Ed Lotterman: A lesson on what the Fed actually does

September 20, 2013 

The Federal Reserve’s policy-setting Open-Market Committee met this week. It surprised financial markets and many pundits by sticking with its established pattern of expanding total reserves in the banking system by purchasing U.S. Treasury bonds and mortgage-backed securities. The immediate response of stock markets — which had sagged a bit in anticipation of the Fed beginning to taper off this policy — was to rise sharply, with the Dow hitting a new record.

My personal opinion was that this was the correct decision for now, but any marginal benefit to the economy from the Fed’s unprecedented low interest rate policy is diminishing. This week’s decision kicks the knottiest policy questions down the road. The Fed will tighten eventually; that is a certainty. The questions of when, in response to what criteria, and under what circumstances remain unanswered.

Time is slipping away. As of the end of the meeting, Chairman Ben Bernanke had 135 days and three more FOMC meetings left before his monetary coach turns into a pumpkin. If the FOMC does not alter course by then, the new chairman will be juggling a hot potato right from the start.

To understand all this, start by reviewing basics of what a central bank like the Fed can do:

The Fed has direct control over only one thing, the total amount of “reserves” in the banking system. Reserves are funds that banks have, largely from deposits, that are not lent out or invested in financial securities.

These reserves fall into two categories. “Required reserves” are the fraction of deposits that by law may not be lent out, but rather must be kept as cash in the bank itself or in a “reserve account” with a Fed District Bank like Minneapolis or Kansas City. These reserves are a safety measure, a liquidity cushion to ensure that the bank will always have available cash to give to any depositor wishing to make a withdrawal.

“Excess reserves” are any reserves above this minimum required. These are kept when a bank decides it wants an additional cushion above the legal minimum or does not see any safe and profitable way to lend or invest the funds.

Excess reserves are also kept at the Fed. One recent complication is that while the Fed paid no interest on reserve accounts for decades, it started in 2008. In other words, banks now effectively have the option of lending money back to the Fed rather than to business or household borrowers, and the interest rate the Fed offers influences that.

All reserves in the banking system plus currency in circulation add up to the “monetary base.” And this “monetary base” historically is closely related to the “money supply,” which is the sum of currency and all bank deposits.

This money supply, in interaction with the demand for money for various purposes, is what determines interest rates. Importantly, over the long run, growth of the money supply relative to the overall economy is what drives the changes in the general price level that we call inflation or deflation.

So the Fed does not “control” either the money supply or interest rates in a strict sense.

Observers talk about the Fed changing interest rates, loaning money to banks, increasing the money supply or purchasing bonds as if these were completely separate tools. In reality, these all boil down to changing the level of reserves via slightly different means.

When established a century ago, the idea was that the Fed would provide “a flexible currency” by loaning money directly to banks that needed loanable funds and that would put up collateral. These “discount window loans” would be repaid when retail loan demand slackened.

The Fed still does make such loans, but they are minor, except in emergencies such as the weeks after 9/11 or many months after the financial crisis began to unfold in October, 2008. Such loans were ignorantly portrayed by some as “gifts,” to banks, but they were indeed loans that now are almost entirely paid off.

The Fed can vary such loaning by increasing or decreasing the interest rates it charges. And it can announce changes in its target for very short term interest rates. That is the purview of the FOMC and an announcement to change or not is the usual outcome of an FOMC meeting.

However, the FOMC can announce any darned target it wants, but interest rates will change only if the Fed varies the quantity of bank reserves. It does so by purchasing or selling bonds “on the open market,” along with any other private buyer or seller of bonds.

When it buys bonds, it pays for them by just creating new bank reserves out of thin air. And when it sells them, reserves are destroyed.

What businesses and households expect for the future is increasingly recognized as important in determining their willingness to change current investment or consumption, so making statements about what it will do in the future is now thought important for the Fed. Hence the current enormous emphasis on FOMC statements and comments by its voting members. But such “future guidance” depends on belief that it will actually be able to do what it promises.

The Fed has increased reserves at an unprecedented rate for five years. Real interest rates have been at historic lows. It says it can unwind this stance as the economy strengthens, without slowing it down again or letting inflation break out. There is much division among economists as to whether and how this can be done. What it did Wednesday is delay the start for six weeks.

Write Ed Lotterman at ed@edlotterman.com.

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