The Fed’s primary role is to formulate monetary policy, that is, to regulate the growth of the money supply and thus control the cost and availability of money.
By exerting its influence over the monetary system of the United States, the Fed performs a unique and important function: promoting economic stability. It is noteworthy that the System’s broad powers of economic stabilization and monetary control were not in place when the Fed was created in 1913.
At that time, the system was to perform the following functions: to reduce and expand the money supply according to economic conditions, to serve as a bank in times of economic crisis, to create a more effective control system, and to establish a more effective regulatory system.
Many of these responsibilities initially fell to the 12 central banks, but as responsibility for the monetary system expanded, power was concentrated at BOG. Today, the Fed’s responsibilities can be described as monetary policy, supervisory and regulatory, and services to depository institutions and the government.
Public discussions of Fed operations almost always focus on dynamic actions that stimulate or suppress economic activity or the price level. We should recognize, however, that this area is only a small part of the Federal Reserve System’s continuing operations.
Far more significant in terms of time and effort are the defensive and accommodative tasks. Defensive activities are those that contribute to the smooth, day-to-day functioning of the economy. In the economy, unexpected developments and shocks occur all the time. If these events are not countered with appropriate monetary policy measures, disruptions may occur.
Large, unexpected shifts of capital out of or into the country and very large financing efforts by large corporations can significantly alter banks’ reserve positions. Takeovers and acquisitions of one company by another that are financed by banks also affect reserve positions.
In our competitive market system, unexpected developments contribute to the vitality of our economy. Monetary policy, however, has a special responsibility to smoothly absorb these events and prevent many of their traumatic short-term effects.
The accommodative function of the nation’s monetary system is the one with which we are most familiar. Meeting the credit needs of individuals and institutions, clearing checks, and supporting depository institutions are all accommodative activities.
The basic policy instruments of the Fed that allow it to increase or decrease the money supply are, as follows:
- Changing reserve requirements
- Changing the discount rate
- Conducting open-market operations
In recent years, the Fed has also engaged in a nontraditional monetary policy:
- Quantitative easing
We will first cover traditional policy tools and then discuss the use of quantitative easing.
The Fed sets reserve requirements for depository institutions (i.e., banks), determines the interest rate at which it lends to banks, and conducts open market operations. By setting reserve requirements, the Fed sets the maximum amount of deposits that the banking system can support with a given level of reserves.
The level of reserves can be directly affected by open market operations, resulting in a contraction or expansion of deposits in the banking system. Discount or interest rate policies on loans to banks also affect the availability of reserves to banks and influence the way they adjust to changes in their reserve positions.
Thus, the Fed has a number of tools at its disposal that allow it to influence the size of the money supply in order to achieve the Fed’s broader economic objectives.
The United States banking system is a fractional reserve system because banks are required by the Fed to hold reserves equal to a specified percentage of their deposits. Bank reserves are defined as vault balances and deposits held at Reserve Banks.
The reserve requirement is the minimum amount of bank reserves that banks must maintain. The reserve ratio is the percentage of deposits that must be held as reserves. If a depository institution has reserves in excess of the required amount, it may lend them out.
In this way, institutions earn a return, and in this way, the money supply is also expanded. In our fractional reserve system, control of the volume of checkable deposits depends primarily on reserve management.
The banking system has excess reserves when bank reserves are greater than required reserves. The closer the banking system keeps its reserves to the required minimum, the more the Fed can control the money creation process through its other tools.
When the banking system has a minimum level of reserves (i.e., when excess reserves are close to zero), a reduction in reserves forces the system to tighten credit. When there is a substantial excess of reserves, the pressure of a reduction in reserves is not felt as strongly. When reserves are added to the banking system, depositors can expand their lending, but they are not forced to do so.
However, because depository institutions receive low-interest rates on reserves, they are motivated to lend excess reserves as much as is consistent with their liquidity requirements in order to maximize profits. When interest rates are high, this motivation is particularly strong.
The ability to change reserve requirements is a powerful tool that the Fed rarely uses. For a number of reasons, the Fed prefers to change reserves through open market operations rather than changing reserve requirements. When the reserve requirement is changed, the maximum amount of deposits that can be covered by a given level of reserves changes.
It is possible to reduce total deposits and the money supply by increasing reserve requirements while holding the dollar amount of reserves constant. Lowering reserve requirements creates the basis for an expansion of money and credit.
It has been argued that “changing reserve requirements” is too powerful an instrument and that its use as a policy tool would destabilize the banking system.
The institutional arrangements by which the banking system adjusts to changing reserve levels might not respond as effectively to changing reserve requirements.
Another advantage of open market operations is that they can be conducted unobtrusively, whereas a change in reserve requirements requires a public announcement. The Fed believes that some of its actions would be met with resistance if they came to the public’s attention.
Changing reserve requirements have been used as a policy tool on occasion. In the late 1930s, the nation’s banks were in an excessively liquid position because of excessive reserves. Banks had large amounts of loanable funds that businesses were unwilling or unable to lend because of the ongoing depression.
The reserves were so large that the Fed could no longer resolve the situation with its other policy tools. Therefore, it substantially increased reserve requirements to absorb the excess reserves in the banking system.
Reserve requirements were lowered during the World War II, to ensure sufficient lending to finance the war effort. However, they were raised again in the postwar period to absorb excess reserves.
In the 1950s and early 1960s, reserve requirements were lowered several times during recessions. In each case, the reduction made excess reserves available to encourage bank lending, facilitate lending, and stimulate the economy.
By using this policy tool, the Fed publicly announced its intention to facilitate lending in hopes of boosting confidence in the economy.
In the late 1960s and 1970s, reserve requirements were selectively changed to restrict lending as the banking system experimented with new ways to circumvent Fed controls. Banks used more tradable certificates of deposit, Eurodollar bonds, and other sources of reserve funds. This prompted the Fed to rein in banks by manipulating reserve requirements for certain liabilities.
The evolution of the banking system eventually led Congress to pass the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980, which significantly changed reserve requirements throughout the financial system.
Until that time, the Fed had control only over the reserve requirements of its members. Nonmember banks were subject to reserve requirements set by their own states, and there were significant differences among the states.
As checks drawn on member banks were deposited at nonmember banks and vice versa, funds were shifted among banks whose deposits were subject to different reserve requirements. This reduced the Fed’s control over the money supply.
The 1980 Act applied uniform reserve requirements to all banks with certain types of accounts. For banks that were members of the Fed, these requirements are generally lower now than before the Act. In general, the reserve requirement for the first $50 million in deposits in transaction accounts at a depository institution is 3 percent.
For deposits over $50 million, the reserve requirement is 10 percent, reduced from 12 percent in April 1992. The “break point” between the 3 percent and 10 percent rates is changed each year based on the percentage change in transaction accounts at all depository institutions.
In general, transaction accounts include deposits from which the account holder may make withdrawals to make payments to third parties or others. Accounts where the number of withdrawals per month is limited are considered savings accounts and not transaction accounts.
Banks and other deposit-taking institutions with high balances in transaction accounts must therefore hold a correspondingly higher percentage of reserves.
Let us illustrate this point by assuming that reserve requirements will be 3 percent on the first $50 million of transaction account balances and 10 percent on amounts above $50 million. Suppose First Bank has $50 million in transaction account balances, while Second Bank has $100 million.
What are the dollar amounts of required reserves for each bank? What percentage of required reserves relative to total transaction deposits must each bank hold?
Note that First Bank was required to hold only 3 percent of its $50 million in transaction accounts as reserves, while Second Bank was required to hold 6.5 percent of its $100 million in transaction accounts as reserves.
Depository institutions with even larger transaction account balances must hold proportionately higher reserves. As a result, their percentage of reserves relative to total transaction accounts will be closer to 10 percent.
A change in reserve requirement percentages on large transaction account balances has the most impact. For example, if the reserve requirement for transaction balances greater than $50 million is increased from 10 percent to 12 percent, Second Bank would have reserve requirements of $7.5 million—or 7.5 percent of its $100 million in transaction accounts.
The required reserves on the second $50 million increase to $6 million, which is the result of multiplying $50 million times 12 percent. Adding the $1.5 million on the first $50 million in transaction accounts and the $6 million on the second $50 million results in total required reserves of $7.5 million, which is 7.5 percent of the total transaction accounts of $100 million.
Thus, it should be evident that even a small change in reserve requirements is likely to have a major impact on the money supply and economic activity.
Discount Rate Policy
The Fed serves as a lender to depository institutions. Banks can borrow money at the Fed’s “discount window” to meet reserve requirements, withdraw deposits, and even make business loans. The Fed’s discount rate is the interest rate that a bank or other depository institution must pay when it borrows money from its regional Federal Reserve Bank.
The Federal Reserve Banks currently offer three discount window programs, referred to as primary loans, secondary loans, and seasonal loans. The primary lending rate is the Fed’s main discount window program, and in practice its rate is used interchangeably with the term “discount rate.”
Although each Fed bank sets its own discount rate, in recent years the rates have been similar at all 12 Reserve Banks. The Fed sets the interest rate on these loans to banks and thus can influence the money supply by raising or lowering the cost of borrowing from the Fed.
Higher interest rates discourage banks from borrowing, while lower rates encourage borrowing. Higher borrowing allows banks to expand their assets and deposit holdings, and vice versa.
Lending to depository institutions by central banks can take two forms. One way is for the borrowing institution to receive an advance or loan secured by its own promissory bill along with the “eligible securities” it holds.
In the second option, the borrower can discount or sell its eligible paper to the Reserve Bank. Eligible paper includes U.S. government and federal agency securities, promissory bills, mortgages of acceptable quality, and bankers’ acceptances. This discounting process underlies the use of the terms “discount window” and “discount rate policy.”
The discount rate policy was originally intended to work as follows. If the Fed wanted to cool an inflation boom, it would raise the discount rate. An increase in the discount rate would lead to a general increase in borrowing rates, which would reduce the demand for short-term credit for restocking inventories and accounts receivable.
This, in turn, would lead to a postponement of the construction of new production facilities, thus reducing demand for capital goods. As a result, income growth would slow. Over time, income would fall and with it demand for consumer goods.
Holders of credit-financed inventories would liquidate their stocks in an already weak market. The resulting drop in prices would tend to stimulate demand for goods and reduce supply. In this way, economic equilibrium would be restored. A reduction in the discount rate should have the opposite effect.
Discount policy is no longer an important instrument of monetary policy and is now considered more of an adjustment or fine-tuning mechanism. As an adjustment mechanism, the discount regime provides some protection for depository institutions, as other aggressive control measures can be temporarily mitigated by banks’ ability to borrow.
For example, the Fed can take a highly restrictive stance through open market operations. Individual banks can counter the pressure by borrowing from their reserve banks. Central banks are willing to tolerate what appears to be a failure of their efforts while banks adjust to the pressure exerted. If they do not reduce their borrowing, they can always counteract by further open market actions by the Fed.
The most commonly used instrument of monetary policy is open market operations, i.e., the purchase and sale of securities in the “open market” by the Fed through its Federal Open Market Committee (FOMC) to alter bank reserves.
The Fed can buy securities to provide additional reserves to the banking system or sell securities to reduce bank reserves. You may ask, “Where does the Fed get the securities to sell?” A quick look at the Fed’s balance sheet will give you the answer.
The Fed’s assets are held primarily in the form of U.S. Treasury securities, government bonds, and mortgage-backed securities, which generally account for more than 85 percent of total assets. Coins and cash in the process of collection account for about 2 percent of total assets.
The remainder consists of assets that include gold certificates and Fed buildings. Federal Reserve notes account for nearly 90 percent of the Fed’s total liabilities and capital. Deposits in the form of depository institution reserves held at Reserve Banks account for about 7 percent of the total.
Other liabilities, notably deposits of the U.S. Treasury and capital in the form of stock purchased by member banks and surplus from operations, account for the remaining liabilities and capital.
The original Federal Reserve Act did not provide for open market operations. However, to maintain the stability of the money supply, this policy tool evolved from the experience of central banks in the early years of the Fed’s operations. Unfortunately, these early efforts were not well coordinated.
The Reserve Banks bought Treasury securities with the funds at their disposal to earn money to cover expenses and to make a profit and pay dividends on the stock held by member banks. All 12 Reserve Banks usually bought and sold the securities in the New York market. Sometimes their combined sales were so large that they upset the market.
In addition, the funds used to buy the bonds ended up with the New York member banks, allowing them to reduce their borrowing from the Reserve Bank of New York. This made it difficult for the Reserve Bank of New York to maintain effective credit control in its area.
As a result, an Open Market Committee was established to coordinate the buying and selling of government bonds. The Federal Open Market Committee was legally established in 1933. In 1935, its current composition was established: the Federal Reserve BOG and five of the presidents of the 12 Reserve Banks, serving on a rotating basis.
Open market operations have become the most important and effective means of monetary and credit control. These operations can take funds out of the market, raising short-term interest rates and helping to contain inflationary pressures, or they can provide easy money conditions and lower short-term interest rates.
Of course, such loose monetary policy does not necessarily cause the economy to recover after a recession. In conjunction with discount rate policy, open market operations are basically an effective means of restricting or facilitating credit.
Open market operations differ from discount operations in that they increase or decrease bank reserves at the initiative of the Fed, not individual banking institutions. In simplest terms, the process works as follows. When the Federal Open Market Committee wants to buy Treasury securities, it solicits bids from dealers and then accepts the best offers that meet its needs.
Dealers receive wire transfers for the securities from the Reserve Banks. These credits are deposited with member banks. The member banks, in turn, receive credit for these deposits at their Reserve Banks. In this way, new bank reserves are created, providing the basis for further credit expansion. The Fed generally limits its purchases to U.S. government securities, primarily because of their liquidity and safety.
When the Fed wants to reduce bank reserves, it sells Treasury securities to dealers. Dealers pay for this by transferring funds from a depository institution to a Reserve Bank. The Reserve Bank then deducts the amount from the reserves of the depository institution.
Open market operations do not always lead to an immediate change in the volume of deposits. This is particularly true when bonds are sold to limit deposit growth.
When bonds are sold by central banks, some banks lose their reserves and are forced to borrow from their central bank. Since they are under pressure from the Fed to repay the loans, they use funds from maturing loans to repay the Reserve Bank. Thus, lending can be gradually constrained by the adjustments banks must make in open market operations.
Quantitative easing (QE) is a nontraditional monetary policy approach to stimulate economic activity when conventional monetary policy methods are ineffective. The Fed buys financial assets from banks and other financial institutions with newly created money, resulting in greater excess reserves at banks and increased money supply and liquidity.
In response to the financial crisis and the Great Recession, which was followed by relatively slow economic growth, the Fed initiated three rounds (QE1, QE2, and QE3) of quantitative easing.
QE1 was initiated in late 2008, when the Fed began large-scale purchases of mortgage-backed securities and government bonds from banks. These measures helped prevent a collapse of the financial system and supported the recovery from the Great Recession.
However, the slowdown in economic activity in 2010 led the Fed to announce QE2, which involved the purchase of an additional $600 billion in Treasury securities.
In an effort to provide further monetary liquidity to stimulate economic growth, QE3 was initiated in September 2012, when the Fed said it planned to purchase $40 billion worth of mortgage-backed securities each month for the foreseeable future. In December 2015, the Fed announced that it was beginning a process of monetary policy normalization that would lead to higher interest rates.
Implementation of Monetary Policy
Monetary policy has traditionally focused either on trying to control the rate of change or growth of the money supply (such as M1) or on setting a specific interest rate. One interest rate that the Fed’s FOMC might focus on is the federal funds rate, the rate on overnight loans from banks with excess reserves to banks that have deficit reserves.
Open market purchases of securities increase bank reserves and increase the money supply. Sales of securities decrease reserves and the money supply.
However, if the target is the money supply, interest rates can fluctuate widely because the demand for money can change relative to a given money supply target. In addition, a focus on the money supply may not have the desired effect on GDP because of changes in the velocity of money in circulation.
In recent years, the Fed, through its FOMC, has chosen to focus on setting target interest rates for the federal funds rate as the primary means of conducting monetary policy. Banks with excess reserves lend to banks that need to borrow money to meet reserve requirements.
Interest rates, such as the federal funds rate, reflect the intersection of the demand for reserves and the supply of reserves. Open market purchases of securities cause the federal funds rate to fall, while sales of securities cause the rate to rise.
Of course, the FOMC can set targets for the federal funds rate, but actual federal funds rates are determined in the market by banks with excess reserves and by banks that need to borrow reserves to meet their reserve requirements.
The Fed uses its open market operations to provide liquidity to the banking system in times of need. For example, the stock market crash of October 19, 1987, triggered concerns about a possible economic collapse. The Fed acted quickly to increase the money supply through the FOMC’s open market purchases.
The terrorist attacks of September 11, 2001, triggered widespread concern about whether stock and other financial markets would function properly in the near future and whether an economic collapse could occur.
The FOMC acted quickly to provide liquidity to the banking system and restore confidence in the financial system by lowering the target federal funds rate from 3.5 percent to 3.0 percent on September 17, 2001.
In 2001, the FOMC further lowered its target federal funds rate to 2.5 percent on October 2, to 2.0 percent on November 2, and finally to 1.75 percent on December 11.
On November 6, 2002, the target rate was lowered to 1.25 percent, followed by another reduction in the target rate to 1.0 percent on June 25, 2003. As the U.S. economy began to grow, concern shifted to the possibility of renewed inflation, prompting the Fed to raise the target rate for the federal funds rate in 2004.
Although the target for the federal funds rate was 5.25 percent at the end of 2006, target rates were quickly lowered as the financial crisis developed in 2007-08 and the Great Recession began in 2008-09. In December 2008, the FOMC set a target range for the federal funds rate between 0.00 and 0.25 percent, which is close to zero.
This target range of 0.00to 0.25 percent was maintained until December 2015, when the target for the federal funds rate was raised to 0.25to 0.50 as a first step toward normalizing monetary policy.
Data on actual federal funds rates collected by the St. Louis Fed Reserve Bank show a close correlation between target rates and observed rates over the 2008-2015 period, with year-end effective federal funds rates in December ranging from 0.07 to 0.24 percent.
The 0.24 percent level was reached in December 2015, when the FOMC announced an increase in the target for the federal funds rate. Due to the severity of the 2007-08 financial crisis and the onset of the Great Recession, the Fed took unusual measures to avoid a potential financial collapse. In addition to setting the federal funds rate at near zero in December 2008, the Fed took a nontraditional monetary policy measure known as quantitative easing in late 2008.
As described in the previous section, the Fed aggressively purchased U.S. Treasury bonds, government securities, and mortgage-backed securities from banks and other financial institutions to inject even more liquidity into the financial system.
The second round of quantitative easing was implemented in 2010 and the third round in 2012 to stimulate economic growth through further monetary liquidity.