Download The Federal Reserve

The Federal Reserve
By
A.V. Vedpuriswar
Feb 10, 2008
Introduction
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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
Monetary policy tools
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The Federal Reserve controls the three tools of monetary
policy:
Reserve requirements
Open market operations
The discount rate
FOMC
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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
FOMC Press Release Dated January 30,
2008
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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.
Today’s 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.
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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
Recent FOMC statements (Click for all
statements)
Press Release
Release Date: January 30, 2008
For immediate release
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.
Today’s 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.
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.
2008 Monetary Policy Releases
Federal Funds rate
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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%.
Discount rate
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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.
Discount windows
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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
Reserve ratio
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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
Open market operations
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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.
Board of Governors Model
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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
The Beige book
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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.
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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.
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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.
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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.
M1, M2, M3
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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.
Economic indicators
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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.
The Economic Calendar ( Click for full year’s
calendar)
US Economy: Various indicators (Click for
full PDF file)