4
The Fed and Monetary
Policy
Federal Reserve System: Third U. S.
Central Bank
 A central bank is a bank for banks. Here is brief history.
 First Bank of the US (1791–1811) but after 20 years the charter
expired and was not renewed
 Second Bank of the US (1816–1836) but after 20 years the charter
again expired and was not renewed
 After a major banking crisis, Federal Reserve Act (1913) created
the 3rd US Central Bank, the Federal Reserve system we have
today. The purpose was to force banks and Fed to have enough
reserves if there was a massive run on the bank.
http://www.youtube.com/watch?v=9V5OP-VmXgE
 Side Note: 1913 was also the same year that the first
income tax return was required.
First return.
Structure of the Federal Reserve System
FIVE MAJOR COMPONENTS:
1. Member Commercial Banks
2. 12 Fed District Banks
3. 7 Members of Board of Governors
4. 12 Open Market Committee (FOMC) Members
5. Advisory Committees from private sector (Fed Advisory
Council, Consumer Advisory Council, Thrift Inst. Advisory Council)
1. Member Banks
 Nationally-chartered banks must be member banks
(many used to have “federal” in their name, e.g.
Commercial Federal Bank)
 State chartered banks may be member banks
(many used have “state” in their name, e.g. First
State Bank of Washington)
 Members banks purchase stock in Fed to become
members, which pays a max dividend of 6%.
 Must meet requirements (min. capital, etc. ) to be a
member
 35% of banks controlling 70% of all deposits are
members
Overview of Fed System
-Sets S/T
interest rates
Fed. Res. District Banks & Branches
Districts created by dividing up the country in roughly equal
portions according to the population in 1912-13
2. Federal Reserve District Banks
 12 districts (Fed. Res. Bank for WW is San Francisco,
www.frbsf.org, and the branch is in Seattle)
 Districts divided by population in 1912
 District bank size related to economic wealth of district
(NY & Chicago are big; NY considered most important)
 District banks owned by private member banks
 Functions: clear checks, replace old currency, provide
loans at discount window, do research.
 Megan Clubb, President of Baker Boyer Bank, is a
board member for Fed Res Bank of San Francisco.
http://www.bakerboyer.com/content/homepage
3. Board of Governors (Fed. Res. Board)
 Headquarters in Wash. DC. See picture next pg.
 7 members appointed by the U.S. president and confirmed by the




Senate
Each member serves a nonrenewable 14-year term (So how come
Greenspan was on for 19 years, 1987-2006?)
U.S. President appoints one member to be chair whose 4-year term
is renewable. Current chair: Janet Yellen replaced Ben Bernanke
as of 1/31/14.
One governor is appointed by U.S. President to be VP for
Supervision (Fin. Reform Act of 2010).
Independence of Federal Reserve facilitated by staggered terms of
Governors (1 term expires every even year) and having budget
separate from Congress
Central Bank Independence Around the World
Fed is supposed to be free from political and bureaucratic
pressure when it formulates policy BUT the Fed is not
immune from the desires of the electorate.
Federal Reserve Headquarters in Wash. DC
The Fed’s Inner Sanctum
The Fed Chair
Paul Volcker
Alan Greenspan
Ben Bernanke
CHAIRMEN (terms):
Paul Volcker (1979-1987)
Alan Greenspan (1987-2006, 19 yrs!)
Ben Bernanke (2006-2014)
Janet Yellen, (2/1/2014 - ??)
Chairman = Power
Janet Yellen
Board of Governors (cont.)
 Board of Governors has two main functions:
1. Regulate commercial banks
 Supervise and regulate member banks and bank holding
companies
 Oversight of 12 Fed district banks
2. Establish and effect monetary policy
 Direct control over three tools of monetary policy
 Set reserve requirements
 Approve discount rate set by district banks
 Sets the rate of interest paid on reserves at the Fed
 Indirect control of Federal Funds rate through open market
operations
 All governors are members of the Federal Open Market Committee
4. Fed Open Market Committee
 Scheduled to meet 8 times per year (or about every 6
weeks) Sometimes has unscheduled meetings in
emergencies. Next meeting is?
http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
 12 members
 7 from the Board of Governors
 1 President of the New York Fed
 4 other district bank presidents on a rotating basis
 Other district bank presidents participate but do not vote on monetary
policy matters
FOMC (cont.)
 Monetary policy goals:
 high employment
 price stability (Low inflation deemed most important goal)
 economic growth
 Forward decisions to NY Fed trading desk through policy
directive, which sets target range for federal funds rate.
 The Beige Book: a periodic report of economic conditions
used by Fed in monetary policy decisions
 Megan Clubb, Baker Boyer Bank President
helps create Beige Book for NW, who did a
business colloquium Feb. 13, 2013

http://coursecast.wallawalla.edu/Panopto/Pages/Viewer/Default.aspx?id=cad13e67-7e67-4226-8e5c-c61d3a15bd15
Fed’s Influence on Economy
Fed influences the money supply in order to achieve its
goals of growth, price stability, and jobs.
Liquidity,
Money Supply
and
Interest Rates
Business and Consumer
Borrowing/Spending
Goals of
Growth
Price Stability
Jobs
5. Advisory Committees
•
•
•
Federal Advisory Council consists of one member
from each Federal Reserve district who represents
the banking industry. Meets with the Board of
Governors in Washington, D.C., at least four times a
year and makes recommendations about economic
and banking issues.
Consumer Advisory Council consists of 30
members who represent the financial institutions
industry and its consumers.
Thrift Institutions Advisory Council consists of 12
members who represent savings banks, S&Ls, and
credit unions.
Advisory Committees (cont.)
Consumer Financial Protection Bureau
 Established as a result of the Financial Reform Act of
2010.
 Responsible for regulating financial products and
services, including online banking, certificates of
deposit, and mortgages
 Republicans and Democrats fought over who should
lead this Bureau
Initial nomination:
Elizabeth Warren
Current head:
Rich Cordray
Seven Tools of Monetary Policy
3. Open
Market Oper.
4. Interest on
Required and Excess
Reserve Balances
Held at Fed
5. Maturity
Extension Program
(expired fall/14)
1. Reserve Req.
Tools of
Monetary
Policy
TEMPORARY TOOLS
In response to the credit
crisis, the Fed created 8 new
tools to promote liquidity.
Only 2 remain today:
7. Overnight reverse purchase
agreements, and
8. Term Deposit Facility
2. Discount
Rate
TOOL#1: Reserve Requirements
 Banks must maintain reserves as percent of deposits/liabilities,
usually around 10% for larger banks

http://www.federalreserve.gov/monetarypolicy/reservereq.htm
 Purpose: to have reserves if there’s a run on the bank (Mary
Poppins, It’s a Wonderful Life, Bear Sterns, WaMu, IndyBank, etc.)
This was the original purpose of the Fed. Reserve Act.
 Reserves are deposits at Fed plus vault cash.
 Fed sets reserve requirements, but this tool is used little as it’s too
powerful (like a sledge hammer to swat a fly) because of the money
multiplier effect
 The central bank of China recently lowered its reserve requirements
to expand the nation’s money supply, since growth has tapered off
recently.
Run on Bank
It’s a Wonderful Life
http://www.youtube.com/watch?v=lbwjS9iJ2Sw
Mary Poppins
http://www.youtube.com/watch?v=C6DGs3qjRwQ
IndymacBank, 2008
http://www.youtube.com/watch?v=IVRgZ9LizZQ
1929
WaMu
2008
The Power of the Money Multiplier
With a reserve requirement of 10%, single deposit of $1 can create 10 new dollars.
Conversely, a single withdrawal of $1 can reduce the money supply by $10
Increase in
deposits
at banks
Required reserves
held on
new deposits
Funds received from
new deposits that
can be lent out
$100,000
$10,000
$90,000
$90,000
$9,000
$81,000
$81,000
$8,100
$72,900
Deposits created = initial deposit / req. reserve % = $1 / .10 = $10 minus any leakage
Limiting Factors to Deposit Expansion
(Leakage)
 Banks may not lend all $$ out
 Public may not re-deposit cash (grandpa stuffs his
mattress)
 $$ is converted to time deposits
 $$ is transferred to a foreign bank account
(maybe for payment of imports)
 $$ is invested in the gov’t or taxes are paid
The power of the money multiplier allows small
changes to influence economic activity in a large
way, both for good and for bad
Hopefully
not this kind
of leakage!
TOOL#2: Discount Rate
NOTE: technically, the name for the Discount Rate changed in 2003 to
the Primary Credit Loan Lending Rate; however, everyone still calls it
the Discount Rate.
Banks might borrow from Fed at the “discount window” for 3 reasons:
(1) To meet short-term reserve deficiencies
(2) Seasonal credit to banks, e.g. loans to banks in agricultural or
tourist areas (farmers borrow and then pay back after harvest, or
tourists comes only a certain time of year, or seasonal inventory for
Christmas/Halloween)
(3) Extended credit for longer-term liquidity problems at troubled banks
(NOTE: it is usually cheaper for a bank to
borrow federal funds from other banks so
the Fed is meant to be used only as a last
resort. Borrowing from the Fed is usually a
stigma – like spending money foolishly and
then having to borrow from dad). However,
during the 2008 liquidity crisis, banks were
lined up for miles to borrow from the Fed.
You want to borrow $10? Sorry, but I’m
staying out of the sub-prime loan
business
Discount Rate (cont.)
 Discount Rate: Interest rate charged on loans made by
Fed thru the discount window. Comes in 3 forms:
 (1) Primary credit, for any purpose of sound banks
 (2) Secondary credit, for banks not as sound (more
risky)
 (3) Seasonal credit, for small banks needing S/T loans
in ag or tourist areas.
 see www.frbdiscountwindow.org
Note: For the first time in history, the Fed opened the Discount Window to
some non-commercial banks in 2008. In addition, many non-bank institutions
(American Express, Morgan Stanley, Goldman Sachs, etc.) rushed to create
bank-like holding companies so that they could borrow from the Fed. Tim
Geithner, Obama’s Treasury Secretary and then President of Fed Res Bank of
NY, said that none of these institutions would have survived the liquidity crisis
without the Fed’s help. Congress is today howling for full disclosure about
exactly which institutions borrowed from the Fed. See article.
Discount Rate (cont.)
Effect of changing rate
 Traditionally (before 2003)
 Lower discount rate: More $$ borrowed from Fed, bank
reserves expand, money supply increases
 Raise discount rate: less $$ borrowed from Fed, bank reserves
contract, money supply decrease
 Discount rate changes used serve as a signal for future changes
in interest rates (especially federal funds rate)
 Today (post 2003)
 Discount rate simply changes in lock step (usually) with the
federal funds target rate, thus no longer really serving as an
effective tool of monetary policy. Usually at least 50bp higher
than Fed. Fds. Rate. However, the Fed occasionally unhinges
the two for short periods of time.
TOOL #3: Open Market Operations
 FOMC uses Beige Book and other data to decide what
the target federal funds rate should be
 Based on the target federal fund rate, FOMC sends a
Policy Directives to the NY Fed Trading Desk (or Open
Market Desk).
 The Trading Desk buys or sells Treasury securities in
order to expand or contract the money supply
 Fed purchases (sells) securities, which increases
(decreases) bank reserves (federal funds), thereby
decreasing (increasing) the Fed. Fds. Rate
Open Market Operations (cont.)
 The federal funds rate is not directly controlled by the FOMC
but it is influenced by the FOMC; this is why the Fed only
sets a target range for the rate.
 Federal funds rate: interest rate charged on S/T loans
between banks, usually made in order to meet reserve
requirements
 Federal funds rate is a benchmark rate for other S/T interest
rates, such as on bank accounts, credit cards, etc.
 Fed purchase (sale) of securities results in an injection of
additional funds into the bank system, lowering (raising)
federal funds rate and other rates, because there are more
(less) funds available for money market and bank lending
Open Market Operations (cont.)
Open Market Operations in Response to the Economy
2001–2003: The Fed frequently used open market
operations to reduce interest rates during this period
of weak economic conditions.
2004–2007: The Fed’s concern shifted from a weak
economy to high inflation as the economy
improved.
2008: The Fed used open market operations to reduce
interest rates in an attempt to stimulate the economy
when economic conditions weakened due to the
credit crisis
Today, with rates near zero, the Fed’s open market
operations are essentially static and mute, replaced
by quantitative easing (QE) long-term bond buying.
Money Supply
 M1 = coin/currency, traveler checks, demand deposits
(checking), NOW accounts, deposits at Fed
 M2 = M1 plus savings, small time deposits
 M3 = M2 plus large time deposits, repos
 See money stock measures (H.6) at
http://www.federalreserve.gov/releases/h6/
 M1 is more volatile than M2 because people’s checking
accounts go up with they get paid and down when they
pay their bills; but there’s much less activity in savings
accounts.
TOOL #4: Interest on Required and
Excess Reserve Balances Held at Fed
The Fed pays interest on required and excess
reserve balances held at the Fed. The interest
rates are determined by the Board of
Governors, who can change the rates effect
monetary policy. Interest rates are declared
every Wednesday at 4:30pm ET, when the
reserve maintenance reports are due. Current
rates are posted at
http://www.federalreserve.gov/monetarypolicy/re
qresbalances.htm
TOOL #5: Maturity Extension Program
(ceased in fall of 2014)
The Fed sold $400 billion of shorter-term Treasury
securities and used the proceeds to buy longer-term
Treasury securities. This extended the average
maturity of the securities in the Fed’s portfolio. By
reducing the supply of longer-term Treasury
securities in the market, this action put downward
pressure on longer-term interest rates. The reduction
in longer-term interest rates, in turn, contributed to a
broad easing in financial market conditions that
provided additional stimulus to support the economic
recovery, especially the housing sector (at least in
theory).
TOOL #6-8: Credit Crisis Tools (temporary tools)
1.
2.
Traditionally, the Fed only lends to depository institutions (commercial
banks). But during the 2009 credit crisis, the Fed lent funds to many
non-bank institutions. Earlier in 2008, the Fed had also lent funds to
Bear Stearns, a non-depository institution. EXPIRED
Facilities created by the Fed to provide liquidity include:
1.
2.
3.
4.
5.
6.
7.
8.
Primary Dealer Credit Facility – overnight loans to bond dealers EXPIRED
Term Auction Facility – banks can borrow for a fixed term EXPIRED
Term Securities Lending Facility – dealers can swap mortgage-backed and
other securities for loans (provided liquidity and lowered mortgages rates)
EXPIRED
Commercial Paper Facilities (two different ones) – created to restore liquidity
in CP markets EXPIRED
Money Market Investor Facility – provide liquidity to MM EXPIRED
Term Asset-Backed Securities Loan Facility – provide liquidity for consumer
and small business loans (credit cards, student loans, car loans, etc.)
EXPIRED
Overnight Reverse Purchase Agreements – helps control money supply
affecting the federal funds rate. STILL HERE
Term Deposit Facility – offers term deposits to banks thereby draining money
supply and helping control the fed funds rate STILL HERE
Using the Tools to Increases the Money
Supply and Decrease Interest Rates
 Increasing the money supply and lowering interest rates
 Open market purchase of Treasury securities via the Trading Desk
in the secondary market increases money supply and lowers
Federal Funds rate (this tool is used most frequently).
 Discount rate (usually in lock step with Federal Funds rate) will also
be lowered, which might encourage borrowing at the discount
window, increasing the money supply. Occasionally the Fed will
change the Discount rate independently from the Fed Funds rate.
 Reserve requirements can be lowered, causing more money to be
loaned out
 The interest rate paid on reserves held at the Fed can be lowered
Using the Tools to Decrease the Money
Supply and Increase Interest Rates
 Decreasing the money supply to raise interest rates
 Open market sale of Treasury securities via the Trading Desk in the
secondary market decreases money supply and raises federal
funds rate (this tool is used most frequently).
 Discount rate (usually in lock step with Federal Funds rate) will also
be raised which might discourage borrowing at the discount
window, decreasing the money supply. Occasionally the Fed will
change the Discount rate independently from the Fed Funds rate.
 Reserve requirements can be raised, causing less money to be
loaned out
 The interest rate on reserves held at the Fed can be raised
Playing the Fed Chair Game
Go to http://www.frbsf.org/education/activities/chairman/
Keep playing until you are reappointed!
Global Monetary Policy
 Each country has its own central bank and most
industrialized countries have banks with similar goals
 Since 1999, European Central Bank (in Frankfurt)
works similar to the US Fed. Euro used in 23
countries (Andorra, Austria, Belgium, Cyprus, Estonia, Finland, France,
Germany, Greece, Ireland, Italy, Kosovo, Luxembourg, Malta, Monaco,
Montenegro, Netherlands, Portugal, San Marino, Slovakia, Slovenia, Spain and
Vatican City)
 Fed must consider conditions in other countries when
looking at the U.S. economy
 Central banks try to work together but conflicting
goals can make cooperation difficult at times
Fed Power & Bail-Outs


The Fed gave loans to Bear Stearns, AIG and others in
an attempt to prevent a meltdown. Do you think large
financial institutions such as these should be rescued
by the Fed?
Many in Congress have argued (such as Ron Paul) that
the Fed has too much power and that Congress should
be involved in decision regarding the use of taxpayer
funds to rescue institutions. Do you agree?
Quantitative Easing QE 1, 2 and 3
• Quantitative Easing #1 refers to Fed purchasing $1.45T mortgage-
•
•
•
•
backed securities and $300B in L/T Treasuries from Mar/09 to mar/10,
with the goal of holding down L/T rates to spur the mortgage market.
This is similar to monetizing the debt. Many are critical of QE because
it is like “printing money” and could eventually increase inflation and
weaken the US dollar.
Quantitative Easing #2 refers to the Fed’s bond buying from Nov/10 to
June/11 ($660 of L/T Treasuries).
Quantitative Easing #3 refers to the Fed’s bond buying from Sept/12 to
Oct/14 (originally $40B/mo of mortgage-backed securities, and $45B of
L/T Treasuries; revised to $35B and $40B in Jan/14 )
See http://www.youtube.com/watch?v=PTUY16CkS-k
very controversial as it is essentially equivalent to the fed “printing
money” which has caused the Fed’s balance sheet to burgeon
Fed’s Balance Sheet has quadrupled since the 2008