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Central banking and the Fed
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Student balance sheets
Generally good job
Make sure you understand:
- If Liab > Assets, NW is negative
- Do not include future income on balance sheet.
- Income (flow) v assets (stock)
- Include depreciated capital
(computer = $1000, depreciation = $600, value of K = $400)
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Money and finance: The superstars of all time
Irving Fisher, Yale
(1867-1947)
Milton Friedman, Chicago
(1912-2006)
James Tobin, Yale
(1918-2002)
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How the Fed influences financial markets
• Supply of money and reserves determined by central bank (Fed,
ECB, …)
• Demand for transactions money (M1) from medium of exchange;
• Equilibrium of supply and demand for money/reserves → shortterm nominal risk-free interest rate.
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iff
DR
SR
-Supply and demand
diagram for federal funds
on daily basis
Federal funds
interest rate
- Fed supplies funds
through its open market
operations (OMOs)
iff*
DR
SR
R*
Bank reserves
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Actual Financial Balance Sheets (pre-crisis 2008:Q1)
Central Bank
Assets
Securities
Loans
from
banks
Other
Total
Commercial banks
Liabilities
631
151
150
932
Cu
770
Bank Reserves
Vault
Cash
Deposits
Other
Total
66.9
46
21
Assets
Liabilities
Reserves
Checkable
deposits
66.9
568
Govt sec.
1111
Savings
accounts
Mortgages
3683
Other
4442
Other
6613
Equity
920
5544
95.1
932
Total
11,474
Total
11,474
Note: the current Fed balance sheet is extremely different and not
representative, so I have used an older balance sheet.
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Actual Financial Balance Sheets (pre-crisis 2008:Q1)
Central Bank
Assets
Securities
Loans
from
banks
Commercial banks
Liabilities
631
151
Cu
Bank Reserves
770
66.9
Assets
Liabilities
Reserves
Checkable
deposits
66.9
Govt sec.
1111
Savings
accounts
Mortgages
3683
Other
Banks are required toVault
hold reserves against transactions
balances.
Other
150
Cash
46
Other
6613 Equity
Reserves are
Total
Deposits
21
cash Other
plus deposits
932
Total
568
5544
4442
920
at95.1
the Fed.
932
Total
11,474
Total
11,474
Normally, R = hD, where h is required reserve ratio.
Note: the current Fed balance sheet is extremely different and not
representative, so I have used an older balance sheet.
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Mechanics of OMO: The Fed buys a security…
Fed
Commercial banks and primary dealers
Assets
Bonds
Liabilities
1000
Bank borrowings
0
Cu
Assets
900
Reserves (bank
deposits)
100
Liabilities
Reserves (bank
deposits)
100
Investments
1000
Checkable
deposits
Equity
1000
100
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… and this increases reserves …
Fed
Commercial banks and primary dealers
Assets
Bonds
Liabilities
1000
+10
Bank borrowings
0
Cu
Assets
900
Reserves (bank
deposits)
100
+10
Liabilities
Reserves (bank
deposits)
100
+10
Investments
Checkable
deposits
1000
-10
Equity
1000
100
1. Fed buys bond.
2. Dealer deposits funds in bank.
3. This creates a credit in the account of the bank at the Fed and
voilà! the Fed has created reserves. (red)
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… and normally this increases investments and M
Fed
Commercial banks and primary dealers
Assets
Bonds
Liabilities
1000
+10
Bank borrowings
0
Cu
Assets
900
Reserves (bank
deposits)
100
+10
Reserves (bank
deposits)
100
+10
Liabilities
Checkable
deposits
Investments
1000
+100 -10
1. Fed buys bond.
2. Dealer deposits funds in bank.
3. This creates a credit in the account of the bank at the Fed and
voilà! the Fed has created reserves. (red)
4. In normal times, the bank lends out the excess, and this leads
to money creation (blue). Today, this just increases reserves.
Equity
1000
+100
100
10
iff
DR
SR
S’R
Increase in
reserves lowers
federal funds
interest rate
Federal funds
interest rate
iff*
iff**
DR
SR
R*
Bank reserves
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How does the Fed actually administer monetary policy?
1.
2.
3.
4.
Federal Open Market Committee (FOMC) meets 8 times
per year to determine the appropriate monetary policy.
FOMC = 7 Governors + 5 voting Presidents of regional
Federal Reserve Banks + 7 non-voting Presidents.
In “normal times,” major Fed instrument is the federal
funds target interest rate. This is the overnight interest
rate on bank reserves lent and borrowed by banks.
The primary decision is the target rate for the federal
funds rate.
- E.g., in July 2013: “.. the Committee decided to keep the target
range for the federal funds rate at 0 to ¼ percent.”
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5. Actual mechanism:
•
•
•
•
•
Open market operations are arranged by the Domestic Trading Desk
at the Federal Reserve Bank of New York (“the Desk”)
Every morning, staff decided if an OMO is needed to keep rate near
target.
Fed contacts the “primary dealers” (e.g., Goldman Sachs, BNP Paribas,
Morgan Stanley, etc.) and asks them to make offers
Fed generally makes temporary purchases (“repos” = purchase and
forward sale, or the reverse) at 10:30 each day, but generally does not
enter more than once per day.
Because the Fed intervenes only daily, the FF rate can deviate from the
target.
6. Then supply and demand
for reserves take over
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iff
DR
Supply and demand
diagram for federal
with interest rate
target
Federal funds
interest rate
Federal funds rate target
iff*
DR
Bank reserves
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iff
DR
Supply and demand
diagram for federal with
interest rate target
Federal funds
interest rate
Federal funds rate target
iff*
DR
Bank reserves
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Today’s zero interest and excess reserves
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iff
DR
SR
S’R
Federal funds
interest rate
iff*
iff**
DR
SR
R*
Bank reserves
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When Fed buys reserves today,
it just increases excess reserves
Fed
Commercial banks and primary dealers
Assets
Bonds
Liabilities
1000
+10
Bank borrowings
0
Cu
Assets
900
Reserves (bank
deposits)
100
+10
Liabilities
Reserves (bank
deposits)
100
+10
Investments
1000
-10
Checkable
deposits
Equity
1000
100
1. Fed buys assess backed mortgage (from bank for simplicity)
2. Bank is glad to unload it, and just holds excess reserves.
3. No impact on the money supply or on federal funds rate. A (very
small) impact on mortgage interest rates.
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The federal funds rate hits the zero lower bound
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Excess reserves
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Make sure you understand this graph!
3,600
9
8
Excess reserves
Federal funds rate
2,800
7
2,400
6
2,000
5
1,600
4
1,200
3
800
2
400
1
0
0
90
92
94
96
98
00
02
04
06
08
10
Fed funds rate (%)
Excess Reserves (billions)
3,200
12
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Recent Fed policies
• The Fed has taken many steps to stimulate the economy after
the deep recession. But the economy was growing slowly, and
unemployment was still high.
• What would you do?
• It decided to undertake “Operation Forward Guidance.”
• This involved making statements about future Fed policy (see
next slide).
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Operation Forward Guidance
June 2011:
The Committee decided today to keep the target range for the federal
funds rate at 0 to 1/4 percent. The Committee continues to
anticipate that economic conditions--including low rates of resource
utilization and a subdued outlook for inflation over the medium
run--are likely to warrant exceptionally low levels for the federal
funds rate for an extended period.
July 2013:
the Committee decided to keep the target range for the federal funds
rate at 0 to 1/4 percent and currently anticipates that this
exceptionally low range for the federal funds rate will be
appropriate at least as long as the unemployment rate remains
above 6-1/2 percent, inflation between one and two years ahead is
projected to be no more than a half percentage point above the
Committee's 2 percent longer-run goal, and longer-term inflation
expectations continue to be well anchored.
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Impact of forward guidance on 8/9/2011 on interest rates
3.00
Treasury rates
2.50
Before 8/9
2.00
After 8/9
1.50
1.00
0.50
1 mo 3 mo 6 mo
1 yr
2 yr
3 yr
5 yr
7 yr
10 yr
Maturity
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Recent term structure interest rates (Treasury)
5
4
3
2
1
Expectations theory
says that short
rates are expected
to rise in coming
years.
Note that this can
explain why Fed
makes statement
about future rates
(look back at Fed
statement.)
0
25
Yield to maturity (% per year)
Older term structure interest rates (Treasury)
20
9/18/2009
9/17/2008
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9/19/2006
May-81
In period of very
tight money (198182) short rates
were very high, and
people expected
them to fall.
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14
12
10
8
6
4
2
0
0
5
10
15
20
25
30
Term or maturity of bond
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Note on theory of the term structure
Many businesses and households borrow risky long-term
(mortgages, bonds, etc.).
These differ from the federal funds rate in two respects:
- term structure (discuss now)
- risk premium (postpone)
The elementary theory of the term structure is the
“expectations theory.”
It says that long rates are determined by expected future
short rates.
Two period example (where rt,T is rate from period t to T):
(*)
(1+r0,2)2 = (1+r0,1) [1+E(r1,2)]
With risk neutrality and other conditions, (*) determines
term structure. (Finance people find many deviations, but
good first approximation.)
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Example
Short rates:
1 year T-bond =
0.41 % per year
2 year T-bond =
1.03 % per year
Implicit expected future rate from 1 to 2 is:
(1+r0,2)2 = (1+r0,1) [1+E(r1,2)]
(1+.0103)2 = (1+ .0041) [1+E(r1,2)]
This implies:
E(r1,2) = 1.65 % per year
[Again, finance specialists point to deviations from this simple
theory.]
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So what was the purpose of Operation Forward Guidance?
To lower long run interest rates by lowering expected future
short term rates!
Problem for students: Go back to two period example above.
Assume that second period expected rate goes to 0.3%. What
happens to two-period interest rate?
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Fed funds to short rates
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Federal funds rate
3 month Treasury bill rate
8
7
6
5
4
3
2
1
0
90
92
94
96
98
00
02
04
06
08
10
12
30
Short rates to long rates
9
10 year T bond
3 month T bill
8
7
6
5
4
3
2
1
0
90
92
94
96
98
00
02
04
06
08
10
12
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Real interest rate for businesses
Real interest rate for businesses
rb = risky rate – inflation rate
= iff + term premium + risk premium -inflation
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The real interest rate for business:
the cost of capital today is back to normal!
Real interest rate for businesses
10
9
Financial crisis
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7
6
5
4
3
2
1
90
92
94
96
98
00
02
04
06
08
10
12
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