The Fed s New Tools for Monetary Policy · Monetary Policy Overview. Suppose that on August 16, 2007, the Fed pumped $1,000 in the system through an open market operation. The Fed’s

The Fed’s New Tools for Monetary Policy

The Lender of Last Resort Gets Creative (Maybe Too Creative)

Kevin D SalyerECN 135, Fall 2009

Spring 2009 K. D. Salyer, ECN 135 2

Monetary Policy Overview

The Three Basic Tools for Policy

1.

Open market operations.

2.

Discount Window

3.

Reserve Requirements

To understand these and their macroeconomic effects, we need to first understand the Fed’s balance sheet.

Fall 2009 K. D. Salyer, ECN 135 3


This is a simplified version of the U.S. Federal Reserve’s balance sheet on August 15, 2007:

Federal Reserve's balance sheet, $ millions (Aug. 15, 2007)US government securities 789,601Repurchase agreements 24,000

Reverse repurchase agreements -31,941Direct loans 264

Assets

Other assets 37,058Currency in circulation 813,085

Liabilities Reserve balances 5,897

Recall: the monetary base is the sum of currency and reserves.



We now turn to the three traditional tools of monetary policy:

1.

Open market operations. This is an outright purchase (or sale) of government securities

from (or to) banks. When conducting this operation, the central bank increases its assets and credits banks’ reserve balances. Eventually, banks withdraw from their reserves at the central bank and turn them into cash. So an open market operation amounts to withdrawing government securities from the economy and replacing them with cash. The central bank can also reduce the amount of cash in circulation, by doing just the opposite: selling government securities and absorbing cash. By far, an open market operation is the best-known of the central bank’s tools.



Suppose that on August 16, 2007, the Fed pumped $1,000 in the system through an open market operation. The Fed’s balance sheet would experience the following changes, once banks have withdrawn the new funds from their reserve accounts (but before creating multiple loans):

Changes in the Fed's balance sheet after a $1,000M open market operation

US government securities +1,000Repurchase agreements 0

Reverse repurchase agreements 0Direct loans 0

Assets

Other assets 0Currency in circulation +1,000

Liabilities Reserve balances 0



2.

Discount Window:

The central bank simply lends money to a bank. The central bank increases its balance of loans, and simultaneously credits the reserves of the borrowing bank. Then the bank withdraws from its reserves, effectively turning them into currency in circulation. Asking for a direct loan usually means that the bank was not able to obtain liquidity in the inter-bank market. Moreover, borrowers are also subject to scrutiny by the central bank, and watched by other banks. Before 2003, the interest rate charged for direct loans (technically called the “primary lending rate”) was lower than FF rate but lending was discouraged. Now the rate is higher and any bank can borrow that is willing to pay the premium.



Open Market Operations and the Discount Window

Since both involve changes in the Fed’s asset position and bank reserves, these are often thought of as identical. But two differences

1.

Only Primary Security Dealers (19 of these) participate in open market operations. Any bank can borrow from the discount window.

2.

Open market operations are usually done in the form of repurchase agreements (discussed below)…the underlying collateral is typically US government securities. In contrast, a

broad range of assets can be used as collateral for discount window borrowings.



3. Reserve requirements.

Banks are required to keep a certain amount of reserves at the central bank. If the central bank increases that requirement, banks are forced to withdraw currency from the economy and put it in their reserve account. The central bank can also do the opposite, i.e. increase the amount of currency in circulation by lowering the reserve requirement. This tool is the least often used.

.

Spring 2009 K. D. Salyer, ECN 135 9


Normally banks obtain liquidity for their daily operations in the Fed Funds market. In the summer of 2007, some U.S. banks started

experiencing losses from their portfolios of mortgages and securitized mortgages. Nobody knew which banks would suffer losses in the future, or how large they could be. So banks starting growing wary of lending to each other, and it became more expensive—or just plain impossible—to raise as much liquidity as needed.

The Fed stepped in to help. Instead of providing liquidity through outright open market operations, it increased the use of an operation that is more frequently used, yet less well known: repurchase agreements. These are short-term loans, usually overnight, extended by the Fed to banks. As collateral, banks transfer high-quality securities to the central bank for the duration of the loan. At expiration, the loan is repaid and the bank takes back its securities.



From an accounting perspective, the repo increases the central bank’s assets and potential currency in circulation, much like an open market operation does. This, for example, is what happened between August 8 and August 15 of 2007.

Soon after, the Fed decided that it didn’t want to increase the potential amount of liquidity in the system, which affects short-term interest rates and inflation. So it offset the repurchase agreements by selling some of its own government securities (or letting them expire without purchasing more), and thus withdrawing cash from the system. So the repos didn’t have any bottom-line effect on liquidity: they merely changed the composition of the Fed’s assets and provided temporary cash to the borrowing banks.


Moneyless Monetary Policy

Here’s how a repurchase agreement would change the Fed’s balance sheet, after offsetting it with an open market operation:

Changes in the Fed's balance sheet after a $1,000M repurchase agreement, offset by an open market operation

US government securities -1,000Repurchase agreements +1,000

Reverse repurchase agreements

0

Direct loans 0

Assets

Other assets 0

Currency in circulation 0 (-1,000 + 1,000)Liabilities

Reserve balances 0


New Tools: Term Auction Facility

After doing this for months, and aware that banks were not getting as much liquidity as they wanted, in December 2007 the Fed unveiled the Term Auction Facility

(TAF). As its name suggests, this is an auction for a limited amount of Fed’s loans. Just like a repo, loans through the new facility require borrowers to cede collateral to the Fed for the duration of the loan. But the TAF represents an improvement with respect to repos in their capacity to provide liquidity. First, it lowers the bar for the type of assets that the Fed accepts as collateral. Second, it is more targeted than repos: the bidding system ensures that the limited loans go to the banks that value them most.



Here is how the Term Auction Facility works: Any of the more than 7,000-pluscommercial banks in the country can bid in the auction, stating what interest rate it will pay for what quantity of funds. The minimum bid rate is determined by the expected federal funds rate in the market over the term of the auction. An individual bank’s bid cannot exceed 50 percent of the value of the collateral that it has available for discount window borrowing. A bank receiving funds cannot prepay, so if the loan turns out to be expensive because interest rates fall during the term of the loan, the borrower is stuck with it.

The procedures of the Term Auction Facility—including the choice of auniform-

or single-price auction, the restriction that no bidder can be allocatedmore than 10 percent of the total being auctioned, and the fact that settlementoccurs two days after the date of the auction—helps to ensure anonymity for thebanks and that the bidders will not be branded as being in desperate need ofimmediate funds



By themselves, TAF loans would increase both assets and liabilities of the Fed, just like open market operations and repos. Here’s the simplified balance sheet on December 26 and August 15:

Federal Reserve's balance sheet, $ millions Aug. 15, 2007 Dec. 26, 2007

US government securities 789,601 754,612Repurchase agreements 24,000 42,500

Reverse repurchase agreements -31,941 -40,542Term Auction Facility loans 0 20,000

Direct loans 264 4,535

Assets

Other assets 37,058 52,869Currency in circulation 813,085 829,193

Liabilities Reserve balances 5,897 4,781

The balance of TAF loans grew from $20bn to $60bn between December 26 and March 12. By doing offsetting open market operations, the Fed can manage liquidity just as in repo’s.


Two additional tools

BUT, these liquidity venues are available only to members of the Federal Reserve system, which are all “depository institutions.”

Also, in March 2008 there was an extreme “flight to quality”: investors would only accept US securities as collateral in repos. The interest rate on repos (with US securities as collateral) fell to 0.20: Investors were willing to hold US Treasury securities with virtually no compensation.

So the Fed got creative: started lending US Treasury securities


TSLF

Term Securities Lending Facility

At this new window, all primary dealers -

all banks and

brokers that trade in government securities with the Fed -

are allowed to borrow up to $200bn of government

securities for 28 days. Borrowers must pledge collateral for these loans, but the minimum quality of the assets is even lower than for the TAF (it includes federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS).

Fed is changing the composition of its assets: from US Treasury securities to riskier assets.


PDCF

The second new facility is the Primary Dealer Credit Facility

(PDCF), which started operating on March 17 2008. This venue provides overnight loans to all primary dealers, backed by even riskier collateral: they accept all collateral eligible for repos, plus investment-grade corporate securities, municipal securities, MBS and asset-backed securities. With the PDCF, all primary dealers have de facto access to the discount window, from which only depository institutions could borrow before.

Unlike the TAF, neither TSLF nor PDCF will increase the assets of the Fed. It will temporarily decrease balances of government securities, and increase those of sketchy securities. And because participant institutions don’t have Fed reserves, TSLF loans don’t affect the monetary base. These two venues circumvent the necessity to conduct open market operations so that the monetary base doesn’t change.


Monetary Policy without the Money

Here’s the balance Fed again, in December and after the PDCF opened:

Federal Reserve's balance sheet, $ millions Dec. 26, 2007 Mar. 19, 2008

US government securities 754,612 660,484Repurchase agreements 42,500 62,000

Reverse repurchase agreements -40,542 -46,143Term Auction Facility loans 20,000 80,000

Primary Dealers Credit Facility 0 28,800Direct loans 4,535 125

Assets

Other assets 52,869 36,603Currency in circulation 829,193 818,362

Liabilities Reserve balances 4,781 3,507


PDCF and TSLF worked!


Monetary Policy without the Money

With its new tools, the Fed has provided liquidity without printing much money. It has temporarily absorbed risky and illiquid securities, and supplied government securities, which are risk-free. So instead of its traditional role in monetary policy the Fed has become a risk-absorber --

or, to put it less kindly, a

pawnbroker.

But things started to change toward the end of 2008….


The Fed’s Balance Sheet

But in Sept. 2008, the Monetary Base started to explode – Inflation??


What about inflation risks?

Beginning in September of 2008, the Fed embarked on a huge expansion in its lending efforts and holdings of alternative assets. The biggest items among assets currently held are $469 billion in term auction credit, $328 billion in currency swaps, $241 billion leant through the CPLF (Commercial Paper Lending Facility), and $236 billion in mortgage-

backed securities now held outright.

Where is it getting the resources to do this??


The change in the Fed’s assets


What about inflation risks?


Where did the Fed get the resources to do all this? In part, it asked the Treasury to borrow on its behalf and some of the Fed expansion has shown up as additional currency held by the public, which made a modest contribution to the explosion of the monetary base seen earlier. But by far the biggest factor was a 100-fold increase in excess reserves. These excess reserves mean that for the most part, banks are just sitting on the newly created reserve deposits, holding these funds idle at the end of each day rather than trying to invest them anywhere.

Fed Liabilities


Now the payment of interest on reserves make sense!!


It appears that the Fed has deliberately cultivated this situation by choosing to pay an interest rate on excess reserves that is equal to what banks could expect to obtain by lending them overnight. As long as banks sit on these excess reserves, the Fed has found close to a trillion dollars it can use for the various targeted programs.

The Fed is trying to revive the securitization markets..and

will worry about excess reserves later.

Plan A: Fed sells assets to US Treasury Plan B: Fed borrows from Public

Janet Yellen

(President of SF Fed): As the economy recovers, the Fed will eventually have to reduce the quantity of excess reserves. To some extent, this will occur naturally as markets heal and some programs consequently shrink. It can also be accomplished, in part, through outright asset sales. And finally, several exit

strategies may be available that would allow the Fed to tighten monetary policy even as it maintains a large balance sheet to support credit markets. Indeed, the joint Treasury-Fed statement indicated that legislation will be sought to provide such tools.

One possibility is that Congress could give the Fed the authority to issue interest-bearing debt in addition to currency and bank reserves. Issuing such debt would reduce the volume of reserves in the financial system and push up the funds rate without shrinking the total size of our balance sheet.


Inflation??

Not yet…but stay tuned.

Next: Some models of banks.


Documents

The Fed s New Tools for Monetary Policy · Monetary Policy Overview. Suppose that on August 16, 2007, the Fed pumped $1,000 in the system through an open market operation. The Fed’s