Financing American government

4 The Federal Reserve System

inflation

An increase in the general price level in the economy. Usually measured over a year. See also: deflation, disinflation.

While central banks around the world differ in their precise specific functions and objectives, in most advanced economies, central banks are charged with promoting price stability, managing economic fluctuations, and averting financial crises. That is, they pursue the goals of low and stable inflation, steady growth of the nation’s output, and stability of the nation’s financial infrastructure. They are often politically independent from the rest of the government; this is certainly the case in the United States.

In times of crisis, however, there can be close coordination between the Treasury and the Fed, which is permitted under the ‘unusual and exigent circumstances’ clause of the Federal Reserve Act. We shall consider crisis conditions at a later stage, but begin with a look at monetary policy in ordinary circumstances.

In normal times, most central banks set policy interest rates to target inflation and unemployment. By influencing interest rates, they can control the cost of borrowing and lending and hence the level of aggregate demand in the economy, which affects unemployment and inflation. Such actions taken by central banks to achieve macroeconomic goals fall under the umbrella of conventional monetary policy.

Federal Reserve System

The central bank system of the United States. Source: Federal Reserve Bank of St. Louis Education Glossary.

Federal Open Market Committee (FOMC)

The main monetary policymaking body of the Federal Reserve System. A Committee consists of 12 voting members; the 7 members of the Board of Governors; the president of the Federal Reserve Bank of New York; and, on a rotating basis, the 4 presidents of other Reserve Banks.

In the United States, the role of the central bank is performed by the Federal Reserve System. As the name suggests, this is a system of institutions, consisting of: The Board of Governors, 12 Federal Regional Reserve Banks, and the Federal Open Market Committee (FOMC). The Board of Governors, based in Washington D.C., is an independent agency of the federal government which provides guidance to the entire System and oversees the 12 regional Federal Reserve Banks. Regional Reserve Banks are responsible for the implementation of monetary policy, and regulation and supervision of financial institutions. Finally, the Federal Open Market Committee (FOMC) sets monetary policy in line with its mandate from Congress to promote maximum employment, stable prices, and moderate long-term interest rates in the United States.

The Federal Reserve conducts monetary policy by targeting a key policy interest rate, the federal funds rate. Changes in the federal funds rate are associated with changes in the interest rates that banks charge households and businesses. As a result, during downturns, provided that inflation is low, the Fed can stimulate the economy by lowering the federal funds rate. Prior to 2008, this was done through open market operations, which involved active participation in the secondary market for treasuries. Since then, it has been done through setting the interest rate on commercial bank deposits (reserves) held at the Fed, which now vastly exceed required holdings.

We describe both approaches here since it is entirely possible that at some point in the future there will be a return to open market operations as the primary channel through which monetary policy operates.

To see how open market operations work, we start with a simplified version of the Fed’s balance sheet. A balance sheet is a financial statement that summarizes the assets and liabilities of an organization at any specific point in time. In any balance sheet, the asset side includes the sum of what the institution owns, and the liability side summarizes what it owes to others.

base money

Cash held by households, firms, and banks, and the balances held by commercial banks in their accounts at the central bank, known as reserves. Also known as: high-powered money.

Figure 6a shows a simplified balance sheet for the Federal Reserve. The most important assets are debt securities, specifically government treasuries such as bills and bonds. The liability side of the Fed balance sheet shows currency in circulation and reserves, where the latter quantity refers to deposits held at the Fed by the nation’s commercial banks. Taken together, currency and reserves are referred to as base money.

reserve requirement

The amount of funds that a bank must hold by law at the Federal Reserve. It is expressed as a ratio of bank reserves to checkable deposits.

excess reserves

The amount of funds held by a bank at the Federal Reserve Bank in excess of its reserve requirement.

To ensure financial stability and protect banks from panic-induced withdrawals, commercial bank deposits (up to a maximum amount, currently $250,000) are protected by deposit insurance, which is ultimately guaranteed by the US government. In return, the Federal Reserve regulates the banking sector. Specifically, it requires all banks to hold part of their funds in the form of reserves placed at the central bank. Until recently, commercial banks in the US were required to hold at least 10% of the value of their deposits as reserves, but in March 2020 the Fed abolished this requirement lowering required reserves to zero. In addition to these mandatory minimum reserve requirements, banks can also hold excess reserves at the Fed.

Figure 6b illustrates a simplified balance sheet for one of the largest banking institutions in the United States, JPMorgan Chase. Banks are important financial intermediaries that collect deposits and issue loans to firms and households. As a result, deposits serve as JPMorgan’s liabilities, and loans are the bank’s assets. Like the Federal Reserve, JPMorgan also holds treasuries (along with other securities).

bank money

Money in the form of bank deposits created by commercial banks when they extend credit to firms and households.

Importantly, JPMorgan is required to hold reserves at the Fed. These reserves appear in the first item of the asset side of the balance sheet (Cash and deposits at banks & Fed). As discussed in The Economy 1.0, banks create money through the process of lending. The loans appear on the asset side of the balance sheet, and the deposits, or bank money, on the liability side. As is clear from the balance sheet, bank money vastly exceeds base money in this balance sheet, and for commercial banks more generally.

fed funds market

The market where banks lend and borrow reserves on an overnight basis.

fed funds rate

The overnight interest rate determined by the equilibrium in the fed funds market. This interest rate is also the key monetary policy rate in the US.

Commercial banks must meet their reserve requirements on a daily basis. To make sure that each bank holds sufficient reserves, banks borrow from one another on the interbank market. In the United States, the market for reserves is called the fed funds market. At the end of each day, banks with excess reserves can lend to banks with a shortage of reserves. These loans are overnight and unsecured (borrowing banks do not need to provide any collateral for the loan). The interest rate on the fed funds market is called the fed funds rate.

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https://books.core-econ.org/insights/financing-american-government/04-the-federal-reserve-system.html#figure-7

Figure 7 The fed funds target rates (daily).

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‘Federal funds target rate [DFEDTAR]’, Board of Governors of the Federal Reserve System (US), retrieved from FRED, Federal Reserve Bank of St. Louis, 25 November 2020.

Figure 7 shows the evolution of the fed funds rate since 1982. Prior to 2009, the Fed had a target rate, and after that, a target range with upper and lower limits. Notice in particular the period after the global financial crisis when the lower limit for this rate reached zero, and remained at or close to this for several years. When interest rates in the economy get this low, the Fed loses the ability to meet its mandate by further reductions in rates and is forced to turn to alternative policy levers, as we discussed.

Note that the rate of interest that the government pays on treasury bills, as determined through auction, cannot rise significantly above the fed funds rate. Otherwise, a bank with excess reserves will prefer to buy short-term treasuries rather than lend in the interbank market. Similarly, the rate on notes and bonds cannot rise too far above the fed funds rate, otherwise there will be strong incentives to bid in these markets too. But long-term securities are imperfect substitutes for bills and overnight lending, so some deviation in rates can and does occur.

The Federal Reserve closely monitors conditions in the fed funds market. During regular Federal Open Market Committee (FOMC) meetings, the Fed sets the target rate for the fed funds rate in order to affect bank lending, inflation, and the economy more broadly. The fed funds target rate is the key policy rate of the US central bank and the main tool of monetary policy. In the next section, we explore how exactly this transmission mechanism works.