“…the main person who influences the business cycle is the head of the Federal Reserve Bank.” – Robert Fogel
We’ve been in the midst of a revamped series on the US Federal Reserve, which was originally published in 2013 but recently refreshed for a presentation we gave to the Kissing Camels Coffee and Donuts club. In our last post we looked at the Federal Reserve system as A Three Legged Stool comprised of a Board of Governors, a network of Regional Fed Banks and a Federal Open Market Committee. While that summary provided some more clarity as to the structure of the Fed, this week we turn our attention to the three primary policy tools the Fed has at its disposal in implementing policy.
According to the Federal Reserve’s website, its purpose is "to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates." More simply put the Fed has been given a dual mandate by Congress to promote full employment and low, stable inflation. Policy makers, of course, cannot just go out and affect employment and inflation directly. Rather, they exercise control over variables that may (or may not) have desired knock on effects, thereby indirectly influencing the general level of prices and economic activity.
The term “monetary policy” is used to describe the various actions the Fed takes to achieve these ends. As defined by a popular college textbook, monetary policy is simply “the management of money and interest rates.” In other words the Federal Reserve is tasked with promoting high employment and low inflation via the effective management of money and interest rates. But how? Let’s pull back the curtain on the three primary policy tools the Fed uses to implement policy.
Policy Tool #1: Banking Reserves
The Fed extends its influence in a variety of ways throughout the banking system. One way in particular is by controlling the amount of reserves banks are required to keep on hand. When a bank receives funds from a depositor, they are required to keep a certain amount of those funds in cash reserves in order to meet a reasonable level of expected outflow needs. Once the required amount of reserves have been set aside, the rest of the funds can be lent out for a profit.
This level of required reserves for most banks is currently 10%, meaning that for every dollar a bank receives in deposits it has to reserve 10 cents and can lend out 90 cents. If the Fed were to raise the reserve requirement this would reduce the amount of money available to loan out, thereby shrinking the availability of credit and slowing economic growth. This reduces the money multiplier and shrinks the money supply which is economically linked to the level of prices for goods and services (inflation). Vice versa, if the Fed were to lower the reserve requirement it would free up banks’ capacity to lend, thereby expanding the money supply and allowing for increased economic activity. So changing reserve requirements for banks is one way in which the Fed might hope to impact general economic activity and inflationary pressures.
Policy Tool #2: The Discount Window
The Fed’s second policy tool is called the “discount window” and refers to the Fed’s ability to extend credit directly to member banks as needed. These loans are made available at a rate of interest called the “discount rate” which is set by the Board of Governors. The discount rate is closely tied to, and is often below, the fed funds target rate, so it also serves as a sort of baseline for interest rates throughout the economy. The discount window is only available in specified quantities to banks that meet certain criteria, so in normal financial conditions it plays a limited role in monetary policy. That said, in times of distress the Fed may choose to relax the limits and standards for loans issued through its discount window in order to inject additional liquidity into the banking system. As we’ll see in our next post, the Fed got very creative with its lending capabilities in response to the financial crisis in 2008 and the years following.
Policy Tool #3: Open Market Operations
The final and most important policy tool available to the Fed is open market operations. These operations are the primary way in which the Fed influences interest rates and the money supply. Through its New York trading desk the Federal Reserve acts as an active participant in the open market for a variety of securities. The primary difference between them and any other market participant is that they are able to buy securities with money created “ex nihilo” - out of nothing. Conversely, when they sell securities the money they receive from those sales is effectively removed from the system.
Although the Fed can technically buy and sell a wide variety of securities, in a normal economic environment their open market actions will be constrained to short-term Treasury securities. By buying and selling these securities they are able to control the level of short-term interest rates and influence to a lesser extent mid and long-term rates. Let’s look at how this is accomplished.
For any minimum required level of reserves, a bank’s short-term cash needs will fluctuate based on deposit and transactional activity during the day at that particular bank. Some days the bank will come up slightly short (called a reserve shortfall) and some days it will have a little extra cash (called excess reserves). If a bank needs additional reserves at the end a day to meet the minimum requirement, it can borrow on a short-term basis from another bank who has more than it needs. These overnight loans take place in a private market called the federal funds market, and the interest rate charged on these loans is called the federal funds rate, or simply the “funds rate”.
The funds rate is one of the most important interest rates in finance due to the fact that it acts as a baseline for all other interest rates charged by a bank. Money markets, mortgages, commercial loans, CDs, credit cards – they are all based to some extent off the level of the funds rate. Therefore, a lower funds rate leads to lower prevailing rates on all types of debt throughout the economy.
When we talk about the Fed raising or lowering interest rates we are specifically referring to the federal funds rate. But how does the Fed actually accomplish this? Through open market operations. Quite literally, the Fed controls the funds rate by buying and selling government securities in the open market. By buying securities directly from a bank they replace that security with cash reserves on the bank’s balance sheet. In doing so, they have increased supply and reduced demand for reserves in the federal funds market, thereby putting downward pressure on the rate charged on those reserves (the funds rate). In contrast, by selling securities in the open market they are replacing cash reserves with securities on a bank’s balance sheet, thereby reducing supply and increasing demand for reserves in the federal funds market and putting upward pressure on the funds rate. It’s simple supply and demand. The Fed’s trading desk in New York is continuously operating in the open market in this fashion in order to keep the funds rate at or near its target.
There are a variety of other ways in which the Federal Reserve is active in the open market, but its influence over the funds rate is by far the most important. During the financial crisis not only did the Fed expand its lending activities beyond traditional discount window loans, it also embarked on large scale asset purchase programs that were far outside the norm of its standard open market operations. Such programs, referred to as “quantitative easing”, dominated the headlines and discussion around monetary policy for years following the financial crisis, and we will look at them in more detail in next week’s post.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.