POMOs, TOMOs, & more: Monetary Policy at a Glance

[brosin]

wps.aw.com/aw_mishkin_econmbfm_8/
The Economics of Money, Banking and Financial Markets, Eighth Edition Frederic Mishkin, 2007

****Disclaimer: this thread in no way gives an opinion on the effectiveness of monetary policy; its intent is to inform what the Fed does and what they are attempting to do, because the markets react to these actions that directly effect the entire banking sector.****



This is the text we used in my Monetary Policy (MP) class - Mishkin is a former Governor of the Federal Reserve. I had a great teacher who had such a great understanding of the Fed; he taught a very boring subject in a way where he made it essential to understand the fundamentals of MP in a way where you could see how their actions effected each of our daily lives. It was one of the few classes in college I really enjoyed throughout, mainly because it was so applicable to things I had been watching for years without having much understanding of what I was watching.


This thread will not be short or exciting - but I know I will use it in the future as a reference. If anyone else finds it useful, even better. I will be citing as necessary, as much of this is taken from my professor Jeff Reynolds' outlines and/or Mishkin's text. The class was a summary of Monetary Policy and the Fed, and this thread will attempt to summarize that summary even further.

[brosin]

Function of Financial Markets¹

"Financial markets & financial intermediaries have the basic function of moving funds from those who have a surplus of funds to those who have a shortage of funds…

Lenders (savers) have extra funds since they wish to spend less than their income…and borrowers (spenders) demand extra funds since they wish to spend more than their income.

• Lender/Savers are primarily households…but also include firms, governments (local, state) and foreigners (HHs and/or governments)

• Borrower/Spenders are primarily firms and government (federal)…but also include HHs and foreigners (HHs and/or governments)

• Borrowers sell securities to lenders in exchange for funds (e.g. GM sells a bond…a debt security…in exchange for funds)

• Channeling of funds from savers to spenders is a voluntary exchange…all are made better off (both lenders and borrowers) and economic well-being is enhanced

• Financial markets promote economic efficiency since scarce resources (loanable funds) are put to where they are most highly valued

• As a result, financial markets contribute to higher production and efficiency in the overall economy…and improve the economic welfare of everyone in the society

…even when “the market” falls in value (think in terms of institutions)."



1 Reynolds, "310ch01&02" p 14-15

[brosin]

Financial System Regulation²

"• Financial system is among the most heavily regulated sectors of the U.S. economy

• Government regulates financial markets for three main reasons…


1. Increasing Available Information

• As a result from the 1929 stock market crash, Securities and Exchange Commission (SEC) enacted

• SEC requires corporations issuing securities to disclose information about their sales, assets and earnings,… and restricts trading by the largest stockholders (insiders)

• CEO stock options and later selling became significant issue in 2002 (Enron, Worldcom)



2. Ensuring Soundness of Intermediaries

Asymmetric information can lead to the widespread collapse of financial intermediaries (financial panic). Several types of regulations exist to ensure soundness…

• Restrictions on assets and activities… legislation from 1933 (repealed in 1999) separated commercial banking from the securities industry, so banks could not engage in risky ventures…now, control only over amount of risky assets held/quantity held

• Deposit insurance…government insures people providing funds to intermediary from financial loss if the intermediary fails (FDIC insurance insures loss of $100,000 per acct.)

• Limits on competition



3. Improving Control of Monetary Policy

Since banks indirectly determine the supply of money, regulation intended also to improve control of money supply

Reserve requirements make it obligatory for all depository institutions to keep a certain fraction of deposits in accounts with the Federal Reserve System (U.S. central bank known as the "Fed"), or to be held as cash in banks' vaults

• Tiered reserve requirements (0-10%), RR, dependent on net transaction accounts at the depository institution

• RR assist Fed in exercising more precise control over the money supply"




2 Reynolds, "310ch01&02" p 35-37

[brosin]

Origins of the Federal Reserve System³

• There were 2 central banks prior to 1900: The First Bank of the US (1791 - 1811) and the Second Bank of the US (1816 - 1836). Both charters were eventually allowed to expire, mainly due to fear of centralized power at the expense of states' rights and fear of moneyed interests. The void caused huge problems in American financial markets as there was no longer a lender of last resort, and no true uniformity or stability - for the next 70 years, the average life span of a bank was 5 years before it would see a panic and go under. Widespread panics occurred often; the panic of 1907 was the major event that sparked the public demands for a new central bank to prevent future panics. It was a long debate, but eventually Congress created the Federal Reserve and the 12 regional Federal Reserve banks in 1913.


Structure of the Federal Reserve System (FRS)

• There are 12 regional Federal Reserve banks (one for each district), and several assisting branch cities in each of the 12 districts that the country is broken into.

• All national banks (commercial banks chartered by Office of Comptroller of Currency) are required to be members of the FRS

• Commercial banks chartered by the states are not required to be members, but they can choose to be.

• As of 2007, 37% of the commercial banks in the US are members of the FRS (I'm trying to find if this has changed - see bold below)

• All banks in the country (members and nonmembers) are required to keep deposits (required reserves/RR) at the Fed as of 1987

Taken from the Fed's website regarding interest rates on excess reserves (ER) in addition to RR: "The Federal Reserve Banks pay interest on required reserve balances--balances held at Reserve Banks to satisfy reserve requirements--and on excess balances--balances held in excess of required reserve balances and contractual clearing balances. The Board of Governors has prescribed rules governing the payment of interest by Federal Reserve Banks in Regulation D (Reserve Requirements of Depository Institutions, 12 CFR Part 204).

The interest rate paid on required reserve balances is determined by the Board and is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions. The interest rate paid on excess balances is also determined by the Board and gives the Federal Reserve an additional tool for the conduct of monetary policy."


Board of Governors

• In D.C., the seven-member Board of Governors is the head of the FRS - they are appointed by the President / confirmed by senate and serve nonrenewable 14-year terms ending in January after their 14th year.

• The 7 Governors are required to come from different districts, and one chairman is chosen among the seven to serve a 4-year renewable term

• the Board holds significant power over monetary policy and non-monetary matters - they set margin requirements in securities markets, set the salary of the President and all officers of each Federal Reserve bank, reviews each bank's budget, and as mentioned above, the Board sets the RR and ER interest rates and has a majority vote in the FOMC where they hold 7 of the 12 votes




3 Mishkin, ch 12 p 311-330

[Rich]

this is good stuff.

thanks, Bros.

[brosin]

****Federal Open Market Committee (FOMC) ⁴****

• usually meets 8 times a year and makes decisions regarding the conduct of open market operations, which influence the money supply and interest rates.

• the FOMC is often referred to as the "Fed" in the press: For example, when the Media says the Fed is meeting, they really mean the FOMC is meeting.

• the committee consists of the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York (the head bank), and the presidents of the remaining four Federal Reserve banks who are not represented on the Board of Governors

• Chairman of the Board of Governors is also the chairman of the FOMC

• because open market operations are the most important policy tool that the Fed has for controlling the money supply, the FOMC is necessarily the focal point for policy-making in the Federal Reserve System (FRS)

• the FOMC does not actually carry out securities purchases or sales; instead, it issues directives to the trading desk at the Federal Reserve Bank of NY where the manager for domestic open market operations supervises a roomful of people who execute the purchases and sales of the government or agency securities - the manager communicates daily with the FOMC members and their staffs concerning the activities of the trading desk


The FOMC Meeting

• The FOMC meeting takes place in the boardroom on the second floor of the main building of the Board of Governors in Washington, D.C. with the seven governors and the 12 Reserve Bank presidents, along with the secretary of the FOMC, the Board's director of Research and Statistics Division and his deputy, and the directors of Monetary Affairs and International Finance Divisions; they sit around a massive conference table

• Although only 5 of the Reserve Bank Presidents have voting rights on the FOMC at any given time, all actively participate in the deliberations; seated around the sides of the room are the directors of research at each of the Reserve banks and other senior board and Reserve Bank officials who by tradition do not speak at the meeting

• Except for the meetings prior to the Feb and July testimony by the chairman of the Board of Governors before Congress, meetings start on Tuesday at 9 am with a quick approval of the minutes of the previous FOMC meeting

• First substantive agenda item is the report by the manager of system of open market operations on foreign currency, domestic open market operations, and other related issues

• Next stage is a presentation of the Board staff's national economic forecast - called the "green book" forecast; both the first two speakers allow for Q&A with the governors and Fed Presidents

• Then the go-round portion involves each of the 12 presidents presenting the economic conditions in his or her district, as well as their bank's national outlook - and then the Board members give their national outlook. *Remarks during this portion avoid the topic of monetary policy*

• After a break, the agenda turns to current monetary policy and domestic policy directive - the Board's director of the Monetary Affairs Division talks about different scenarios for monetary policy actions outlined in the "blue book" - a Q&A session follows

• (most important) the Fed Chairman then sets the stage for the following discussion by presenting his views on the state of the economy and his recommendation for what monetary policy action should be taken; each FOMC member will then give their views, and after that, the Chairman will summarize the discussion and propose specific wording for the directive on the federal funds rate target transmitted to the open market desk

• secretary of the FOMC formally reads the proposed statement, and the members of the FOMC vote; all votes are made public, and it is extremely rare for the chairman's vote to not be on the winning side

• then there is an informal lunch buffet, during which the participants hear a presentation on the latest developments in Congress on banking legislation and other legislation relevant to the Federal Reserve; the buffet ends at 2:15 when the meeting breaks and a public announcement is made about the outcome of the meeting: whether the federal funds rate target and discount rates have been raised, lowered, or left unchanged, and an assessment of the "balance of risks" in the future, whether towards higher inflation or a weaker economy.



4 Mishkin, ch 12 p 311-330

[brosin]

That's the easy part: now let's dig in...

(Click pictures for the full views - should be a little easier to see)

Tools of Monetary Policy




This is a simplistic version of a money market supply and demand chart. For those not familiar with economics, this is the notion of equilibrium (where supply and demand cross). In the money market, equilibrium establishes how big the monetary base is and what the interest rate is. As with all goods and services, the money demand ("md") curve is downward sloping (the less supply you have, the more the costs will be). Unlike most goods (where the supply curve is diagonal and makes an "X" with the demand curve because of the costs associated with creating that good which effect how much of it can be made), the money supply ("ms") curve is vertical because it is a fixed number determined by the Fed. At all times, it can only be at one place, so the monetary base is fixed and vertical at all times.


The Money (Reserves) Market and the Federal Funds Rate

• The Federal Funds Rate is the "interest rate" on the left axis, and the dependent variable. It is dependent on the monetary base (x axis), which is the independent variable and set by the Fed. It is the rate on overnight loans of reserves from one bank to another. Essentially, though, it can just be seen as demand for money, demand for loans... because all banks combined would make up the total demand for investment capital.

• With the amount of reserves that the banks are sitting on, it is not that people and small businesses don't want / need to borrow - it is a matter of the banks not wanting to take the risks. And why should they if the Fed is paying interest on Excess Reserves since 2008? So it's a matter of the banks deciding to finally lend, and then it will spiral up on itself as they race eachother to get the most customers (i.e. inflation).

• Just because the supply of money is always fixed/vertical, that doesn't mean it stays there long and doesn't shift. Each day, that amount will change depending on what the FOMC decides to do with overnight temporary Open Market Operations (OMOs). For simplistic purposes, we will assume the demand for money (money demand/"md" curve) does not move.

• Let's assume the Fed sees that lending markets loosened up unexpectedly overnight, and they want to pull it back a bit in the near term. They want to take money out of the system ("monetary base" on the chart) in more simplistic terms:

Graphically:


Original


TO



•This is graphically what has happened. They have subtracted from the monetary base (money supply) by taking money out of reserves by selling Treasuries or other securities for cash, that they then leave out of the system for the time being. The money supply (ms) has moved to the left from 1 to 2 (reserves and monetary base got smaller), and if you look to the left axis at the point where the 2 lines are now intersecting, the interest rate has now gone up.

• That is why an upward moving Fed Funds Rate is a good thing, as it seems to indicate that the Fed was surprised by the amount of lending the banks wanted to do at the current levels, which would seem to indicate an increase in demand to lend (assuming no change in the amount of demand to borrow).

•I watch it for these reasons - it seems to me to be the *best indicator there is as to what bank lending is doing on the shortest of time horizons

[brosin]

(Placeholder)


Open Market Operations

•••••••




Discount Lending

•••••••





Reserve Requirements

•••••••