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Overview of fed

  1. 1. Group 9 & 10 Federal Reserve System OVERVIEW OF FEDERAL RESERVE SYSTEM1. BACKGROUND The Federal Reserve System (FED or is the central banking system of the United States. It was establish in 1913, with the enactment of the Federal Reserve Act. By creating the Federal Reserve System, Congress intended to eliminate the severe financial crisis that had periodically swept the nation, especially the sort of financial panic that occurred in 1907. According to this Act, FED evolved over time into an independent entity to attend to the nation’s credit and monetary needs without undue influence from political pressure or situation. In keeping its independence within the government, the system works without appropriations from Congress. The current structure of the system has three major components established by the original act. The system consists of a Board of Governors, twelve regional Federal Reserve Banks throughout the nation and the member banks.2. CHARACTERISTICS The U.S Federal Reserve System has several features that distinguish it: - Setting apart centralized authority into many divisions. - Ownership and control by member banks - Optional membership in the Fed of some banks Federal Reserve System is a decentralized central bank. Its authority is vested in the Board of Governors and the presidents of twelve Regional Reserve banks (district banks). FED is also considered to be an independent entity from government because its decisions do not have to be ratified by the President or anyone else in the executive branch of government. The System is, however, subject to oversight by the U.S. Congress. It must work Page 1
  2. 2. Group 9 & 10 Federal Reserve System within the framework of the overall objectives of economic and financial policy established by the government; therefore, the description of the System as ―independent within the government‖ is more accurate. It is independent, moreover, because it finances its own operation. FED does not have right to solely approve or disapprove the monetary policy or relevant legal issues. It must rely on the FOMC and district banks to carry out the banking policies developed at the national level. Especially, stocks are owned by the bank members, not the Government. In the U.S only chartered banks, which only satisfy required conditions, are accepted to join the Fed’s member banks.3. FUNCTIONS  Serving Government Federal Government’s Banker The Fed maintains a checking account for the Treasury Department and processes payments such as social security checks and IRS refunds. Government Securities Auctions The Fed serves as a financial agent for the Treasury Department and other government agencies. The Fed sells, transfers, and redeems government securities. Also, the Fed handles funds raised from selling T-bills, T-notes, and Treasury bonds. Issuing Currency The district Federal Reserve Banks are responsible for issuing paper currency, while the Department of the Treasury issues coins.  Serving Bank Check Clearings Check clearings is the process by which banks record whose account gives up money, and whose account receives money when a customer writes a check. Supervising Lending Practices Page 2
  3. 3. Group 9 & 10 Federal Reserve System To ensure stability in the banking system, the Fed monitors bank reserves throughout the system. Lender of Last Resort In case of economic emergency, commercial banks can borrow funds from the Federal Reserve. The interest rate at which banks can borrow money from the Fed is called the discount rate  Regulating the Banking System The Fed generally coordinates all banking regulatory activities. Reserves Each financial institution that holds deposits for its customers must report daily to the Fed about its reserves and activities. The Fed uses these reserves to control how much money is in circulation at any one time. Bank Examinations The Federal Reserve examines banks periodically to ensure that each institution is obeying laws and regulations. Examiners may also force banks to sell risky investments if their net worth, or total assets minus total liabilities, falls too  Regulating the Money Supply The Federal Reserve is best known for its role in regulating the money supply. The Fed monitors the levels of M1 and M2 and compares these measures of the money supply with the current demand for money. Stabilizing the Economy The Fed monitors the supply of and the demand for money in an effort to keep inflation rates stable4. THE STRUCTURE OF FEDERAL RESERVE SYSTEM The Federal Reserve System was established by the Federal Reserve Act in 1913 and began operating in 1914. It is an unusual mixture of public and private elements. Page 3
  4. 4. Group 9 & 10 Federal Reserve System The structure of the Federal Reserve System is based on five components: the Board of Governors of the Federal Reserve System, the Federal Open Market Committee, the Federal Reserve Banks, member banks, and advisory committees. Figure 1 illustrates the organizational relationship of these components. Federal Open BOARD OF GOVERNORS Market (CHAIRMAN & VICE CHAIRMAN) Committee (FOMC) Federal Consumer Thrift Advisory Institutions Advisory Advisory Committees Advisory Council Council Council FEDERAL RESERVE BANKS (12) FEDERAL RESERVE BRANCHES (25) Member Banks Figure 1: Federal Reserve Structure4.1. BOARD OF GOVERNORS The Board of Governors, frequently called the Federal Reserve Board, represents the ultimate authority of the Federal Reserve System. Located in Washington, D.C., the board consists of seven members, mostly professional economists, appointed by the President of the United States and confirmed by the Senate. Governors serve 14-year, staggered terms to ensure stability and continuity over time. The chairman and vice- Page 4
  5. 5. Group 9 & 10 Federal Reserve System chairman are appointed to four-year terms and may be reappointed subject to term limitations.  Responsibilities: - Providing centralized authority. - Establishing regulations. - Supervising activities of the Federal Reserve Banks. - Overseeing and approves merger applications. - Controlling effectively the discount rate. - Calculating Margin Requirements. - Setting Reserve Requirements4.2. FEDERAL OPEN MARKET COMMITTEE (FOMC) The Federal Open Market Committee (FOMC) is the Feds monetary policy making body. The voting members of the FOMC are the Board of Governors, the president of the Federal Reserve Bank of New York and presidents of four other Reserve Banks, who serve on a rotating basis. All Reserve Bank presidents participate in FOMC policy discussions. The chairman of the Board of Governors chairs the FOMC. Hence, FOMC is considered as an example of the interdependence built into the Feds structure. It combines the expertise of the Board of Governors and the 12 Reserve Banks. Regional input from Reserve Bank directors and advisory groups brings the private sector perspective to the FOMC and provides grassroots input for monetary policy decisions.  Responsibilities: - Monitor District Economy. - Convey regional economic perspectives to the Board of Governors (Beige Book). - Examine and Supervise banks. - Lend to banks (Discount Window). - Provide financial services to banks and the U.S. Treasury in the region. Page 5
  6. 6. Group 9 & 10 Federal Reserve System - Recommend Discount Rate changes. - Nine Board of Directors representing banks, business, and the public 4.3. FEDERAL RESERVE BANKS (DISTRICT BANKS) The Reserve Banks, also known as district banks, are nongovernmental organizations, set up similarly to private corporations, but operated in the public interest. The districts are headquartered in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. So far, there are totally 25 Reserve bank branches.  Responsibilities: - Clear checks - Issue new currency - Withdraw damaged currency from circulation - Administer and make discount loans to banks in their districts - Evaluate proposed mergers and applications for banks to expand their activities - Act as liaisons between the business community and the Federal Reserve System amine bank holding companies and state- chartered member banks - Collect data on local business conditions - Use their staffs of professional economists to research topics related to the con-duct of monetary policy4.4. MEMBER BANKS: Member banks can be divided into three types according to which governmental charters and whether or not they are members of FED: (1) A state-chartered bank is a financial institution that receives its charter from a state authority such as the Arkansas State Bank Department. These banks are supervised jointly by their state Page 6
  7. 7. Group 9 & 10 Federal Reserve System chartering authority and either the Federal Deposit Insurance Corporation (FDIC) or the Fed. (2) A national bank is chartered issued by the Office of the Comptroller of the Currency. This choice of state or national charter for commercial banks is referred to as the "dual banking system." (3) A state nonmember banks is not chosen by FED because some of mismatch with the standard requirements.  Responsibilities: - As a member, each bank is required to hold stock in its respective Reserve bank. - Member banks also have to hold 3 percent of their capital as stock in their Reserve Banks.4.5. ADVISORY COUNCILS (1) Federal Advisory Council (FAC), which is composed of twelve representatives of the banking industry, consults with and advises the Board on all matters within the Boards jurisdiction. The council ordinarily meets four times a year, the minimum number of meetings required by the Federal Reserve Act. (2) Consumer Advisory Council also meets with the Board of Governors at least four times each year. Composed of 30 members, the group represents the interests of consumers and creditors. Its function is to advise the Board of Governors on such matters related to the Feds authority in the areas of consumer and creditor laws. (3) Advisory committees (one for each Reserve Bank) take a responsibility for advising banks on matters of agriculture, small business and labor. Every two years, the Board solicits the advice and views of these committees by emails. (4) Thrift Institutions Advisory Council, established in 1980 with the Monetary Control Act, provides information related to issues and Page 7
  8. 8. Group 9 & 10 Federal Reserve System concerns of thrift institutions. The council is composed of representatives from savings banks, savings and loan associations, and credit unions. It meets at least four times every year. Assessing the Federal Reserve System’s Structure  Independence from Political Influence - The Fed controls its own budget, which is an important criterion for central bank independence. - It does occasionally come under political attack, especially when it believes it must raise interest rates.  Decision Making by Committee - The Fed meets this criterion for independence because the FOMC is a committee. - The chair may dominate policy decisions, but the fact that there are 12 voting members provides an important safeguard against arbitrary action by a single individual.  Accountability and Transparency - The FOMC releases huge amounts of information to the public. - However, there is no regular press conference or real questioning of the chair on the FOMC’s current policy stance. - Moreover, some information is released well after the fact of the meeting. - Also, the Committee’s refusal to state its objectives clearly and concisely hampers communication.  Policy Framework - The Congress of the United States has set the Fed’s objectives, but the statement is vague enough that the Fed can essentially set its own goals. - Many people have argued that the system should be replaced by one in which the FOMC’s objectives are made clear and the Committee Page 8
  9. 9. Group 9 & 10 Federal Reserve System announce a specific numerical objective for consumer price inflation over some horizon. FEDERAL RESERVE SYSTEM (FED) VS. EUROPEAN CENTRAL BANK (ECB)In world economy, nowadays, the Fed and the ECB are the most influential andpowerful central banks. Their decisions or issues can change the whole globaleconomy in different directions, maybe they lead to better or worse cases. Ourgroup thinks it is interesting to make a comparison of two important banks.Although FED and ECB have not established in the same legal issue ormethodology, and history, they still have some similarities as same as somemajor differences. In this part, we focus on the organizational structure, role inthe economy, and the monetary policy framework. Besides, the purpose of thiscomparison is to give a brief overview of the history, structure, objectives, andmonetary policy strategies of The European Central Bank (ECB) and TheFederal Reserve System (Fed). Table 1 below is the brief description fromcomparing two central banks. FED (FEDERAL OF RESERVE ECB (EUROPEAN SYSTEM OF SYSTEM) CENTRAL BANK)ESTABLISHED YEAR 1914 1998SUPERVISOR Board of Governors in control NCBs Governors in charge FED decentralizes its authority Governing Council, comprising 22 DECENTRALIZATION into 12 Federal Reserve Banks, members: the ECB Executive each serving a specific region of Board (6 members) and the the country. The Board of Governors of the 16 NCBs Governors (7 members), based in (National Central Banks) of the Washington, DC, set up to Euro system oversee the Fed System. Page 9
  10. 10. Group 9 & 10 Federal Reserve System - Governors (14 year terms) - All president and governing - Chairman (4 year terms) council (8 year terms) y - Appointed by the US President - Appointed b National LEGAL TERM - Approved by the Congress governments - Approved by the European ParliamentINDEPENDENCE - Still report regularly to the - More independent than FED FROM Congress - Lay under the Maastricht Treaty POLITICAL - Under the Federal Reserve Act INFLUENCE (1913) Multiple objectives: to promote Price stability is the primary maximum employment, price objective as set in the Maastricht stability, and moderate long-term Treaty. The ECB has quantified MONETARY interest rates. Price stability not this as medium-term inflation POLICY defined, but widely viewed as 1- goal of ―below but close to 2%‖. OBJECTIVES 2% comfort zone (skewed toward upper portion) for core PCE inflation Focus on economic forecasts; Two pillar strategy: rates adjusted to optimize - First pillar focuses on longer- on expected outcomes and minimize shorter-term economic and price MONETARY risks of deviating from those developments (―economic POLICY outcomes (factoring in costs of pillar‖); STRATEGY those deviations). - Second pillar term inflation Preference for gradualism unless outlook based on monetary risks dictate more aggressive analysis action DECISION The decision-making authority is The main decision-making body is MAKING hold by the FOMC. But it needs Governing Council, which BODY to be ratified by the Chairman. formulate monetary policy. Page 10
  11. 11. Group 9 & 10 Federal Reserve System The 12 Reserve Banks The Executive Board is in charge implement it. of implementing it. OPEN MARKET OPERATION Repurchase Agreements Reserve transaction at weekly (Repos) on daily basis with auctions with maturities of two MAIN very short-term weeks maturity(sometime can range from 1->90days) Outright purchases or sales Transaction with 3 months MONETARY of Government securities maturities, conducted on monthlyPOLICY TOOLS (once a week) basis SUB(OPERATIONAL Non standard fine tuning POLICY) operations used various Both use instruments similar tools STANDING FACILITIESto implement OVERNIGHT LIQUIDITYthe monetary Discount Window Lending Marginal Lending Facility policy The provision of overnight Overnight facility at an interest adjustment credit at an interest rate _ marginal lending rate _ discount rate, which stay rate(usually 100 basis points at least 25-50 basis points below above target refinancing rate) the target for the federal funds rate. DEPOSIT FACILITY Required reserve balance and Banks with excess reserve can excess balance have been paid deposit them overnight at an by the interest rate on required interest rate 100 basis points reserve since 2008. below the target refinancing rate. This rate ranges from 0 to ¼ This rate has been used since percent. 1999 Page 11
  12. 12. Group 9 & 10 Federal Reserve System RESERVE REQUIREMENT Reserve requirement is not used - Called minimum reserve, which to influence the inflation, but based on the level of liabilities in used to stabilize the demand of hand over a month. reserve. Based on two weeks - Remunerations, be at the average average balance on accounts of refinancing rate over the with unlimited checking period. privileges. Table 1: Differences between FED and ECB FEDERAL RESERVE SYSTEM: MONETARY POLICY BASICS Monetary policy includes all the Federal Reserve actions that change the money supply in order to influence the economy. Its purpose is to curb inflation or to reduce economic stagnation or recession. Hence, it would encompass various activities of the U.S. Treasury for those relating to foreign exchange operations and the receipt and disposition of public funds can affect the supply of money. Thus, a more realistic definition of monetary policy is that it consists of the directives, policies, pronouncements, and actions of the Federal Reserve System that affect aggregate demand or national spending. Among these, the dominant action consists of open market operations. These involve the buying and selling of seasoned Treasury securities by the Federal Reserve. When Treasury securities are purchased, the Federal Reserve does so with newly created money. This money can serve as reserves for the financial system and allows commercial banks and other depository institutions to make new loans and investments, Page 12
  13. 13. Group 9 & 10 Federal Reserve System thereby expanding the money supply and aggregate demand. The opposite happens when the Federal Reserve sells government securities1. GOALS OF MONETARY POLICY The goals of monetary policy are amended in the dual mandate in the Federal Reserve Act, and other legislation indicates goals of policy: (1) Price stability (by maximum purchasing power) (2) Employment stability ( by maximum employment) There are two factors to achieve the employment goal. First, low and stable inflation rate retention maximizes the economy growth rate in order to maximize the sustainable employment. Secondly, FED can enhance this goal by timely adjustments in its policy stance to adapt the economic changes. By implementing effective monetary policy, the Fed can maintain stable prices, thereby supporting conditions for long-term economic growth and maximum employment.2. LIMITATIONS OF THE FED MONETARY POLICY Monetary policy is not the only force that influences on national output, unemployment, and prices. There are many forces go along with aggregate demand and supply and the whole economy, such as: Fiscal policy, which is undertaken by the Government, has an impact on both demand and supply side. Although price stability is FED’s goal, it is easy or affected by the changes of both fiscal policy and monetary policy. Fiscal policy usually affects the economy through changes in taxes, governmental spending and economic decisions or also political mattes.. Many factors can be quietly unpredictable and influence the economy in unforeseen point. On the demand side, for instance, the changes in consumer and business confidence would lead to the changes in the lending posture lending by the commercial bank or creditors. On the Page 13
  14. 14. Group 9 & 10 Federal Reserve System supply side, natural disasters, disruptions in the oil market… would restraint the productivity growth. Useful information is limited not only by lags in the construction and availability of key data but also by later revisions, which can alter the picture considerably. The stat utor y goals of maximum employment and stable price are easier to achieve if the public understands those goals and believes that the FED will take effective measures to achieve them. Hence, resident confidence for FED should maintain to achieve the better results in implementing monetary policy.3. GUIDES OF THE FED MONETARY POLICY RULE The FED monetary policy rule has been calculated by a number of elements and methods. In this part, discussion will focus on some important of these:3.1. THE TAYLOR RULE The ―Taylor rule,‖ named after the prominent economist John Taylor, is another guide to assessing the proper stance of monetary policy. It relates the setting of the federal funds rate to the primary objectives of monetary policy—the extent to which inflation may be departing from something approximating price stability and the extent to which output and employment may be departing from their maximum sustainable levels. John Taylor noted that these characteristics of FOMC policy actions could be summarized in a simple expression (original equation): .5 p − p * * i p .5y r 1.5 p − p * * * .5y r p Where; _ i is the nominal federal funds rate, _ p is the inflation rate, Page 14
  15. 15. Group 9 & 10 Federal Reserve System _ p* is the target inflation rate, _ y is the percentage deviation of real gross domestic product (GDP) from a target, _ r* is an estimate of the ―equilibrium‖ real federal funds rate. Under this characterization: - The funds rate is raised (lowered) when actual inflation exceeds (falls short of), - The long-run inflation objective and is raised (lowered) when output exceeds (falls short of) a target level. - In subsequent analyses this target has been interpreted as a measure of ―potential GDP.‖ When inflation and real GDP are on target, then the policy setting of the real funds rate is the estimated equilibrium value of the real rate. To make this rule effective, however, data on the inflation rate and GDP must be known to the FOMC. In practice, the equation can be specified with lagged data on inflation and GDP. More generally the equation can be written as follows: a pt − 1 − p * P * * it 100bln y t −1 / y t−1 r p Where; pt–1 is the previous quarter’s PCE inflation rate measured on a year-over- year basis, yt –1 is the log of the previous quarter’s level of real GDP, ytP–1 is the log of potential real GDP as estimated by the Congressional Budget Office. Drawbacks of the Taylor Rule: The level of short-term interest rates associated with achieving longer- term goals, a key element in the formula, can vary over time in unpredictable ways. Moreover, the current rate of inflation and position of the economy in relation to full employment are not known because of data lags and Page 15
  16. 16. Group 9 & 10 Federal Reserve System difficulties in estimating the full-employment level of output, adding another layer of uncertainty about the appropriate setting of policy.3.2. FOREIGN EXCHANGE RATES Exchange rate movements are an important channel through which monetary policy affects the economy, and exchange rates tend to respond promptly to a change in the federal funds rate. Moreover, information on exchange rates, like information on interest rates, is available continuously throughout the day. Interpreting the meaning of movements in exchange rates, however, can be difficult. A decline in the foreign exchange value of the dollar monetary policy has become. But exchange rates respond to other influences as well, notably developments abroad; so a weaker dollar on foreign exchange markets could instead reflect higher interest rates abroad, which make other currencies more attractive and have fewer implications for the stance of U.S. monetary policy and the performance of the U.S. economy. Conversely, a strengthening of the dollar on foreign exchange markets could reflect a move to a more restrictive monetary policy in the United States. But it also could reflect expectations of a lower path for interest rates elsewhere or a heightened perception of risk in foreign financial as-sets relative to U.S. assets. Some have advocated taking the exchange rate guide a step further and using monetary policy to stabilize the dollar’s value in terms of a particular currency or in terms of a basket of currencies. However, there is a great deal of uncertainty about which level of the exchange rate is most consistent with the basic goals of monetary policy, and selecting the wrong rate could lead to a protracted period of deflation and economic slack or to an overheated economy. Also, attempting to stabilize the ex-change rate in the face of a disturbance from abroad would short-circuit the cushioning effect that the associated movement in the exchange rate would have on the U.S. economy. Page 16
  17. 17. Group 9 & 10 Federal Reserve System3.3. POLICY ASYMMETRY Policy bias exists because turning points in economic activity—peaks and troughs of business cycles—are infrequent. Changes in economic activity as measured by output and employment are highly persistent. Given such persistence, once it becomes apparent that a cyclic peak likely has occurred, the issue is never whether the Fed will raise the target funds rate but whether and how much the Fed will cut the target rate. Similarly, once it is apparent that an expansion is underway, the solution is not whether the Fed will cut the target rate, but the extent and timing of increases. Transitory and anomalous shocks to the data are ordinarily rather easy to identify. Both Fed and market economists develop estimates of these aberrations in the data shortly after they occur. The principle of looking through aberrations is easy to state but probably impossible to formalize with any precision. Policymakers piece together a picture of the economy from a variety of data, including anecdotal observations. When the various observations fit together to provide a coherent picture, the Fed can adjust the intended rate with some confidence. The market generally understands this process, as it draws similar conclusions from the same data.3.4. CRISIS MANAGEMENT These rules are suspended when necessary to respond to a financial crisis.  For examples of the Greenspan era are the stock market of 1987, the combination of financial market events in late summer and early fall 1998 that culminated in the near failure of Long Term Capital Management, crisis avoidance coming up to the century date change at the end of 1999. In this case, the response was tailored to circumstances unique event. Because markets had confidence in the Federal Reserve, including confidence that extra provision of Page 17
  18. 18. Group 9 & 10 Federal Reserve System liquidity would be withdrawn before risking an inflation problem. In the absence of such confidence, the Fed’s ability to respond would be severely curtailed.4. TRADITIONAL INSTRUMENTS (TOOLS) OF FEDERAL MONETARYPOLICY  Why does FED need tools to control or implement its policy? Because the function of the central bank has grown and today, the Fed primarily manages the growth of bank reserves and money supply in order to allow a stable expansion of the economy. To implement its primary task of controlling money supply, there are three main tools the Fed uses to change bank reserves: (1) The target federal funds rate (FFR) (2) The discount window lending (the primary credit rate) (3) The Reserve Requirements (1) THE TARGET FEDERAL FUNDS RATE AND THE OPEN MARKET OPERATIONS  The target funds rate is the Federal Open Market Committee’s primary policy instrument. On the other word, it is the interest rate at which banks make overnight loans to each other. It is sensitive to changes in the demand for and supply of reserves in the banking system, thus provides a good indication of the availability of credit in the economy.  The Open Market Operations (OMO) plays a role of buying and selling U.S. government securities to raise or lower the interest rate. It means OMO change the amount money supply or money base. - This tool consists of Federal Reserve purchases and sales of financial instruments, securities issued by the U.S. Treasury, Federal agencies and government-sponsored enterprises. Open market operations are carried out by the Page 18
  19. 19. Group 9 & 10 Federal Reserve System Domestic Trading Desk of the Federal Reserve Bank of New York. The transactions are undertaken with primary dealers. - When the Fed wants to increase reserves, it buys securities and pays for them by making a deposit to the account maintained at the Fed by the primary dealer’s bank. - When the Fed wants to reduce reserves, it sells securities and collects from those accounts. Trading securities, the Fed influences the amount of bank reserves, which affects the federal funds rate, or the overnight lending rate at which banks borrow reserves from each other. (2) THE DISCOUNT WINDOW LENDING  The discount window lending is the Fed’s primary tool for ensuring short-term financial stability, eliminating bank panics, and preventing the sudden collapse of financial institutions in financial difficulties.  The lending rate which the Fed charges banks for these loans is the discount rate (officially the primary credit rate). - Through its discount and credit operations, Reserve Banks provide liquidity to banks to meet short-term needs stemming from seasonal fluctuations in deposits or unexpected withdrawals. Longer term liquidity may also be provided in exceptional circumstances. In making these loans, the Fed serves as a buffer against unexpected day-today fluctuations in reserve demand and supply. This contributes to the effective functioning of the banking system, alleviates pressure in the reserves market and reduces the extent of unexpected movements in the interest rates. Page 19
  20. 20. Group 9 & 10 Federal Reserve System - The Fed rarely uses the discount rate as a policy tool. As its changes are strong signals of the Federal Reserves’ intentions and no guarantee that banks will borrow. - However, at times of market disruption, for instance, the September 11, 2001, terrorist attacks, loans extended through the discount window can supply a considerable volume of Federal Reserve balances.  This tool is also considered as an important safeguard against bank runs. To sum up, it is the lender of last resort, means making loans to banks when no one else can or will. (3) THE RESERVE REQUIREMENTS Reserve requirements are the reserve assets depository institutions must keep to ―backing‖ transaction deposits. Reserve assets include vault cash and deposits at Federal Reserve Banks. In short, the reserve requirement is the percentage of deposits in demand deposit accounts that financial institutions must set aside and hold in reserves. The original purpose of this tool was to ensure banks were sound and to reassure depositors that they could withdraw currency on demand. It is lightly different from the current purpose. Today, the reserve requirement is primarily to stabilize the demand for reserves and keep the target federal funds rate close to the market rate. Hence, in practice, if the Fed raises the reserve requirement, banks have less money to lend, which restrains the growth of the money supply. On the other hand, if the Fed lowers the reserve requirement, banks have more money to lend and the money supply increases. The Fed rarely changes the reserve requirement. In fact, it is the least-used monetary policy tool because changes in the reserve requirement significantly affect financial institution operations. Reserve requirement changes are seen as a sign that monetary policy has swung strongly in a new direction. Page 20
  21. 21. Group 9 & 10 Federal Reserve System  T HE CORRELATION OF MONETARY P OLICY AND INFLATION STABILIZATION EASE (LOOSE) TIGHT MONEY SUPPLY MONEY SUPPLY Buy government securities Sell government securities Lower interest rate Higher interest rate METHOD Lower reserve requirements rate Increase reserve requirements (RRR) rate (RRR) More Money Supply in MACRO- Less Money Supply in circulation circulation ECONOMY (Money back to Federal reserve) (Money creation is set) Stimulate economy Fight Inflation More borrowing and lending Less borrowing and lending EFFECTS E NCOURAGE INVESTMENT D ECLINE INVESTMENT SPENDING SPENDING RESULT B OOSTING ECONOMIC D ELAY THE WHOLE GROWTH ECONOMY CASE STUDY: FEDERAL RESERVE RESPONSES TOWARD THE FINANCIAL CRISIS (2007-2009) THE FINANCIAL CRISIS (2007): REVIEWING THE DISASTER In near the end of 2007, the great financial crisis exploded in US, and rapidly affected most of the global economy. In an interconnected world, a seeming liquidity crisis can very quickly turn into a solvency Page 21
  22. 22. Group 9 & 10 Federal Reserve System crisis for financial institutions, a balance of payment crisis for sovereign countries and a full-blown crisis of confidence for the entire world Indeed, this explosion related to the Housing Market Bubbles Pop, which has not been subject to pricing ―bubbles‖ as the other assets market. Most of people, investing in real estate, have not ever thought about price declining of their house as the enormous amount of money they have to pay to the transaction cost of purchasing, legal fees of owning and maintaining costs for house blurred their analytical and assessing vision. However, theoretically, the price of housing, like the price of any good or service in a free market, is driven by supply and demand. When demand increases and/or supply decreases, prices go up. So, if there is a sudden or prolonged increase in demand, prices are sure to rise. The policy to keep away from the recession in 2001 was a wrong decision. According to this, the federal funds rate was lowered 11 times _ from 6.5% in 5/2001 to 1.75% in 12/2001. This action which created the flood of liquidity in the economy made money cheaper. As result, it was easy to become an attractive pitfall, which caused damage the restless bankers and borrowers. This environment of easy credit and the upward spiral of home prices made investments in higher yielding subprime mortgages look like a new rush for gold. In 6/ 2003, interest rates continued downing 1%, the lowest rate in 45 years. The whole financial market resembled this rate. But, every good item has a bad side, and several of these factors started to emerge alongside one another. The trouble started when the interest rates started rising and home ownership reached a saturation point.6/ 2004, onward, the Fed raised rates so much that by 6/2006, the Federal funds rate had reached5.25%. Declines Begin: There were early signs of distress: by 2004, U.S. homeownership had peaked at 70%; no one was interested in buying houses. Then, during the last quarter of 2005, home prices started to fall, Page 22
  23. 23. Group 9 & 10 Federal Reserve System which led to a 40% decline in the U.S. Home Construction Index during 2006. This caused 2007 to start with bad news from multiple sources. Every month, one subprime lender or another was filing for bankruptcy. During February and March 2007, more than 25 subprime lenders filed for bankruptcy, which was enough to start the tide. In April, well-known New Century Financial also filed for bankruptcy. Investments and the Public: Problems in the subprime market began hitting the news, raising more peoples curiosity. Horror stories started to leak out. According to 2007 news reports, financial firms and hedge funds owned more than $1 trillion in securities backed by these now- failing subprime mortgages - enough to start a global financial tsunami if more subprime borrowers started defaulting. By June, Bear Stearns stopped redemptions in two of its hedge funds and Merrill Lynch seized $800 million in assets from two Bear Stearns hedge funds. But even this large move was only a small affair in comparison to what was to happen in the months ahead. August 2007: The Landslide Begins The financial market could not solve the subprime crisis on its own and the problems spread beyond the United States borders. The interbank market froze completely, largely due to prevailing fear of the unknown amidst banks. By that time, central banks and governments around the world had started coming together to prevent further financial catastrophe. It became apparent in August 2007 that the financial market could not solve the subprime crisis on its own and the problems spread beyond the United States borders. THE FEDERAL RESERVE’S RESPONSES TO THE CRISIS In the national financial corruption, from 2007 to 2009, the Fed announced many plans/ strategies to try to push long-term interest rates Page 23
  24. 24. Group 9 & 10 Federal Reserve System down. By reducing the supply of long-term interest rate Treasuries, the Fed intends to force investors to accept lower rates of return on the ultra-safe securities, or to move their money into a wide range of riskier investments that could do more to promote growth. In this part, we will pay attention to the Quantitative Easing (QE), the unconventional monetary policy, is the Fed’s major policy to escape from the crisis. The chart below will direct the changes in money supply from the very beginning of the financial crisis (2007) to the points after applying the QE policy in economy. Figure 2: M2 vs. True money supply (2000-2010) The figure 2 compares the year-over-year (YOY) growth rates of True Money Supply (TMS - the blue line) and M2 (the red line). As at the end of January the TMS yearly rate of change was down a few percent from its high, but was still well into double digits and in the top quartile of its 10-year range. The M2 rate of change, however, was at a 10-year low. As explained in previous commentaries, the large divergence over the past year between these two monetary aggregates is primarily due to declines in the nonmonetary components of M2 (the main non-monetary components of M2 being money-market funds and time deposits). From the chart, the money aggregates (2000-2001) rate was low. But, after the Page 24
  25. 25. Group 9 & 10 Federal Reserve System Fed enforced the ―cheap money‖ rules, this rate soared rapidly. It was the point that led to the greater crisis in 8/ than small-recession in 2001. SUBSEQUENT BAILOUT IN 2008 (FOR FINANCIAL INSTITUTION S) The Treasury and the Federal Reserve began working on a $700 billion bailout plan. Most of amounts was used to repurchase and invest to keep some important financial institutions from bankruptcy. - On Sept. 8, 2008, the U.S. Treasury seized control of mortgage giants Fannie Mae and Freddie Mac and pledged a $200 billion cash injection to help the companies cope with mortgage default losses. - About a week later the government bailed out American International Group Inc., or AIG, with $85 billion. - The Fed refused to save Lehman Brothers and the company was forced to file for bankruptcy. Some of the largest financial institutions were on the verge of collapse as the mortgage market melted down. As the crisis hit the global market, the credit freeze spread. - President George W. Bush signed the bailout plan into law October 3, 2008. - October 29, 2008, the Fed cut the key interest rate to 1 percent.  Expectation The Fed’s chairman claimed the bailout was necessary to provide stability in the economy and prevent disruption in the financial system. The interest rate cut aimed to revive the economy, help free up credit and make loans cheaper to consumers and businesses.  Result: Page 25
  26. 26. Group 9 & 10 Federal Reserve System The financial markets remained in turmoil for several months. Credit remains tight to this day; although it loosened significantly compared to when lending nearly came to a halt during the collapse period. Mortgage rates in figure 4 fell significantly after the interest rate cut and amid expectations that the Fed would start buying mortgage-backed securities. Figure 4: Mortgage rates during the collapse and government bailout REASONS FOR IMPLEMENTING UNCONVENTIONAL TOOLS The size of the monetary policy funds rate shortfall has also caused the Fed to expand its use of unconventional policy tools that change the size and composition of its balance sheet. - The Fed started to employ these balance sheet tools in late 2007 as unusual strains and dislocations in financial markets clogged the flow of credit. - Typically, changes in the funds rate affect other interest rates and asset prices quite quickly. - However, the economic stimulus from the Feds cuts in the funds rate was blunted by credit market dysfunction and illiquidity and higher risk spreads. Accordingly, the Fed started to lend directly to a broader range of counterparties and against a broader set of Page 26
  27. 27. Group 9 & 10 Federal Reserve System collateral in order to enhance liquidity in critical financial markets, improve the flow of credit to the economy, and restore the full effect of the monetary policy interest rate easing. Toward the end of 2008, the recession deepened with the prospect of a substantial monetary policy funds rate shortfall. - In response, the Fed expanded its balance sheet policies in order to lower the cost and improve the availability of credit to households and businesses. - One key element of this expansion involves buying long-term securities in the open market. The idea is that the funds rate and other short-term interest rates fall to the zero lower bound; there may be considerable scope to lower long-term interest rates. The FOMC has approved the purchase of longer-term Treasury securities and the debt and mortgage-backed securities issued by government-sponsored enterprises. - These initiatives have helped reduce the cost of long-term borrowing for households and businesses, especially by lowering mortgage rates for home purchases and refinancing. In terms of overall size, the Feds balance sheet(B.S) has more than doubled to just over $2 trillion. - The increase in B.S. has likely only partially offset the funds rate shortfall, and the FOMC has committed to further balance sheet expansion by the end of this year. - Looking ahead even further over the next few years, the size and persistence of the monetary policy shortfall suggest that the Feds balance sheet will only slowly return to its pre-crisis level. This gradual transition should be fairly straightforward, as most new assets acquired by the Fed are either marketable securities or loans with maturities of 90 days or less. THE QUANTITATIVE EASING (QE) POLICY Page 27
  28. 28. Group 9 & 10 Federal Reserve System (UNCONVENTIONAL TOOLS) The original definition of Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre- determined quantity of money into the economy. This is distinguished from the more usual policy of buying or selling government bonds to keep market interest rates at a specified target value.  HOW THE FED APPLIED QE POLICY IN U.S.?  It’s the electronic equivalent of starting up the Fed’s printing presses to create money for buying financial assets in the market – in this case long-term U.S. Treasury bonds. Buying bonds pushes down their yields and the interest rates across the debt markets that are closely tied to U.S. Treasury rates. The chart in Figure 3 following is the timeline chart of from the money infusion in the Fed’s monetary policy to rescue the national economy. END OF QE-1 END OF QE-2 2007-2008 FINANCIAL CRISIS (March 31, 2010) (June 30, 2011) QE-2 QE-1 (Nov. 3, 2010) (Nov. 25, 2008) Figure 3: Timeline of FED implementing the money infusion Page 28
  29. 29. Group 9 & 10 Federal Reserve SystemTHE FIRST QUANTITATIVE EASING (QE-1) (NOV. 25, 2008 – MAR. 31, 2010) The Fed initiated purchases of $500 billion in mortgage-backed securities. - It announced purchases of up to $100 billion in debt obligations of mortgage giants Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks. - The Fed cut the key interest rate to near zero, Dec. 16, 2008. - In March 2009, the Fed expanded the mortgage buying program and said it would purchase $750 billion more in mortgage-backed securities. - The Fed also announced it would invest another $100 billion in Fannie and Freddie debt and purchase up to $300 billion of longer- term Treasury securities over a period of six months. - The quantitative easing program, or QE1, concluded in the first quarter of 2010, with a total of $1.25 trillion in purchases of mortgage-backed securities and $175 billion of agency debt purchases. - After completing the purchase of $1.25 trillion in mortgage-backed securities, $300 billion in Treasury bonds and $175 billion in federal agency debt, the Fed ended QE1.  QE1 was initially open-ended. The Fed did not set an end date for the program until about six months out, as it slowed the buying pace.  Expectation: - The Fed wanted to lower mortgage interest rates and increase the availability of credit for homebuyers to help support the housing market and improve financial market conditions. - Many industry experts expected mortgage rates to rise after QE1 ended.  Result: Page 29
  30. 30. Group 9 & 10 Federal Reserve System - Mortgage rates dropped significantly, to as low as 5 percent in figure 4, about a year after QE1 started. - Contrary to analysts expectations, mortgage rates tumbled after the program ended. See in Figure 5 Figure 4: Mortgage rate reacted during QE-1 Figure 5: Mortgage rate reacted after QE-1 endedTHE SECOND QUANTITATIVE EASING (QE-2) (NOV. 3, 2010 – JUN. 30, 2011) Page 30
  31. 31. Group 9 & 10 Federal Reserve System The Fed continued to reinvest payments with the larger amount than the first purchase on securities purchased during the QE-1 program. - In second investment, it began the purchase of $600 billion of longer-term Treasury securities. - As the announcement, the Fed pushed the entire second budget into $600 billion bond purchasing program.  QE-2 was conducted at an even pace, and the end date was telegraphed from the start of the program.  Expectations: - The Fed said QE-2 would help promote a stronger pace of economic recovery. - Industrial observers expected QE-2 to keep mortgage rates low or push the rates lower. - Lower borrowing costs should help some homeowners refinance, even if many others don’t qualify because of weak credit scores or diminished home equity. It also should help businesses that can qualify for loans through cheaper credit, though larger corporations already can access money at cheap rates. - The Fed figures that buying up government debt, in theory, should push investors into riskier assets — such as stocks and corporate bonds — and raise their value. - It also will tend to weaken the dollar, helping U.S. exporters be more competitive in overseas markets.  Results: - Contrary to what was expected, mortgage rates spiked more than half a percentage point in a little more than a month after QE-2 started. When the program ended, the 30-year fixed-rate mortgage rate was about 30 basis points higher than it was when QE-2 started. - However, after the QE-2 ended, the mortgage rate was dramatically tumbledown. See in Figure 7 Page 31
  32. 32. Group 9 & 10 Federal Reserve System Figure 6: Mortgage rate during QE-2 Figure 7: Mortgage rate after QE-2 ended THE RESULTS OF THE QUANTITATIVE EASING POLICIES Through two rounds of pumping money into the U.S. economy, instead, stabilizing the price and promoting employment rate should have been paid more concern; the Fed was going too far from these two main functions as a central bank. Pumping money into the market could not help the every homeowners refinancing. By this way, the gap between the poor and the rich is more severe and bigger than ever. Although, the Fed’s starting points are based on the economic situations and the household’s needs. But, its predictions might be no precisely true as it should be.UNEMPLOYMENT RATE (HIGH THAN PREDICTED ) As shown in Figure 8, over the past two decades, the Fed has set the federal funds rate, a key gauge of the stance of monetary policy, in a Page 32
  33. 33. Group 9 & 10 Federal Reserve System fairly consistent relative to various economic indicators such as unemployment and inflation. (Figure 8 shows the quarterly average funds rate and unemployment rate, and the four-quarter inflation rate for prices of core personal consumption expenditures.) During the current and two previous recessions—around 1991, 2001, and 2008—the Fed responded to large jumps in unemployment with aggressive cuts in the funds rate. In addition, episodes of lower inflation also were generally associated with a lower funds rate. Figure 8: Federal Funds rates, Unemployment rates, Inflations rates The unemployment rate is important as a gauge of joblessness. For this reason, its also a gauge of the economys growth rate. However, the unemployment rate is a lagging indicator. This means it measures the effect of economic events, such as a recession, and so occurs after one has already started. It also means the unemployment rate will continue to rise even after the economy has started to recover. The unemployment rate is another indicator used by the Federal Reserve to determine the health of the economy when setting monetary policy. Investors also use unemployment statistics to look at which sectors are losing jobs faster. They can then determine which sector-specific mutual funds to sell. The year-over-year unemployment rate will tell you if unemployment is worsening. If more people are looking for work, less people will be Page 33
  34. 34. Group 9 & 10 Federal Reserve System buying, and the retail sector will decline. Also, if you are unemployed yourself, it will tell you how much competition you have, and how much leverage you might have in negotiating for a new position. As the unemployment rate reaches 6-7%, the government gets concerned, and tries to create jobs through stimulating the economy. It may also extend or add benefits to help the unemployed.  After implementing the QE-1, Unemployment peaked at 10.2% in October 2009. It rose steadily from its low of 4.4% in March 2007. It did not really become a concern until a year later when it broke above 5% in March 2008. By then, the economy had contracted., the unemployment rate rose rapidly, breaking 6.2% in August 2008, 7.2% by November 2008, 8.1% by February 2009, and 9.4% three months later, finally reaching 10.2% in October, 2009.  After the QE-2 enacted, although unemployment is projected to range between 8.7-9.1% through 2011, according to the Federal Reserves June 2011 forecast. But, it will decline slowly, falling to 7.5-8.7% in 2012, 6.5 - 8.3% in 2013. These forecasts seem a little optimistic, since unemployment was still 9.1% as of August 2011. (See in Figure 9) Page 34
  35. 35. Group 9 & 10 Federal Reserve System Figure 9: Unemployment rate historical data from 1948 to 2012 Source: US Bureau Labor Statistics Figure 10: Unemployment rate vs. Jobs hard to get (1978-9/2011) Source: US Department of Labor and The Confidence BoardIn its monthly survey of consumer confidence, the Conference Board asks theirrespondents whether jobs are available, plentiful, or hard to get. The percentagesaying that ―jobs are hard to get‖ (JHTG) is highly correlated with theunemployment rate. In August, (Figure 10) it increased to 50% from 44.8% inJuly. Its most recent low was 42.4% during April 2011. So the labor market hasactually been deteriorating every month for the past three months, according tothis measure. It gets worse: The latest reading is the highest since May 1983.And that’s after the White House spent $880 billion aimed at creating 3.7million jobs over the past two and a half years.  The main reason for this issue was an ineffective method ―money infusion‖ too much. It makes commodity price soar highly, reaches out of consumers’ hands. Declining in retail sales, supply, CPI… gave an impulse to downsize or dismiss workers. In addition, most businesses slashed their payrolls in 2008 and 2009 and didn’t turn around and Page 35
  36. 36. Group 9 & 10 Federal Reserve System rehire everyone they let go. Still, the high correlation between JHTG and the jobless rate is unnerving given that the former is the highest in almost three decades.Commodity price (crucial part) Figure 11: Real Retail Sales Source: Federal Reserve Board The rise in commodity prices has directly increased the rate of inflation while also adversely affecting consumer confidence and consumer spending. It is shown clear in Figure 11, which indicated that the CPI (consumer price index) was one of elements affecting the change in retail sales. In figure 11, the retail sales had some good news from economic recovery, commodity price still so high for consumer. The basic facts are familiar. Oil prices have risen significantly, with the spot price of West Texas Intermediate crude oil near $100 per barrel as of the end of last week, up nearly 40 percent from a year ago. Proportionally, prices of corn and wheat have risen even more, roughly doubling over the past year. And prices of industrial metals have increased notably as well, with aluminum and copper prices up about one-third over the past 12 months. When the price of any product moves Page 36
  37. 37. Group 9 & 10 Federal Reserve System sharply, the economists first instinct is to look for changes in the supply of or demand for that product. And indeed, the recent increase in commodity prices appears largely to be the result of the same factors that drove commodity prices higher throughout much of the past decade: strong gains in global demand that have not been met with commensurate increases in supply. From 2002 to 2008, a period of sustained increases in commodity prices, world economic activity registered its fastest pace of expansion in decades, rising at an average rate of about 4-1/2 percent per year. This impressive performance was led by the emerging and developing economies, where real activity expanded at a remarkable 7 percent per annum. The emerging market economies have likewise led the way in the recovery from the global financial crisis: From 2008 to 2010, real gross domestic product (GDP) rose cumulatively by about 10 percent in the emerging market economies even as GDP was essentially unchanged, on net, in the advanced economies. Naturally, increased economic activity in emerging market economies has increased global demand for raw materials. Moreover, the heavy emphasis on industrial development in many emerging market economies has led their growth to be particularly intensive in the use of commodities, even as the consumption of commodities in advanced economies has stabilized or declined. For example, world oil consumption rose by 14 percent from 2000 to 2010; underlying this overall trend, however, was a 40 percent increase in oil use in emerging market economies and an outright decline of 4-1/2 percent in the advanced economies. In particular, U.S. oil consumption was about 2- 1/2 percent lower in 2010 (Figure 12) than in 2000, with net imports of oil down nearly 10 percent, even though U.S. real GDP rose by nearly 20 percent over that period. Page 37
  38. 38. Group 9 & 10 Federal Reserve System Figure 12: Crude oil chart (May, 2010- May, 2011) Source: Finviz.com Page 38
  39. 39. Group 9 & 10 Federal Reserve System Figure 13: US dollar chart (5/2010 – 5/2011) Source: Finviz.com Figure 14: CRB Index (Commodity Price Index) (5/2010 – 5/2011) Source: Finviz.comThe value of the US Dollar and the price of Crude Oil are DIRECTLYRELATED (as comparing two charts in Figure 12 and Figure 13) and anyonethat would deny that is either Liar, a Cheat, a Buffoon, an Idiot or a shill for theFederal Reserve and Wall Street which makes a fortune when there is a lot ofvolatility in the currency markets and thus they hate more than anything in theworld a stable US Dollar. - Let’s have a close look in two charts in Figure 13 and Figure 14. Notice in the above two charts of the US Dollar and the CRB Index that when Bernanke, the Fed’s chairman, started talking about cranking up the printing presses in June 2010 that the value of the Dollar began falling and the prices of commodities started rising. Page 39
  40. 40. Group 9 & 10 Federal Reserve System - Also, note that in Nov., 2010 that the value of the US Dollar rallied for a few weeks and the CRB Index that tracks the prices for commodities went down over the same timeframe. - Next note at the beginning of 2011 that the value of the US Dollar started to fall again the prices of commodities started to go up.  Finally, note that since early May that the value of the US Dollar has stabilized in the 74 to 76 range that comm0odity prices have stabilized as well and even started to come down as traders and investors around the world .  So, as we know, he value of the US Dollar falls due to the out-of- control “money printing” at the Fed, of course commodity prices that are priced in Dollars would go up. Something that most everyone at the Federal Reserve forgot long ago, but then the Fed and US Treasury were after something else when it comes to all this money printing and devaluation of the US Dollar and that was goosing the stock market in hopes that companies and the American People would think that everything is now ―fine and dandy,‖ the economy is back on track and all of the unwashed masses will be solved by the Fed.THE FED’S BALANCE SHEET AFTER TWO QE Page 40
  41. 41. Group 9 & 10 Federal Reserve System Figure 15: The Fed’s liabilities Source: Board of Governors of the FED The dollar might soar again. That is good as same as bad news. It led to a flight away from counterparty risk and a flight to quality. The US Dollar Index soared from a low of 71.99 during the summer of 2008 to a peak of 89.54 on March 4, 2009. In figure 15, the Fed’s liabilities blew very high in the financial crisis period (2007- 2009). And after ending the QE-2 (2011) again soar quickly and higher than ever. Because the Fed’s monetary policy in crisis basically injects money into market to avoid the financial institution collapses, encourage risky investments, stimulus manufacturing and consuming. To do these things, the first action is to help borrowers lending money by easing credit (other name of QE). or put money in the consumers’ hands to push them run the consuming cycle. Purchasing Treasury securities and other long term securities are to lower down the short-term rate and also Federal funds rate to make money ―flood‖ in market. But with the huge amount of debts, it may be a signal for new recession: (1) Foreign official and international accounts deposited $102.8 billion at the Fed, up sharply from $57.6 billion at the start of the year, and well above the previous high of $88.9 billion during the week of January 7, 2009. (2) The flight to quality is most apparent in the plunge in 10-year government bond yields around the world to record lows. This morning these yields are at 0.92% in Switzerland, 1.00% in Japan, 1.66% in Sweden, 1.71% in Germany, 1.89% in the US, 2.11% in Page 41
  42. 42. Group 9 & 10 Federal Reserve System Canada, 2.19% in the UK, and 2.47% in France. On the other hand, yields are much higher among the credit-challenged governments of Spain (5.19%), Italy (5.44%), and Greece (18.56%). (3) At the end of last week, the high yield spread in the US widened to 651bps from 416bps at the beginning of the year. It is the widest since November 30, 2009. This spread is an excellent leading economic indicator and suggests that the outlook is deteriorating. Page 42