Download Defensive open market operations

Chapter 18
The Tools Of Federal
Reserve Policy
©Thomson/South-Western 2006
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The Federal Reserve Goals and
Tools
 Goals
 influence greater output
 lower the unemployment rate
 prices level stability
 tools of monetary policy or instruments of
monetary policy
 open market operations
 discount window policy
 reserve requirement policy
 intermediate target variables
 short-term interest rates
 monetary aggregates (M1, M2, M3)
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Open Market Operations:
Fundamental Considerations
 Open market operations
 Buying and selling of securities in the open market
 The Fed is empowered to buy or sell



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U.S. Treasury securities
federal agency securities
banker's acceptances
other securities
 If the Fed sells $225 million in U.S. Treasury bills to a
government securities dealer
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Discovery Of Open Market Operations
And The Banking Act Of 1935
 Discovery
 Prior to 1920,the discount window was the only Fed policy
tool,
 The Fed's revenues were only the interest received on the
Fed's discounts loans.
 An early 1920s recession led to a drop in revenue, so
individual Fed banks bought U.S. government securities.
 When banks purchased securities, interest rates fell, and
credit conditions eased.
 The Banking Act of 1935:
 eliminated individual Fed banks’ power to conduct
separate policies, and
 shifted a significant amount of power to the Board of
Governors in Washington, D.C.
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Domain of the Fed's Open
Market Activity
 Federal Reserve's open market operations could be carried
out in any asset.
 To avoid favoritism, politics, and unintentional signals, the Fed only
buys U.S. government and agency securities and banker's
acceptances.
 When the Fed buys $400 million in Treasury bonds and bills
from banks,
 reserves and the monetary base expand dollar-for-dollar, but
 the money supply is not directly or immediately affected.
 This happens when banks initiate the multiple deposit-expansion
process by making loans and buying securities.
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The Effectiveness Of Open
Market Operations
 Impacts of Open Market Operations
 Impact on Bank Reserves, the Monetary Base, and the
Monetary Aggregates:
 The Fed can exert relatively accurate control over bank reserves
and the monetary base by manipulating its security portfolio.
 Impact on Security Prices and Interest Rates (Yields):
 When the Fed buys government securities in the open market, it
bids up security prices and therefore reduces their yields.
 Marketable securities are substitutable, so a decline in government
security yields spills over to yields on other assets.
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Advantages of Open Market
Operations
 Precision:
 firm and accurate control over aggregate bank reserves
and the monetary base, while
 a high degree of accuracy cannot be achieved through
changes in the discount rate or reserve requirements.
 Flexibility:
 in the market each day, buying and selling large quantities
of securities
 very easy for the Fed to alter course
 Source of Initiative:
 The Fed is able to dominate aggregate bank reserves and
the monetary base.
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Early Disadvantages of Open
Market Operations
 Signaling:
 Changes in the discount rate and reserve
requirements are superior to open market
operations in signaling policy changes to the
public.
 Regional Bias:
 Prior to well-developed financial markets, a
regional bias operated in open market operations,
because the effects were concentrated in select
urban areas where security dealers were located;
open market operations did not disperse across
the nation.
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Open Market Operations and the
Federal Funds Rate
 The effects of the Fed's open market
operations transmit very quickly throughout
the nation through the federal funds market.
 The supply of reserves is determined by
Federal Reserve policy.
 When the Fed purchases securities, bank
reserves are boosted dollar-for-dollar.
 When the Fed sells securities, bank reserves
decline dollar-for-dollar.
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Figure 18-1
Purchase of Securities
Federal Funds Rate
S1
S2
4.0
3.5
Demand
Reserves
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Technical Aspects Of Open
Market Operations
 Defensive Operations versus Dynamic
Operations
 Defensive open market operations
 open market operations made for the purpose of
"defending" bank reserves and the monetary base
against the influence of outside forces
 Dynamic open market operations
 open market operations made to deliberately
change the course of economic activity
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Outright Transactions versus
Repurchase Agreements
 Outright transactions
 The Fed uses outright purchases to bring about long-run
or permanent growth in reserves and the monetary
aggregates.
 Repurchase agreements (and reverse repurchase
agreements)
 The Fed uses repurchase agreements (repos) and
reverse repurchase agreements to neutralize the impact
on reserves and the monetary base of transitory changes.
 Recall a repurchase agreement is a money market instrument
wherein one party sells securities with an explicit agreement to buy
them back at a specified future date and price.
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Table 18-1
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The Policy Directive
 Arriving at the Policy Directive
 Eight times annually, FOMC meets in Washington to formulate
monetary policy.
 It issues a policy directive to the manager of the System Open
Market Account.
 Implementation of the Policy Directive
 The manager of the System Open Market Account will:
 9:00 a.m.: contact dealers in government securities to get expectations of
conditions during the day
 10:00 a.m.: receive a report from the Fed staff on the expected movement
of several important factors that influence bank reserves
 10:30 a.m.: phone the U.S. Treasury for forecast on deposits
 mid-morning: get approval from reps from the Board of Governors and
the FOMC
 Implement purchases or sales through TRAPS (Trading Room Automated
Trading System)
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Discount Window Policy
 The discount window is a facility through which the Federal
Reserve district banks lend reserves directly to depository
institutions.
 Discount policy is the set of conditions under which banks are
permitted to borrow reserves and the interest rate charged
(discount rate).
 Categories of Conditions:
 Primary credit- granted to banks in good condition who are permitted to borrow as much
as they want
 discount rate > fed funds rate
 Secondary credit
 provided to troubled banks that are experiencing liquidity problems
 ½ percentage point higher rate
 Seasonal credit
 provided to banks subject to seasonal fluctuations in loan demand—like
agricultural activity
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The 2003 Federal Reserve Change
in Discount Window Policy
 Prior to 2003,
 discount rate < fed funds;
 the Fed had to create policies to discourage overuse of
the discount window, and
 Use was a “privilege” not a “right.”
 After 2003,
 Lombard system
 discount rate > fed funds rate;
 use became a right rather than a privilege, so
 So relatively high discount rate naturally discouraged
overuse of the discount window.
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Figure 18-2
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The Reserve Requirement
Instrument
 Since 1935, the Fed has had the authority to
set and change reserve requirements or
required reserve ratios that banks must
maintain.
 Before 1980, reserve requirements only
existed for member banks, now enforced for
all banks.
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Institutional Aspects of Reserve
Requirements
 The Monetary Control Act of 1980 established
a new structure of reserve requirements for all
banks and thrift institutions.
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Table 18-2
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Institutional Aspects of Bank
Reserve Management
 Reserve Averaging
 Banks must meet the required reserve ratio (on a
daily average) over the settlement period.
 Carryover Allowance
 2% leeway may be carried over one settlement
period.
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The Economic Effects Of Changes In
The Reserve Requirement
 Influence on the Money Supply and Interest Rates
1 k
m1 
rr  re  k
A change in rr has an impact on m1:
Let rr=.1, k=.9, re=.005, then m1=1.891
Let rr=.09, k=.9, re=.005, then m1=1.910
Change in m1 is not as large as it was when
we used naïve multiplier in chapter 14.
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Advantages of the Reserve
Requirement Tool
 Speed of Impact:
 When the Fed changes reserve requirements, all
institutions experience an immediate change in their
excess-reserve position.
 Neutrality:
 Unlike open market operations and discount rate changes,
the impact of reserve requirement changes is spread
across all banks and thrift institutions uniformly.
 Potential Use in an Emergency:
 At rare times when other tools cannot do the job, changes
in reserve requirements may be needed to neutralize
major changes in the monetary base.
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Disadvantages of the Reserve
Requirement Tool
 Bluntness:
 A one percentage point reduction (increase) in the reserve
requirement would release (absorb) $7 billion of excess
reserves.
 Such large changes make this tool too clumsy to be used
regularly.
 Lack of Flexibility:
 Unlike other tools, an early reversal of a previous position
would constitute the Fed making a significant and obvious
admission of error.
 Frequent changes in reserve requirements create
uncertainty for banks.
 Raising the reserve requirement level can trigger liquidity
problems for many banks.
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