fed's Board of Governors that it was accepting the recommendation by 2 Reserve banks to reduce the Reserve Banks discount rate by 50 basis points from 6.25 percent to 5.75 percent.  The announcement also indicated that longer-than-usual borrowing would be tolerated and that collateral requirements would be liberalized to include paper under pressure by the crisis.  The announcement was received warmly by traders other than those caught with their shorts up-not referring to their underwear. They got wedgies big time.

The Fed also engaged in a bit of "jawboning," sometimes thought of as another tool of monetary policy.  In this instance, the jawboning took the form of urging banks to use the discount window if needed, emphasizing that it would not be regarded as a sign of weakness.  It apparently went further and arranged for four large banks to borrow $500 million each as a demonstration to encourage others.

The Fed's discount-rate cut did not result in significant increase in usage of the discount window, but it still had a major impact in reassuring market participants.  The markers became much calmer after the action.  Nevertheless, market participants and others soon renewed their cries for the Fed to ease monetary policy in the conventional way of cutting the target Federal Funds rate.  More that one such easing was soon reflected in rates for Fed Fund futures.  This pressure on the Fed to ease on or before its next regularly scheduled meeting on September 18 creates potential further instability if the Fed disappoints the markets.  Even if the Fed considers an easing a good idea, it will be somewhat reluctant to allow markets to dictate such moves because of the moral hazard problem it will generate in the future. 

*Appeared in the Harry S. Dent newsletter on September 1, 2007.