“I think we’re mysterious to people. I think they’re not sure what we do.” - Jeffrey Lacker, Federal Reserve Bank of Richmond
We are excited to be partnering with Liberty Street Films to bring their new documentary, Money For Nothing: Inside The Federal Reserve, to our local community here in Colorado Springs. If you are in the area, please consider joining us on either November 19th or 20th at 7:30pm at the historic Kimball’s Twin Peak Theater downtown. We are in the middle of a four-part series entitled Fed Ed in order to lay the groundwork for a greater understanding and appreciation of the film’s content. In The Genesis we took a look back in time at the events that led to the creation of the Federal Reserve in 1913. Then, in Frankenstein’s Monster we recapped the last 100 years of the Fed’s evolution and proactive involvement in global markets. This week we try to pull back the curtain on the mystery of how the Federal Reserve is structured and its basic operational functions. We will conclude our series next week with a post dedicated to the policy of quantitative easing.
The opening quote from Jeffrey Lacker is actually taken from an interview in Money for Nothing. It’s a sad but true reality that the average American is heavily impacted by the Fed’s policies, but really has very little understanding of what the central bank actually does. Before we get into the nuts and bolts of the Fed’s activities, let’s begin with a brief summary of the various components that make up the central banking system here in the US.
Board of Governors: The Board of Governors (the “Board”) is a government agency based in Washington DC and is at the top of the food chain in the Federal Reserve System. It is comprised of seven members, all appointed by the President and confirmed by the Senate. Each member serves a 14-year term, and the board is led by a Chairman and Vice-Chairman who both serve 4-year terms.
Function: Manage the Federal Reserve system, set banking reserve requirements, and review and determine the discount rate
Federal Open Market Committee: The Federal Open Market Committee (the “FOMC”) is the policy-making branch of the Federal Reserve. The committee is made up of the seven members of the Board and the twelve presidents of the regional Federal Reserve banks. Although all members participate in discussions, voting members include only the seven members of the Board, the President of the Federal Reserve Bank of New York and four other regional bank presidents who take turns serving 1-year terms.
Function: Set monetary policy and direct open market operations to implement that policy
12 Regional Federal Reserve Banks: Part of the intent of the Federal Reserve Act of 1913 was to spread power out across the nation’s geography rather than having it all focused on the East Coast. Thus, the country was split into 12 distinct regions, each having its own Federal Reserve bank providing services locally and serving as representation on boards and committees back East. The map below shows these various regions and the cities in which their regional banks are located. In the same way commercial banks provide services to individuals, these regional entities provide services to the commercial banks themselves. They can be thought of as boots on the ground, carrying out the actual operations of the central bank.
Function: Clear checks, distribute new currency, remove damaged currency from circulation, administer discount loans to member banks, serve as liaison between local business communities and the Federal Reserve and collect data and conduct economic research
The Fed system also includes various advisory committees as well as the thousands of member banks scattered all across the country, but the three bodies outlined above are the functional “branches” of the central bank that set and implement policy.
Now let’s look at the nuts and bolts of what the Fed actually does on a daily basis. 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, and as we covered in last week’s post, 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.
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.
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: Open Market Operations
The Fed is an active participant in the open market for a variety of securities, but primarily for government bills, notes and bonds. Through these open market operations they are able to control the level of short-term 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 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. Additionally, when we talk about the Fed “setting interest rates” we are usually referring specifically to the funds rate. The Fed has a current target of 0-0.25% for the funds rate, which is what is meant by saying that the Fed has “set interest rates at zero”.
So how do they control the funds rate? 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. 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. More recently, however, the Fed’s large scale asset purchases referred to as “quantitative easing” have dominated the headlines and discussion around monetary policy. Quantitative easing is a less traditional and more controversial form of open market operations, and it will be the topic of next week’s post.
Policy Tool #3: The Discount Window
In addition to the federal funds market, certain banks also have access to short-term loans directly from the Fed via what’s called “the discount window”. These loans are available at 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.
We’ve seen now how the Board of Governors, the Federal Open Market Committee and the 12 Regional Federal Reserve Banks go about attempting to manage money and interest rates via their primary tools of bank reserves, open market operations and the discount window. In addition to these functions the Fed also serves a number of more mundane responsibilities including distributing new currency, regulating member banks and drafting federal law governing the banking and consumer credit industries. Whether or not one agrees with the way in which our central bank wields its significant power and influence over the economy and financial markets is an entirely separate topic, but hopefully pulling back the curtain on the Federal Reserve has made it a bit less mysterious.
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.