The Federal Reserve System

History of formation and development of FRS. The organizational structure of the U.S Federal Reserve. The implementation of Monetary Policy. The Federal Reserve System in international sphere. Foreign Currency Operations and Resources, the role banks.

Рубрика Финансы, деньги и налоги
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Язык английский
Дата добавления 01.07.2011
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1. General information about Federal Reserve System

1.1 History of formation and development of FRS

1.2 The organizational structure of the U.S Federal Reserve

2. Monetary policy of Federal Reserve System

2.1 Monetary policy

2.2 The implementation of Monetary Policy

2.3 The Federal Reserve System in international sphere


List of Literature



In his term paper I will discuss the creation of the Federal Reserve of its functions, which includes the Federal Reserve System. How to influence interest rates on exchange rates, as banks around the world depend on the Federal Reserve system. I think it is very important and interesting topic for me because I am a financier. In this paper I will try to reveal all the details.

The U.S. economy and the world economy are linked in many ways. Economic developments in this country have a major influence on production, employment, and prices beyond our borders; at the same time, developments abroad significantly affect our economy. The U.S. dollar, which is the currency most used in international transactions, constitutes more than half of other countries' official foreign exchange reserves. U.S. banks abroad and foreign banks in the United States are important.

The Federal Reserve has supervisory and regulatory authority over a wide range of financial institutions and activities. It works with other federal and state supervisory authorities to ensure the safety and soundness of financial institutions, stability in the financial markets, and fair and equitable treatment of consumers in their financial transactions.

As the U.S. central bank, the Federal Reserve also has extensive and well-established relationships with the central banks and financial supervisors of other countries, which enables it to coordinate its actions with those of other countries when managing international financial crises and supervising institutions with a substantial international presence

1. General information about Federal Reserve System

1.1 History of formation and development of FRS

The U.S. Congress as the supreme legislative body passed the Federal Reserve System (some domestic sources call it the Federal Reserve Act - approx. Per.), Which marks the beginning of its work 1913. Interest of the U.S. banking system in the establishment of country's central bank has increased markedly since the banking crisis of 1907. At this time, several large financial institutions were close to bankruptcy and closure due to the fact that banks in this period experienced significant difficulties in meeting the demand depositors withdraw their funds and turn them into cash. In addition, small banks in agricultural areas of the country at this time sought to obtain from its correspondent banks in major cities heavily in cash. During the banking crisis, savings banks usually require pre-application for withdrawal of bank deposits, and many banks in both New York and across the country artificially limited the appeal of deposits in cash. At that time, several months cash sold above their face value, yielding additional economic system.

In 1908, Congress passed the so-called law Oldrncha-Ryland (Aldrich-Vreeland Act), in essence demanded the establishment of the National Commission treatment, whose functions were attributed to the development of the project for the central issuing bank of the country. Appointed a commission consisting of nine senators and nine House members held several hearings on the issues under examination, and organized an extensive special investigation being banking in the United States and in foreign countries. Materials of these studies were so comprehensive, that the final report of this commission consisted of 23 heavy volumes. In 1913, President Woodrow Wilson, despite some opposition to the idea of a central institution issuing bank in the U.S., has entered into financial and economic practices of U.S. financial institution such as the Federal Reserve System.

In the beginning, the main purpose of the Federal Reserve System was to help banks during the banking crisis and stock market fever. It was further established that in the period in question there has been no fully satisfactory mechanisms for the needs of banks in the appropriate level of liquidity. Initially, control over the quantity of bank credit, money supply and the rate of interest does not fall within Fed. In this era of economic and financial relations between the U.S. dominated the gold standard ', and it was assumed that the amount of gold stored in the bowels of the U.S. banking system is the mechanism that regulates the amount of money in circulation and bank credit. The founding fathers of the Fed in his dreams represented the central bank of issue, which would be capable of providing elastic supply of cash by means of discounting commercial banks. Original position, lying in the basement of the organization of the Federal Reserve System, based on a kind of cooperative system in which the U.S. federal government, the banking system, businessmen, entrepreneurs and ordinary consumers would cooperate on an equal footing. Initially, the Law on the Federal Reserve System in 1913 detailed the development of relations between the twelve Federal Reserve Bank and Federal Reserve Board (renamed in 1935 in the Board of Governors of the Federal Reserve System) does not provide. From 1914 to 1922, officials from the twelve Federal Reserve banks hold periodic meetings and consultation meetings, which developed the direction of monetary policy and make decisions accordingly. In those early years of the Federal Reserve System, a series of socio-political power in one center at a time when the foundations of the Federal Reserve System.

The role and importance of Federal Reserve Banks. Every single Federal Reserve Bank itself has played an important role in conducting and realization of a particular monetary policy, despite the fact that the management of these processes as a whole belongs to the Board of Governors of the Federal Reserve. Firstly, as members of the Federal Open Market Committee, five of the twelve presidents of Federal Reserve Banks are actively involved in developing and determining objectives and tactical objectives of monetary policy. " Second, the Board of Directors of the Federal Reserve Banks and produces certain outlines a specific point level of bank interest rates - one long key parameters of the economic system, which is submitted for consideration and approval by the Board of

In addition, Federal Reserve Bank made an important contribution to the development of concepts of monetary and credit relations, governing the activities of the Federal Open Market Committee. Most Reserve Banks publish articles and monthly reports on current issues of financial and economic life, with a number of these works received very widespread. Participation by all federal banks in the development of the main directions of monetary policy provides equal representation on these issues from different districts, but also provides the Board of Governors of the Federal Reserve variety of information from places that otherwise would have been unlikely to see such a centralized body, the Council Governors of the Federal Reserve. For example, in the late sixties and early seventies, the Federal Reserve Bank of St. Louis has played an important role by providing the corresponding impact on the entire Federal Reserve System, and thus contributes to the transition from a flexible monetary policy to a more rigid. In the late seventies, the Federal Reserve Bank of Minneapolis has managed its actions to convince stakeholders to individuals at the Fed to pay more attention to the importance and influence of the effects of expectations in financial and economic spheres of a certain monetary policy pursued by the Federal Reserve System. In 1980 - 1982's economic model of the money market, developed by the Federal Reserve Bank of San Francisco, has made a significant contribution to the understanding of the entire Federal Reserve

Federal Reserve banks have a decisive influence on the management of the entire U.S. banking sphere. These functions include monitoring and inspection activities 1,000 member banks of the Federal Reserve, 6000, bank holding companies, corporations, whose activities fall under the jurisdiction of the Law Edge 2, branches and representative offices of foreign banks in the U.S. In addition, the Federal Reserve Banks provide loans to banks experiencing financial difficulties. The purpose of such events (remember the number of loans of commercial banks in New York, Oklahoma and Seattle) is to provide a stable financial environment and isolation of banks facing difficulties in order to prevent possible under these circumstances, a crisis of confidence.

The last area of responsibility of the Federal Reserve Banks is to provide a happy financial services. These include the processing of checks, issuance and receipt of cash, sale and storage of securities the U.S. federal government, wire transfers of funds. Federal Reserve banks can be classified as some "semi." Corporations, mainly due to the mechanism of elections and appointments of directors. Each Federal Reserve Bank is a corporation having a charter for the right to introduce the operations issued by public authorities, and, of course, includes the shareholders, board members and president. Stockholders of the Federal Reserve Bank are member banks of the Fed's district, but they choose only six of the nine directors of the Federal Reserve Bank: three directors of the first rank (class A), representing the usual bankers of creditors, and three directors of the second rank (class B), representing leading representatives of industrial or agricultural companies, are actively used in the practice of loan funds. Board of Governors of the Federal Reserve further appoint three directors of the third rank (class C) in each Federal Reserve Bank. See Table 1 p. 30

According to the original plan for the organization of the Fed thought it necessary to represent in his person the authorities and the general public. In addition, the Director of the third rank may not hold in the bank to any other post. Board of Governors of the Federal Reserve chooses and appoints the chairman and his deputy from among the directors of the third rank.

Distribution of profit to any Federal Reserve Bank as a result of activity also reflects the previously noted by the nature of its structure. Each bank - member of the Fed - is obliged to purchase from the Federal Reserve Bank of its district a certain number of shares for an amount of 3% of its own equity and retained earnings, lawfully this amount on demand can be doubled. With the increase of share capital and profits of commercial banks, he is obliged to purchase more shares to maintain a regulated three-percent level. Dividends paid on these shares, limited to 6%, and more than 90% of the total income of the Federal Reserve Banks returned to the U.S. Treasury. The main purpose of the Federal Reserve Banks is not extracting the maximum profit, but an embodiment of life and economic reality of a certain U.S. monetary policy and guide multi-faceted economic and financial activities of the Federal Reserve System.

Each of the twelve Federal Reserve Banks is a weekly financial report on the results of its activities to the Board of Governors of the Federal Reserve, which summarizes and processes incoming information, and then publish at the end of each week. Federal Reserve Banks is located in Washington and designed to adjust and meet the mutual claims and claims Federal Reserve Bank, arising from the movement of bank deposits from one Federal Reserve district to another.

According to the adopted legislation, all national banks to the U.S. are required to maintain their membership in the Federal Reserve System, in addition, a number of banks in the state voluntarily expressed their desire to join the Fed. Their request was granted. Until 1980, banks belonging to the Fed, have certain advantages over other banks and savings and loan institutions. Having the status of a member of the Federal Reserve bank, the financial authority acquired a certain prestige. Fed member banks are entitled to receive loans from Federal Reserve Bank of order, as well as to place, these banks cash, services of the Federal Reserve provided for clearing of checks, we finally obtain the necessary advice on financial matters of interest. In addition, the Fed's member banks have the right to use the teletype lines for the Fed funds transfer. In fairness it should be noted that the services of clearing checks were not the exclusive privilege of member banks of the Fed as the bank does not belong to this system, had the right to register with the Fed

Law of the deregulation of deposit takers and the control of monetary circulation in 1980 removed most of the differences between the member banks the Federal Reserve and other banking institutions. In the seventies, more than 500 banks have stopped his membership in the Federal Reserve System, mainly due to a sharp rise in market rates of interest in that period. The high level of market rates of interest was sharply raising the opportunity cost of reserve requirements of member banks of the Fed. The legislative act of 1980 eliminated the differences in reserve requirements from different banks and deposit-taking institutions.

1.2 The organizational structure of the U.S. Federal Reserve

The Fed has three parts: See table 2. P 31

- Central Council of Governors, which is located in Washington, DC

- 12 of the Federal Reserve Banks spread across the U.S

- Operations Committee on the open market.

The Board of Governors consists of seven members (governors) are appointed by the President of the United States and approved by the U.S. Senate for 14 years without the right destination for a second term (the exception is a situation where the governor has replaced its predecessor and leaves the 14 year period. In this case, if all the governors fully worked out his term, the U.S. president can nominate only two new candidates (if re-elected president, he can choose two more candidates for governor). This rule applies to exclude the chance that the president will appoint to the Board of Governors only his supporters, which will allow him to exert influence on the Fed. However, in practice many governors who leaves his job at the Fed before the expiration of 14-year period, and many presidents were nominated for more than two governors. The term of office of governors always expire on January 31. By law, the governors should be "financial, agricultural, industrial and commercial interests, as well as all regions of the country."

U.S. territory is divided into four regions, each of which operate with Federal Reserve Banks. In the first region includes the Boston, Philadelphia and Richmond. The second group includes Cleveland and Chicago, the third - Atlanta, St. Louis and Dallas, the fourth - Minneapolis, Kansas City and San Francisco. Each region can be delegated to the governors of not more than one representative.

Since his appointment as members of the Board of Governors of the Federal Reserve have the same freedom of action, as the U.S. Supreme Court. After taking office, they cannot be dismissed on the grounds that their views do not reflect the views of other governors or officials. This rule was introduced in order to fully protect the Fed from external influences and to exclude the impact of political motives in the governor's decision. The governors work in constant cooperation with the U.S. administration. They often come out with a report to Congress.

"Face" The Fed is the Chairman of the Board of Governors, which is responsible for the activities of the entire system. Chairman of the Board of Governors and Vice-President may hold office for four years. The U.S. president selects from among the governors, the nomination must be approved by the Senate. Curiously, many leaders of the Federal Reserve hold office more than 14 years. Chapter Board of Governors of the Federal Reserve from time to time meets with U.S. President and the Minister of Finance. Chairman of the Board of Governors of the Federal Reserve also has a number of commitments at the international level, in particular, is an alternative member of the Board of Governors of the United States in the International Monetary Fund and a member of the U.S.

Federal Reserve Bank

According to the law of the Fed's entire territory of the United States divided by 12 reserve districts, each of which is serviced by the Federal Reserve Bank of the district. Federal Reserve Banks are the main operational arm of the Federal Reserve System, acting as the central bank for its district. Each of them is a kind of joint-stock company whose shares are owned by member banks of the district.

Network of Federal Reserve Banks, along with their 25 branches carry out such functions as the Fed actuation of a nationwide payments system, the distribution of the national currency, controlling and regulating member banks and bank holding companies, as well as the function of the banker for the U.S. Treasury. Each Reserve District marked its letter and number, so all the U.S. currency will carry a note with the number and letter of the Reserve Bank, who first released it into circulation. In addition to performing the functions of the Federal Reserve system as a whole, such as conducting banking and credit policy, each Reserve Bank serves as a repository for funds from other banks in his district and provides loans to banks experiencing financial difficulties.

Each Reserve Bank has a board consisting of 9 directors from non-employees of the bank. Three directors who belong to the class A, represent commercial banks that are members of the Fed. Three directors and three Class B Class C represent the public. Director of class B and C are elected by commercial banks, members of the Fed. Board of Governors in Washington appoints Class C directors from among the directors of class C Board of Governors is elected chairman of the board of directors and his deputy. Director of class B and C cannot be in a bank or bank holding company nor officials nor the directors nor employees. Director of P cannot hold shares in a bank or bank holding company. The Board of Directors in turn appoint a president and vice president of Reserve Bank, whose choice must be confirmed by the Governing Council.

Each Reserve Bank branch has its own board of directors consisting of 5 or 7 people. Most of those directors appointed by the Reserve Bank of that office, while others are appointed by the Governing Council.

The Board of Directors of Reserve Banks and their branches provide the Federal Reserve full information about the economic situation in virtually every corner of the country. This information is used by the Federal Open Market Committee and the Governing Council to make important decisions about monetary policy. The information gathered Reserve banks are also available to the public in a special report, which is informally called the Beige Book (The Beige Book). It is published approximately two weeks before each meeting of the Federal Open Market Committee. In addition, every two weeks, the board of each bank should provide the Governing Council about the discount rate of the bank. And the change it cannot happen without the confirmation of the Governing Council.

Revenue reserve banks receive mainly from interest on government securities that were purchased on the open market. Other important sources of revenue include interest on the existing system, foreign currency investments, interest on loans to depository institutions, as well as fees for the provision of services to depository institutions.

After paying all the costs the Federal Reserve Banks send the remains of their income to the treasury. Revenues and expenditures of the Federal Reserve banks from 1914 to the present day are included in the Annual Report of the Governing Council. If the Reserve Bank is liquidated for any reason, all income after payment of bills sent to the treasury.

The Committee on Open Market (Federal Open Market Committee - FOMC)

The Federal Open Market Committee (FOMC), a component of the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations. It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money supply. It is the principal organ of United States national monetary policy. (Open market operations are the buying and selling of United States Treasury securities.) The Committee sets monetary policy by specifying the short-term objective for those operations, which is currently a target level for the federal funds rate (the rate that commercial banks charge between themselves for overnight loans). The FOMC also directs operations undertaken by the Federal Reserve System in foreign exchange markets, although any intervention in foreign exchange markets is coordinated with the US Treasury, which has responsibility for formulating US policies regarding the exchange value of the dollar.

When the Fed makes its first steps in the economic practice of the United States, nobody seriously considered the open market operations as a sort of instrument control and economic relations. At this time the Fed to purchase securities of the federal government primarily in order to get enough of a profitable asset, if the profits from giving the federal reserve banks loans and advances is, for whatever reasons, inadequate. Most of the Federal Reserve Banks felt that the most convenient venue for such transactions is a New York City, and it is here in the twenties informal committee composed of representatives from all twelve Federal Reserve Bank, begun to coordinate their actions on securities the federal government. While almost immediately after its inception, this body began to affect the state of the economic system, compensating through appropriate purchase and sale of securities circulation of yellow metal in the economy and create additional reserves for the system of private banks, legislative activity, the Federal Open Market Committee (FKOR) has been executed and legalized only after the adoption of the Banking Act 1935.

Federal Open Market Committee directs open market operations in securities. At their meetings the members FKOR considering current economic conditions and determine the most appropriate in their view of monetary policy and the direction of its development. After this, the Federal Open Market Committee is preparing a directive order to manage ongoing operations in the open market, which is also the vice-president of the Federal Central Bank of New York. This order does not specify its further actions on the open market itself decides where, how and how much to buy or sell securities of the federal government. Legislative available only outlines the proposed direction of monetary policy and sets the values and levels of key parameters of the banking system, such as the level of free reserves, the sale rate the Federal Reserve and several other parameters of the monetary and credit relations. In turn, current operations manager on the open market is taking the necessary purchases or sales of securities of the federal government needed to achieve the objectives of the policy before it. [See 5 p. 29]

2010 Members of the FOMC

o Ben S. Bernanke, Board of Governors, Chairman

o William C. Dudley, New York, Vice Chairman

o James Bullard, St. Louis

o Elizabeth A. Duke, Board of Governors

o Thomas M. Hoenig, Kansas City

o Sandra Pianalto, Cleveland

o Sarah Bloom Raskin, Board of Governors

o Eric S. Rosengren, Boston

o Daniel K. Tarullo, Board of Governors

o Kevin M. Warsh, Board of Governors

o Janet L. Yellen, Board of Governors

* Alternate Members

o Charles L. Evans, Chicago

o Richard W. Fisher, Dallas

o Narayana Kocherlakota, Minneapolis

o Charles I. Plosser, Philadelphia

o Christine M. Cumming, First Vice President, New York [see 16 p.29 ]

2. Monetary policy of Federal Reserve System

2.1 Monetary Policy and the Economy

The main objectives of monetary authorities in the U.S.

U.S. monetary policy has two main objectives:

1) stimulating production and employment

2) maintaining a "stable" prices. These goals are listed in the adopted in 1977 amendments to the Federal Reserve System.

As the economy develops in a cyclical output and employment levels are regularly above or below the projected long-term trend. Despite the fact that monetary policy can not affect the production or employment in the long run, in the short term it under her power. For example, when the demand for industrial products is reduced and there comes a recession, the Fed can stimulate economic growth - of course, time - and help the economy closer to the long-term levels of production by lowering interest rates. Therefore, in the short term, the Fed and other central banks are taking measures to stabilize the economy, resulting in levels of production and employment in relative conformity with the projected long-term economic growth.

The question arises: if the Fed can stimulate the economy out of recession, why it cannot stimulate the economy all the time? In fact, successive attempts to accelerate economic growth, placing them beyond the long-term levels, put pressure on the factors limiting the performance, which will result in more and higher inflation, not accompanied by long-term decline in the unemployment rate or an increase in output. In other words, the policy of continuing to support economic growth not only bring the country long-term benefits, but also to make people pay for high inflation.

Inflationary pressure has a negative impact on the economy because, on the one hand, promotes the growth of interest rates on long-term loans, with another - creates a situation of uncertainty for businesses and consumers, greatly complicating long-term planning. In addition, high inflation distorts the meaning of economic decisions, leading to an arbitrary increase or decrease in the rate of profit after tax in the various sectors of the economy.

Thus, ensuring price stability is one of the main goals of the Fed. While monetary policy cannot make the economy grow faster than capacity allows long-term growth, or reduce the level of unemployment in the long term, but it can stabilize prices across longer time periods.

Because the Fed can influence the average rate of inflation in the economy, some experts and some members of Congress, emphasized the need to define the objectives of monetary policy in the task of maintaining price stability. However, fluctuations in levels of output and employment is also costing the public dearly. In practice, the Fed, like any central bank has to control not only inflation but also about economic growth in the short term.

Two main objectives pursued by the Fed tend to contradict each other. One of the contradictions arise when deciding on what the purpose is of paramount importance at a time. For example, suppose that during a recession the Fed takes measures to prevent the excessive rise in unemployment. Short-term success in this area could result in long-term problems if the monetary policy for too long will be aimed at stimulating employment, since it would lead to higher inflationary pressures. Therefore, it is very important for the Fed to find a balance between short-term stabilization and long-term objective for low inflation.

The Fed controls the rate of inflation or influence output and employment levels through changes in the cost of short-term loans. Impact on the level of interest rates is carried out mainly through open market operations and the federal funds rate, both these methods work in the market of bank reserves, also called the federal funds market.

In accordance with the law, banks and other depository institutions (for brevity, they are all in this material are referred to as "Bank") to create specific funds that can be used to meet unexpected cash outflows. These funds are in cash held in banks' vaults or as deposits at the Fed. Currently, banks are obliged to keep from 3% to 10% of funds held in interest-bearing and interest bearing checking accounts as reserves, depending on the total dollar amount available on such accounts in each bank. In addition, banks can generate additional reserves required for settlements as "overnight" and other payments.

Banks in need of additional short-term reserves can borrow them from other banks, which currently have excess reserves. Such loans are made on the so-called federal funds market and interest rates on short-term loans is determined by the federal funds rate, which is the "target". Manipulation of the rate and change in reserves leads to a corresponding adjustment of interest rates, money market, which ultimately allows you to balance the demand for cash and cash offer. Thus, the increase in excess reserves, supplied to the market federal funds, leading to a drop in interest rates, and vice versa.

Banks can also borrow reserves from the Federal Reserve Banks use the so-called «Discount window" and the interest rate, which is set for these loans is called the discount rate. Total number of funds, the adopted through the "discount window", as a rule, very small, because the Fed does not encourage such loans, except in cases where banks borrow to offset the short-term shortage of reserves.

In fact, the role of interest rates in the U.S. monetary policy is that its change could signal a significant change in monetary policy. Raising the discount rate indicates an restrictive policy, and its decline could mean a transition to a policy of stimulating economic growth. See table 3 p 31

Open market operations are the main tool used the Fed to influence the supply of free reserves in the banking system. This term refers to ongoing Fed buying and selling government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York. If the Fed wants to lower interest rates on federal funds market, it buys from banks in government securities, resulting in the amount of funds held by banks, is higher than the obligatory amount and the bank is able to provide the excess reserves as loans to other banks federal funds market.

Thus, the Fed buying securities on the open market increases the money supply in the banking system, resulting in lower interest rates on federal funds market. In order to increase bets the Fed sells government securities, and receives in payment of bank funds, which reduces the amount of the money supply in the banking system and leads to an increase in interest rates in the money market.

Purchases and sales of foreign currency FOMC implemented jointly with the Ministry of Finance, bearing full responsibility for these operations. The Fed does not set in this area targets, or desired levels of exchange rates. Instead, the Fed takes measures to reduce the negative effects of erratic fluctuations in the currency markets, in particular, fluctuations caused by speculation and tend to impede the effective functioning of the currency markets or financial markets generally. For example, in some periods, characterized by a sharp depreciation of the dollar, the Fed bought the currency (by selling foreign), to counter the negative pressure. Foreign exchange intervention with the dollar, regardless of who is the initiator: the Fed, the Treasury or regulatory authority of a foreign country - should not change the amount of funds offered by banks in the money market or interest rates. Targeted prevention of the influence of foreign exchange intervention on bank reserves and interest rates, carried out by the responsible authorities, cannot use these transactions as an instrument of monetary policy.

Increased aggregate demand for products made by U.S. companies reach such a variety of ways, leads to the fact that firms begin to increase production volumes and the number of workers. This increases their need to expand production capacity and, hence, promotes the growth of cost of inputs. Rising incomes, resulting from increasing production, in turn, leads to increased consumption.

Effects of changes in monetary policy are usually long term, and the duration of their impact on the economy may be different. The main effect provided by these changes, the overall increase in the production of goods and services, usually manifests itself during the period it takes from 3 months to 2 years. And the effect of changes in monetary policy on inflation is significantly during more prolonged periods of between one to three years and even longer.

However, it is very difficult any pinpoint the period during which changes n monetary policy will affect the economy, because such changes are intended to influence the demand and, consequently, their influence depends on the reaction of people, which is volatile and difficult to predict. In particular, the effect is provided by measures of monetary policy on the economy, depends on the opinions of Americans about how the actions taken by the Fed, will affect the rate of inflation in the future.

2.2 The Implementation of Monetary Policy

The Federal Reserve exercises considerable control over the demand for and supply of balances that depository institutions hold at the Reserve Banks. In so doing, it influences the federal funds rate and, ultimately, employment, output, and prices.

The Federal Reserve implements U.S. monetary policy by affecting conditions in the market for balances that depository institutions hold at the Federal Reserve Banks. The operating objectives or targets that it has used to effect desired conditions in this market have varied over the years. At one time, the FOMC sought to achieve a specific quantity of balances, but now it sets a target for the interest rate at which those balances are traded between depository institutions--the federal funds rate. By conducting open market operations, imposing reserve requirements, permitting depository institutions to hold contractual clearing balances, and extending credit through its discount window facility, the Federal Reserve exercises considerable control over the demand for and supply of Federal Reserve balances and the federal funds rate. Through its control of the federal funds rate, the Federal Reserve is able to foster financial and monetary conditions consistent with its monetary policy objectives. The Federal Reserve influences the economy through the market for balances that depository institutions maintain in their accounts at Federal Reserve Banks. Depository institutions make and receive payments on behalf of their customers or themselves in these accounts. The end-of-day balances in these accounts are used to meet reserve and other balance requirements. If a depository institution anticipates that it will end the day with a larger balance than it needs, it can reduce that balance in several ways, depending on how long it expects the surplus to persist. For example, if it expects the surplus to be temporary, the institution can lend excess balances in financing markets, such as the market for repurchase agreements or the market for federal funds.

During most of the 1970s, the Federal Reserve targeted the price of Federal Reserve balances. The FOMC would choose a target federal funds rate that it thought would be consistent with its objective for M1 growth over short intervals of time. The funds-rate target would be raised or lowered if M1 growth significantly exceeded or fell short of the desired rate. At times, large rate movements were needed to bring money growth back in line with the target, but the extent of the necessary policy adjustment was not always gauged accurately. Moreover, there appears to have been some reluctance to permit substantial variation in the funds rate. As a result, the FOMC did not have great success in combating the increase in inflationary pressures that resulted from oil-price shocks and excessive money growth over the decade.

By late 1979, the FOMC recognized that a change in tactics was necessary. In October, the Federal Reserve began to target the quantity of reserves--the sum of balances at the Federal Reserve and cash in the vaults of depository institutions that is used to meet reserve requirements--to achieve greater control over M1 and bring down inflation. In particular, the operational objective for open market operations was a specific level of non-borrowed reserves, or total reserves less the quantity of discount window borrowing. A predetermined target path for non-borrowed reserves was based on the FOMC's objectives for M1. If M1 grew faster than the objective, required reserves, which were linked to M1 through the required reserve ratios, would expand more quickly than non-borrowed reserves. With the fixed supply of non-borrowed reserves falling short of demand, banks would bid up the federal funds rate, sometimes sharply. The rise in short-term interest rates would eventually damp M1 growth, and M1 would be brought back toward its targeted path.

The demand for Federal Reserve balances has three components: required reserve balances, contractual clearing balances, and excess reserve balances.

Required reserve balances are balances that a depository institution must hold with the Federal Reserve to satisfy its reserve requirement. Reserve requirements are imposed on all depository institutions--which include commercial banks, savings banks, savings and loan associations, and credit unions--as well as U.S. branches and agencies of foreign banks and other domestic banking entities that engage in international transactions. Since the early 1990s, reserve requirements have been applied only to transaction deposits, which include demand deposits and interest-bearing accounts that offer unlimited checking privileges. An institution's reserve requirement is a fraction of such deposits; the fraction--the required reserve ratio--is set by the Board of Governors within limits prescribed in the Federal Reserve Act. A depository institution's reserve requirement expands or contracts with the level of its transaction deposits and with the required reserve ratio set by the Board. In practice, the changes in required reserves reflect movements in transaction deposits because the Federal Reserve adjusts the required reserve ratio only infrequently.

A depository institution satisfies its reserve requirement by its holdings of vault cash (currency in its vault) and, if vault cash is insufficient to meet the requirement, by the balance maintained directly with a Federal Reserve Bank or indirectly with a pass-through correspondent bank (which in turn holds the balances in its account at the Federal Reserve). The difference between an institution's reserve requirement and the vault cash used to meet that requirement is called the required reserve balance. If the balance maintained by the depository institution does not satisfy its reserve balance requirement, the deficiency may be subject to a charge.

The supply of Federal Reserve balances to depository institutions comes from three sources: the Federal Reserve's portfolio of securities and repurchase agreements; loans from the Federal Reserve through its discount window facility; and certain other items on the Federal Reserve's balance sheet known as autonomous factors.

In theory, the Federal Reserve could conduct open market operations by purchasing or selling any type of asset. In practice, however, most assets cannot be traded readily enough to accommodate open market operations. For open market operations to work effectively, the Federal Reserve must be able to buy and sell quickly, at its own convenience, in whatever volume may be needed to keep the federal funds rate at the target level. These conditions require that the instrument it buys or sells be traded in a broad, highly active market that can accommodate the transactions without distortions or disruptions to the market itself.

The market for U.S. Treasury securities satisfies these conditions. The

U.S. Treasury securities market is the broadest and most active of U.S. financial markets. Transactions are handled over the counter, not on an organized exchange. Although most of the trading occurs in New York City, telephone and computer connections link dealers, brokers, and customers--regardless of their location--to form a global market.

Open Market Operations

The Federal Reserve Bank of New York conducts open market operations for the Federal Reserve, under an authorization from the Federal Open Market Committee. The group that carries out the operations is commonly referred to as “the Open Market Trading Desk” or “the Desk.” The Desk is permitted by the FOMC's authorization to conduct business with U.S. securities dealers and with foreign official and international institutions that maintain accounts at the Federal Reserve Bank of New York. The dealers with which the Desk transacts business are called primary dealers. The Federal Reserve requires primary dealers to meet the capital standards of their primary regulators and satisfy other criteria consistent with being a meaningful and creditworthy counterparty. All open market operations transacted with primary dealers are conducted through an auction process.

Each day, the Desk must decide whether to conduct open market operations, and, if so, the types of operations to conduct. It examines forecasts of the daily supply of Federal Reserve balances from autonomous factors and discount window lending. The forecasts, which extend several weeks into the future, assume that the Federal Reserve abstains from open market operations. These forecasts are compared with projections of the demand for balances to determine the need for open market operations. The decision about the types of operations to conduct depends on how long a deficiency or surplus of Federal Reserve balances is expected to last. If staff projections indicate that the demand for balances is likely to exceed the supply of balances by a large amount for a number of weeks or months, the Federal Reserve may make outright purchases of securities or arrange longer-term repurchase agreements to increase supply. Conversely, if the projections suggest that demand is likely to fall short of supply, then the Federal Reserve may sell securities outright or redeem maturing securities to shrink the supply of balances.

Even after accounting for planned outright operations or long-term repurchase agreements, there may still be a short-term need to alter Federal Reserve balances. In these circumstances, the Desk assesses whether the federal funds rate is likely to remain near the FOMC's target rate in light of the estimated imbalance between supply and demand. If the funds rate is likely to move away from the target rate, then the Desk will arrange short-term repurchase agreements, which add balances, or reverse repurchase agreements, which drain balances, to better align the supply of and demand for balances. If the funds rate is likely to remain close to the target, then the Desk will not arrange a short-term operation. Short-term temporary operations are much more common than outright transactions because daily fluctuations in autonomous factors or the demand for excess reserve balances can create a sizable imbalance between the supply of and demand for balances that might cause the federal funds rate to move significantly away from the FOMC's target.

Reserve requirements have long been a part of America's banking history. Depository institutions maintain a fraction of certain liabilities in reserve in specified assets. The Federal Reserve can adjust reserve requirements by changing required reserve ratios, the liabilities to which the ratios apply, or both. Changes in reserve requirements can have profound effects on the money stock and on the cost to banks of extending credit and are also costly to administer; therefore, reserve requirements are not adjusted frequently. Nonetheless, reserve requirements play a useful role in the conduct of open market operations by helping to ensure a predictable demand for Federal Reserve balances and thus enhancing the Federal Reserve's control over the federal funds rate.

Requiring depository institutions to hold a certain fraction of their deposits in reserve, either as cash in their vaults or as non-interest-bearing balances at the Federal Reserve, does impose a cost on the private sector. The cost is equal to the amount of forgone interest on these funds--or at least on the portion of these funds that depository institutions hold only because of legal requirements and not to meet their customers' needs.

The burden of reserve requirements is structured to bear generally less heavily on smaller institutions. At every depository institution, a certain amount of receivable liabilities is exempt from reserve requirements, and a relatively low required reserve ratio is applied to receivable liabilities up to a specific level. The amounts of receivable liabilities exempt from reserve requirements and subject to the low required reserve ratio are adjusted annually to reflect growth in the banking system. Changes in reserve requirements can affect the money stock, by altering the volume of deposits that can be supported by a given level of reserves, and bank funding costs. Unless it is accompanied by an increase in the supply of Federal Reserve balances, an increase in reserve requirements (through an increase in the required reserve ratio, for example) reduces excess reserves, induces a contraction in bank credit and deposit levels, and raises interest rates. It also pushes up bank funding costs by increasing the amount of non-interest-bearing assets that must be held in reserve. Conversely, a decrease in reserve requirements, unless accompanied by a reduction in Federal Reserve balances, initially leaves depository institutions with excess reserves, which can encourage an expansion of bank credit and deposit levels and reduce interest rates.

In the 1960s and 1970s, the Federal Reserve actively used reserve requirements as a tool of monetary policy in order to influence the expansion of money and credit partly by manipulating bank funding costs. As financial innovation spawned new sources of bank funding, the Federal Reserve adapted reserve requirements to these new financial products. It changed required reserve ratios on specific bank liabilities that were most frequently used to fund new lending. Reserve requirements were also imposed on other, newly emerging liabilities that were the functional equivalents of deposits, such as Eurodollar borrowings. At times, it supplemented these actions by placing a marginal reserve requirement on large time deposits --that is, an additional requirement applied only to each new increment of these deposits.

As the 1970s unfolded, it became increasingly apparent that the structure of reserve requirements was becoming outdated. At this time, only banks that were members of the Federal Reserve System were subject to reserve requirements established by the Federal Reserve. The regulatory structure and competitive pressures during a period of high interest rates were putting an increasing burden on member banks. This situation fostered the growth of deposits, especially the newly introduced interest-bearing transaction deposits, at institutions other than member banks and led many banks to leave the Federal Reserve System. Given this situation, policy makers felt that reserve requirements needed to be applied to a broad group of institutions for more effective monetary control--that is, to strengthen the relationship between the amount of reserves supplied by the Federal Reserve and the overall quantity of money in the economy.

The Monetary Control Act of 1980 (MCA) ended the problem of membership attrition and facilitated monetary control by reforming reserve requirements. Under the act, all depository institutions are subject to reserve requirements set by the Federal Reserve, whether or not they are members of the Federal Reserve System. The Board of Governors may impose reserve requirements solely for the purpose of implementing monetary policy. The required reserve ratio may range from 8 percent to 14 percent on transaction deposits and from 0 percent to 9 percent on non-personal time deposits. The Board may also set reserve requirements on the net liabilities owed by depository institutions in the United States to their foreign affiliates or to other foreign banks. The MCA permits the Board, under certain circumstances, to establish supplemental and emergency reserve requirements, but these powers have never been exercised.

Following the passage of the MCA in 1980, reserve requirements were not adjusted for policy purposes for a decade. In December 1990, the required reserve ratio on non-personal time deposits was pared from 3 percent to 0 percent, and in April 1992 the 12 percent ratio on transaction deposits was trimmed to 10 percent. These actions were partly motivated by evidence suggesting that some lenders had adopted a more cautious approach to extending credit, which was increasing the cost and restricting the availability of credit to some types of borrowers. By reducing funding costs and thus providing depository institutions with easier access to capital markets, the cuts in required reserve ratios put depository institutions in a better position to extend credit.

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