The Federal Reserve

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The Federal Reserve

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Title: The Federal Reserve


1
The Federal Reserve
  • By
  • A.V. Vedpuriswar

Feb 10, 2008
2
Introduction
  • The Federal Reserve ( The Fed) is the central
    bank of the US.
  • It is widely considered to be the most
    influential central bank in the world.
  • The Fed is quite independent.
  • Unlike other central banks it is a network of 12
    District Federal Reserve Banks.
  • There are six / seven members of the Board of
    Governors of the Federal Reserve System who are
    nominated by the President and confirmed by the
    Senate.
  • A full term is fourteen years. One term begins
    every two years, on February 1 of even-numbered
    years. A member who serves a full term may not be
    reappointed.
  • The president of the Federal Reserve Bank of New
    York serves continuously, while the presidents of
    the other reserve banks rotate in their service
    of one-year terms.
  • Ben S. Bernanke is the current Chairman while
    Donald L. Kohn is the Vice Chairman

3
Monetary policy tools
  • The Federal Reserve controls the three tools of
    monetary policy
  • Reserve requirements
  • Open market operations
  • The discount rate

4
FOMC
  • The  Federal Open Market Committee (FOMC) is the
    branch of the Federal Reserve Board that
    determines the direction of monetary policy.
  • The FOMC consists of twelve members the seven
    members of the Board of Governors of the Federal
    Reserve System the president of the Federal
    Reserve Bank of New York and four of the
    remaining eleven Reserve Bank presidents, who
    serve one-year terms on a rotating basis.
  • The FOMC meets eight times per year to set key
    interest rates, such as the discount rate, and to
    decide whether to increase or decrease the money
    supply.
  •  The meetings of the committee, which are secret,
    are the subject of much speculation on Wall
    Street.
  • Recent press releases illustrate how the FOMC
    takes decisions.

5
FOMC Press Release Dated January 30, 2008
  • The Federal Open Market Committee decided today
    to lower its target for the federal funds rate 50
    basis points to 3 percent.
  • Financial markets remain under considerable
    stress, and credit has tightened further for some
    businesses and households. 
  • Moreover, recent information indicates a
    deepening of the housing contraction as well as
    some softening in labor markets.
  • The Committee expects inflation to moderate in
    coming quarters, but it will be necessary to
    continue to monitor inflation developments
    carefully.
  • Todays policy action, combined with those taken
    earlier, should help to promote moderate growth
    over time and to mitigate the risks to economic
    activity. 
  • However, downside risks to growth remain. 
  • The Committee will continue to assess the effects
    of financial and other developments on economic
    prospects and will act in a timely manner as
    needed to address those risks.

6
  • Voting for the FOMC monetary policy action were
    Ben S. Bernanke, Chairman Timothy F. Geithner,
    Vice Chairman Donald L. Kohn Randall S.
    Kroszner Frederic S. Mishkin Sandra Pianalto
    Charles I. Plosser Gary H. Stern and Kevin M.
    Warsh. 
  • Voting against was Richard W. Fisher, who
    preferred no change in the target for the federal
    funds rate at this meeting.
  • In a related action, the Board of Governors
    unanimously approved a 50-basis-point decrease in
    the discount rate to 3-1/2 percent. 
  • In taking this action, the Board approved the
    requests submitted by the Boards of Directors of
    the Federal Reserve Banks of Boston, New York,
    Philadelphia, Cleveland, Atlanta, Chicago, St.
    Louis, Kansas City, and San Francisco

7
Recent FOMC statements (Click for all statements)
8
Federal Funds rate
  • The interest rate at which a depository
    institution lends immediately available funds to
    another depository institution overnight.
  • This is what news reports are referring to when
    they talk about the Fed changing interest rates.
  • In fact, the FOMC sets a target for this rate,
    but not the actual rate itself (because it is
    determined by the open market).
  • The short end of the yield curve moves up and
    down more than the long end.
  • Monetary policy works with a lag.
  • So anticipation is important.
  • In 1998, the Fed lowered the rate from 5.5 to
    4.75.
  • Between June 1999 and May 2000, the rate went up
    from 4.75 to 6.5.
  • During 2001 and 2002, the Fed brought down the
    rate from 6.5 to 1.
  • In the past 14 weeks, the Fed has cut rates by
    225 basis points from 5.25 to 3.

9
Discount rate
  • The discount rate is the rate that Federal
    Reserve Banks lend to member banks on a temporary
    basis.
  • This helps the banks maintain the appropriate
    level of reserves.
  • The central bank adjusts the supply of currency
    within national borders by adjusting the bank
    rate.
  • When the central bank reduces the bank rate, it
    increases the attractiveness for commercial banks
    to borrow, thus increasing the money supply.
  • When the central bank increases the bank rate, it
    decreases the attractiveness for commercial banks
    to borrow, consequently decreasing the money
    supply
  • Each Federal Reserve Bank sets the discount rate
    for its own region subject to approval from the
    Federal Reserve Board in Washington.
  • This type of borrowing from the Fed is
    fairly limited. 
  • Institutions will often seek other means of
    meeting short-term liquidity needs.

10
Discount windows
  • The Federal Reserve Banks offer three discount
    window programs to depository institutions
  • primary credit - loans are extended for a very
    short term (usually overnight) to depository
    institutions in generally sound financial
    condition. This is what is generally meant by the
    term discount rate
  • secondary credit - Depository institutions that
    are not eligible for primary credit may apply for
    secondary credit to meet short-term liquidity
    needs or to resolve severe financial difficulties
  • seasonal credit is extended to relatively small
    depository institutions that have recurring
    intra-year fluctuations in funding needs, such as
    banks in agricultural or seasonal resort
    communities

11
Reserve ratio
  • Commercial Banks make money by lending out the
    money received from depositors.
  • The Fed requires commercial banks to hold a
    certain amount of these deposits as reserves
  • Reserves are vault cash or deposits at the
    Federal Reserve
  • Required Reserve Ratio (rr)
  • Required Reserves rr x Deposits
  • Max increase in money supply New money /Reserve
    ratio

12
Open market operations
  • The Fed adjusts money supply through buying and
    selling government securities.
  • For example, to tighten the money supply, or
    decrease the amount of money available in the
    banking system, the Fed sells government
    securities.
  • To loosen money supply, it may buy securities.
  • A repo is a temporary measure.
  • It involves the sale (now) and repurchase (later)
    of securities instead of an outright purchase.

13
Board of Governors Model
  • For every 100 basis points cut in Fed funds rate,
    GDP will change by
  • 0.6 at the end of 1 year
  • 1.7 at the end of two years

14
The Beige book
  • Made public in 1983, the Summary of Commentary on
    Current Economic Conditions by Federal Reserve
    District, or Beige Book, rather than being filled
    with raw data, takes a more conversational
    approach.
  • The book has 12 regional reports from each of the
    member Fed district banks, and one national
    summary.. 
  • This is the first chance investors have to see
    how the Fed draws logical and intuitive
    conclusions from the raw data presented in other
    indicator releases.
  • The Beige Book is published eight times per year,
    just before each of the  FOMC meetings.

15
  • The Beige Book aims to give to give a broad
    overview of the economy, bringing many variables
    and indicators into the mix.
  • Discussion will be about things such as labor
    markets, wage and price pressures, retail and
    ecommerce activity and manufacturing output.
  • Investors can see comments that are
    forward-looking
  • The Beige Book will contain comments that look to
    predict trends and anticipate changes over the
    next few months or quarters.
  • Investors and Fed watchers look to the Beige Book
    to gain insight into the next FOMC meeting. 

16
  • Is there language that shows fear about
    inflation?
  • Do the reports suggest that the economy needs a
    financial boost to continue growing?
  • To read the Beige Book effectively, one must
    become accustomed to "Fed speak.
  • Occasionally, the Beige Book will give evidence
    that may contradict what a previous indicator has
    presented the Employment Report may suggest that
    there is slack in the labor market, while Beige
    Book reports may give anecdotal evidence that
    wage pressures are forming, or that certain
    specific labor markets are tight.

17
  • The last thing the Fed wants to do with its words
    is corner itself into a pre-supposed policy
    decision prior to the next FOMC meeting.
  • Investors won't ever see a definitive statement
    about the Fed going one way or the other with 
    monetary policy , but there may be valuable clues
    in the Beige Book .
  • The Fed directors and their staffs will try to
    obtain an economic pulse that can't be found in
    any other indicator's report.
  • They will interview business leaders, bank
    presidents, members of other Fed boards and
    hundreds of other informal networks before
    writing the reports that will be compiled in the
    Beige Book.

18
M1, M2, M3
  • M1 currency in circulation, demand, checkable
    deposits, non bank travellers checks.
  • M2 M1 savings deposits, small denomination
    time deposits, retail money market mutual funds.
  • M3 M2 institutional money funds, large
    denomination time deposits, repurchase
    agreements, Eurodollars.
  • M3 is no longer used.

19
Economic indicators
  • The Fed looks at various indicators while setting
    policy.
  • There is a complete economic calendar of events
    and data releases which are closely monitored by
    analysts and the Fed.
  • See next slide.

20
The Economic Calendar ( Click for full years
calendar)
21
US Economy Various indicators (Click for full
PDF file)