How does the Fed influence the equilibrium fed funds rate to
move toward its target rate?
What purpose does the Fed’s discount window now serve?
In practical terms, the Fed engages in two types of OMO,
dynamic and defensive. As those names imply, it uses dynamic
OMO to change the level of the MB, and defensive OMO to offset
movements in other factors affecting MB, with an eye toward
maintaining the federal funds target rate determined by the Federal
Open Market Committee (FOMC) at its most recent meeting. If it
wanted to increase the money supply, for example, it would buy
bonds “dynamically.” If it wanted to keep the money supply stable
but knew that a bank was going to repay a large discount loan
(which has the effect of decreasing the MB), it would buy bonds
“defensively.”
The responsibility for actually buying and
selling government bonds devolves upon the Federal Reserve Bank of
New York (FRBNY). Each trading day, FRBNY staff members look
at the level of reserves, the fed funds target, the actual market
fed funds rate, expectations regarding float, and Treasury
activities. They also garner information about Treasury market
conditions through conversations with so-called primary dealers,
specialized firms and banks that make a market in
Treasuries. With the input and consent of the Monetary Affairs
Division of the Board of Governors, the FRBNY determines how much
to buy or sell and places the appropriate order on the Trading Room
Automated Processing System (TRAPS) computer system that links all
the primary dealers. The FRBNY then selects the best offers up to
the amount it wants to buy or sell. It enters into two types of
trades, so-called outright ones, where the bonds permanently join
or leave the Fed’s balance sheet, and temporary ones, called repos
and reverse repos. In a repo (aka a repurchase agreement), the Fed
purchases government bonds with the guarantee that the sellers will
repurchase them from the Fed, generally one to fifteen days hence.
In a reverse repo (aka a matched sale-purchase transaction), the
Fed sells securities and the buyer agrees to sell them to the Fed
again in the near future. The availability of such self-reversing
contracts and the liquidity of the government bond market render
open market operations a precise tool for implementing the Fed’s
monetary policy.
The so-called discount window, where banks come to borrow
reserves from the Federal district banks, is today primarily a
backup facility used during crises, when the federal funds market
might not function effectively. As noted above, the discount
rate puts an effective cap on ff* by providing banks with an
alternative source of reserves (see Figure 16.4 ). Note that no
matter how far the reserve demand curve shifts to the right, once
it reaches the discount rate, it merely slides along it.
As lender of last resort, the Fed has a responsibility to
ensure that banks can obtain as much as they want to borrow
provided they can post what in normal times would be considered
good collateral security. So that banks do not rely too
heavily on the discount window, the discount rate is usually set a
full percentage point above ff*, a “penalty” of 100 basis points.
(This policy is usually known as Bagehot’s Law, but the insight
actually originated with Alexander Hamilton, America’s first
Treasury secretary, so I like to call it Hamilton’s Law.) On
several occasions (including the 1984 failure of Continental
Illinois, a large commercial bank; the stock market crash of 1987;
and the subprime mortgage debacle of 2007), the discount window
added the liquidity (reserves) and confidence necessary to stave
off more serious disruptions to the economy.
Only depository institutions can borrow
from the Fed’s discount window. During the financial crisis of
2008, however, many other types of financial institutions,
including broker-dealers and money market funds, also encountered
significant difficulties due to the breakdown of many credit
markets. The Federal Reserve responded by invoking its emergency
powers to create additional lending powers and programs,
including the following:www.federalreserve.gov/monetarypolicy
Term Auction Facility (TAF), a “credit facility” that allows
depository institutions to bid for short term funds at a rate
established by auction.
Primary Dealer Credit Facility (PDCF), which provides overnight
loans to primary dealers at the discount rate.
Term Securities Lending Facility (TSLF), which also helps
primary dealers by exchanging Treasuries for riskier collateral for
twenty-eight-day periods.
Asset-Backed Commercial Paper Money Market Mutual Liquidity
Facility, which helps money market mutual funds to meet redemptions
without having to sell their assets into distressed markets.
Commercial Paper Funding Facility (CPFF), which allows the
FRBNY, through a special-purpose vehicle (SPV), to
purchase commercial paper (short-term bonds) issued by nonfinancial
corporations.
Money Market Investor Funding Facility (MMIFF), which is
another lending program designed to help the money markets (markets
for short-term bonds) return to normal.
Most of these programsblogs.wsj.com/economics/2011/08/09/a-look-inside-the-feds-balance-sheet-12/tab/interactive
phased out as credit conditions returned to normal. (The Bank of
England and other central banks have implemented similar
programs.“Credit Markets: A Lifeline for Banks. The Bank of
England’s Bold Initiative Should Calm Frayed Financial Nerves,”
The Economist, April 26, 2008, 74–75.)
The financial crisis also induced the Fed to engage in several
rounds of “quantitative easing” or Large Scale Asset Purchases
(LSAP), the goals of which appear to be to increase the prices of
(decrease the yields of) Treasury bonds and the other financial
assets purchased and to influence the money supply directly. Due to
LSAP, the Fed’s balance sheet swelled from less than a trillion
dollars in early 2008 to almost 3 trillion by August 2011.
Stop and Think Box
What in Sam Hill happened in Figure
16.5 ? (Hint: The dates are important.)
Terrorists attacked New York City and
Washington, DC, with hijacked airplanes, shutting down the nation
and parts of the financial system for the better part of a week.
Some primary dealers were destroyed in the attacks, which also
brought on widespread fears of bankruptcies and bank runs. Banks
beefed up reserves by selling bonds to the Fed and by borrowing
from its discount window. (Excess reserves jumped from a long-term
average of around $1 billion to $19 billion.) This is an excellent
example of the discount window providing lender-of-last-resort
services to the economy.
The discount window is also used to provide moderately shaky
banks a longer-term source of credit at an even higher penalty rate
.5 percentage (50 basis) points above the regular discount
rate. Finally, the Fed will also lend to a small number of
banks in vacation and agricultural areas that experience large
deposit fluctuations over the course of a year. Increasingly,
however, such banks are becoming part of larger banks with more
stable deposit profiles, or they handle their liquidity management
using the market for negotiable certificates of deposit NCDs or
other market borrowings.
key takeaways
The Fed can move the equilibrium fed funds rate toward its
target by changing the demand for reserves by changing the required
reserve ratio. However, it rarely does so anymore.
It can also shift the supply curve to the right (add reserves
to the system) by buying assets (almost always Treasury bonds) or
shift it to the left (remove reserves from the system) by selling
assets.
The discount window caps ff* because if ff* were to rise above
the Fed’s discount rate, banks would borrow reserves from the Fed
(technically its district banks) instead of borrowing them from
other banks in the fed funds market.
Because the Fed typically sets the discount rate a full
percentage point (100 basis) points above its feds fund target, ff*
rises above the discount rate only in a crisis, as in the aftermath
of the 1987 stock market crash and the 2007 subprime mortgage
debacle.