3 - Lectura Complementaria - Understanding Open Market Operations by M.A. Akhtar FRB of NY

The Federal R eserve B ank of N ew York is responsible for
day-to-day im plem entation of the nations m onetary pol-

icy. It is prim arily through open m arket operationspur-
chases or sales of U .S. G overnm ent securities in the
open m arket in order to add or drain reserves from the
banking system that the Federal R eserve influences
m oney and financial m arket conditions that, in turn,
affect output, jobs and prices.
This edition of Understanding Open Market
Operations seeks to explain the challenges in form ulat-
ing and im plem enting U .S. m onetary policy in todays
highly com petitive financial environm ent. The book high-
lights the broad and com plex set of considerations that
are involved in daily decisions for open m arket opera-
tions and details the steps taken to im plem ent policy.
M ichael Akbar Akhtar, vice president of the
Federal R eserve B ank of N ew York, leads the reader
w hether a student, m arket professional or an interested
m em ber of the publicthrough various facets of m one-
tary policy decision-m aking, and offers a general per-
spective on the transm ission of policy effects throughout
the econom y.
Understanding Open Market Operations pro-
vides a nontechnical review of how m onetary policy is
form ulated and executed. Ideally, it w ill stim ulate read-
ers to learn m ore about the subject as w ell as enhance
appreciation of the challenges and uncertainties con-
fronting m onetary policym akers.
W illiam J. M cD onough
President
Foreword
Understanding Open Market Operations / i
M uch has changed in U .S. financial m arkets and institu-
tions since 1985, w hen the last edition of Open Market
Operations, w ritten by Paul M eek, w as published. The
form ulation and im plem entation of m onetary policy also
have undergone som e notew orthy changes over the
years. C onsequently, the current edition is a substantial-
ly new book rather than sim ply an update of the earlier
w ork. Even so, I have m ade considerable use of m ateri-
als from Paul M eeks book and have follow ed its struc-
ture w here possible.
I ow e a special debt of gratitude to the O pen
M arket D esk staff at the Federal R eserve B ank of N ew
York: to Peter Fisher for allow ing m e to observe the daily
operations over an extended period of tim e; to Spence
H ilton, Sandy Krieger, Ann-M arie M eulendyke and John
Partlan for extensive com m ents on drafts; and to all of
the D esk staff for graciously and patiently answ ering m y
questions.
M any other colleagues at the N ew York Fed also
m ade significant contributions to this books publication,
including Peter B akstansky, R obin B ensignor, Scott Klass,
Steve M alin, C arol Perlm utter, Ed Steinberg, C harles
Steindel and B etsy W hite, as w ell as M artina H eyd and
Eileen Spinner, w ho provided m uch of the data assis-
tance, and Elisa Am broselli, w ho typed num erous ver-
sions of the m anuscript; D avid Lindsey and Vincent
R einhart of the B oard of G overnors also m ade m any use-
ful suggestions. I am greatly indebted to them all.
M . A. Akhtar
Acknowledgment
Understanding Open Market Operations / i
As the nations central bank, the Federal R eserve System
is responsible for form ulating and im plem enting m one-
tary policy. The form ulation of m onetary policy involves
developing a plan aim ed at pursuing the goals of stable
prices, full em ploym ent and, m ore generally, a stable
financial environm ent for the econom y. In im plem enting
that plan, the Federal R eserve uses the tools of m onetary
policy to induce changes in interest rates, and the
am ount of m oney and credit in the econom y. Through
these financial variables, m onetary policy actions influ-
ence, albeit w ith considerable tim e lags, the levels of
spending, output, em ploym ent and prices.
The form ulation of m onetary policy has under-
gone significant shifts over the years. In the early 1980s,
for exam ple, the Federal R eserve placed special em pha-
sis on objectives for the m onetary aggregates as policy
guides for indicating the state of the econom y and for
stabilizing the price level. Since that tim e, how ever,
ongoing and far-reaching changes in the financial system
have reduced the usefulness of the m onetary aggregates
as policy guides. As a consequence, m onetary policy
plans m ust be based on a m uch broader array of indica-
tors. Today, the m onetary aggregates still play a useful
role in judging the appropriateness of financial conditions
and in m aking m onetary policy plans, but their role is
quite sim ilar to that of m any other financial and nonfinan-
cial indicators of the econom y.
To a considerable extent, changes in policy for-
m ulation have been accom panied by corresponding
changes in the im plem entation approach. In the early
1980s, m onetary policy w as im plem ented by targeting a
quantity of bank reserves that w as based on num erical
objectives for the m onetary aggregates. As the Federal
R eserve reduced its reliance on the m onetary aggre-
gates and conditioned its policy decisions on a w ide
range of indicators, the im plem entation strategy shifted
tow ard a focus on reserve and m oney m arket conditions
consistent w ith broader policy goals, rather than on
achieving a particular quantity of reserves.
N o one approach to im plem enting m onetary
policy can be expected to prove satisfactory under all
econom ic and financial circum stances. The actual
Understanding Open Market Operations / 1
O N E
Introduction
approach has been adapted from tim e to tim e in light of
different considerations, such as the need to com bat
inflation and the desire to deal w ith uncertainties stem -
m ing from structural changes in the financial system .
Thus, it is fair to say that the current im plem entation
approach is likely to continue to evolve in response to
changing circum stances.
R egardless of the particular approach, im ple-
m enting m onetary policy involves adjustm ents in the
supply of bank reserves, relative to the reserve dem and,
in order to achieve and m aintain desired m oney and
financial m arket conditions. Am ong the policy instru-
m ents used by the Federal R eserve, none is m ore im por-
tant for adjusting bank reserves than open m arket oper-
ations, w hich add or drain reserves through purchases or
sales of securities in the open m arket. Indeed, open m ar-
ket operations are, by far, the m ost pow erful and flexible
tool of m onetary policy.
Focusing on open m arket operations, this book
offers a detailed description of how m onetary policy is
im plem ented. B y tracing the econom ic and financial con-
ditions that influence the actual decision-m aking
process, it attem pts to provide a sense of the uncertain-
ties and challenges involved in conducting day-to-day
operations. The book also review s the m onetary policy
form ulation process, and offers a broad perspective on
the linkages betw een m onetary policy and the econom y.
2 / Understanding Open Market Operations
Policy Formulation
The basic link betw een m onetary policy and the econo-
m y is through the m arket for bank reserves, m ore com -
m only know n as the federal funds m arket. In that m arket,
banks and other depository institutions trade their non-
interest-bearing reserve balances held at the Federal
R eserve w ith each other, usually on an overnight basis.
O n any given day, depository institutions that are below
their desired reserve positions borrow from others that
are above their desired reserve positions. The bench-
m ark interest rate charged for the short-term use of
these funds is called the federal funds rate. The Federal
R eserves m onetary policy actions have an im m ediate
effect on the supply of or dem and for reserves and the
federal funds rate, initiating a chain of reactions that
transm it the policy effects to the rest of the econom y.
The Federal R eserve can change reserves m ar-
ket conditions by using three m ain instrum ents: reserve
requirem ents, the discount rate and open m arket opera-
tions. The B oard of G overnors of the Federal R eserve
System (hereafter frequently referred to as the B oard)
sets reserve requirem ents, under w hich depository insti-
tutions m ust hold a fraction of their deposits as reserves.
At present, as described in the next chapter, these
reserve requirem ents apply only to checkable or transac-
tions deposits, w hich include dem and deposits and
interest-bearing accounts that offer unlim ited checking
privileges. D irectors of the R eserve B anks set the dis-
count rate and initiate changes in it, subject to review
and determ ination by the B oard of G overnors. The
R eserve B anks adm inister discount w indow lending to
depository institutions, m aking short-term loans.
The Federal O pen M arket C om m ittee (FO M C )
directs the prim ary and, by far, the m ost flexible and
actively used instrum ent of m onetary policyopen m ar-
ket operationsto effect changes in reserves. The
C hairm an of the B oard of G overnors presides over
FO M C m eetings, currently eight per year, in w hich the
C hairm an, the six other governors, and the 12 R eserve
B ank presidents assess the econom ic outlook and plan
m onetary policy actions. The voting m em bers of the
FO M C include the seven m em bers of the B oard of
T W O
Monetary Policy and the Economy
G overnors, the president of the Federal R eserve B ank of
N ew Yorkdesignated, by tradition, as the vice chair-
m an of the FO M C and four other R eserve B ank presi-
dents w ho serve in annual rotation. There is som etim es
discussion as w ell at the FO M C m eetings of reserve
requirem ents and the discount rate, although these tools
are outside the FO M C s jurisdiction.
U nder the Federal R eserve Act as am ended by
the Full Em ploym ent and B alanced G row th Act
of 1978 (the H um phrey-H aw kins Act), the
Federal R eserve and the FO M C are
charged w ith the job of seeking to pro-
m ote effectively the goals of m axim um
em ploym ent, stable prices, and m oderate
long-term interest rates.The H um phrey-
H aw kins Act requires that, in the pursuit of
these goals, the Federal R eserve and the
FO M C establish annual objectives for
grow th in m oney and credit, taking
account of past and prospective econom ic develop-
m ents. This provision of the Act assum es that the econ-
om y and the grow th of m oney and credit have a reason-
ably stable relationship that can be exploited tow ard
achieving policy goals. The law recognizes, how ever, that
changing econom ic conditions m ay necessitate revisions
to, or deviations from , m onetary grow th plans.
Since about 1980, far-reaching changes in the
financial system have caused considerable instability in
the relationship of m oney and credit to the econom y. In
particular, m onetary velocitiesratios of nom inal G D P
(gross dom estic product) to various m onetary aggre-
gateshave show n frequent and m arked departures
from their historical patterns, m aking the m onetary
aggregates unreliable as indicators of econom ic activity
and as guides for stabilizing prices. Velocities of M 1 (cur-
rency, checkable deposits and travelers checks of non-
bank issuers) and M 2 (M 1 plus saving and sm all tim e
deposits and retail-type m oney m arket
m utual fund balances) have fluctuat-
ed w idely in recent years, and their
average values over the last five to ten
years have been m uch different from
their long-run averages (Figure 2-1).
For exam ple, until the late 1980s, M 2
velocity had been relatively stable over
longer periods, w hile its short-run m ove-
m ents w ere positively correlated to inter-
est rate changes. In the early 1990s, how -
ever, M 2 velocity departed from its historical pattern and
drifted upw ard even as interest rates w ere declining.
Som e observers believe that ongoing, rapid
financial changes w ill continue to cause instability in the
financial linkages of the econom y, underm ining the use-
fulness of m oney and credit aggregates as guides for
policy. O thers expect the financial innovation process to
settle dow n, leading to a restoration, at least to som e
The Federal Reserves
monetary policy
actions have an
immediate effect on the
supply of or demand
for reserves and the
federal funds rate.
extent, of the usefulness of m oney and credit as policy
guides. W hatever the future outcom e of these controver-
sies, the Federal R eserve has been obliged, for som e
tim e now , to reduce its reliance on num erical targets for
m oney and credit in form ulating m onetary policy. In
recent years, the FO M C has used a w ide range of finan-
cial and nonfinancial indicators in judging econom ic
trends and the appropriateness of m onetary and finan-
cial conditions, and in m aking m onetary policy plans. In
effect, under this eclectic approach, the FO M C s strate-
gy for changing bank reserve levels aim s at inducing
broad financial conditions that it believes to be consistent
w ith final policy goals.
In m aking m onetary policy plans, the Federal
R eserve and the FO M C are involved in a com plex,
dynam ic process in w hich m onetary policy is only one of
m any forces affecting em ploym ent, output and prices.
The governm ents budgetary policies influence the econ-
om y through changes in tax and spending program s.
Shifts in business and consum er confidence and a vari-
ety of other m arket forces also affect saving and spend-
ing plans of businesses and households. C hanges in
expectations about econom ic prospects and policies,
through their effects on interest rates and financial con-
ditions, can have significant influence on the outcom es
for jobs, output and prices. N atural disasters and com -
m odity price shocks can cause significant disruptions in
output supply and the econom y. Shifts in international
5.6
5.8
6.0
6.2
6.4
6.6
6.8
7.0
7.2
7.4
Level Percentage points
2
4
6
8
10
16
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996
1.5
1.6
1.7
1.8
1.9
2.0
2.1
0.25
1
2
20
4
40
6
60
8
10
80
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996
M1 Velocity and 3-Month Treasury Bill Rate
Monetary Velocities and Interest Rates
Notes: (1) Quarterly observations.
(2) Velocities are ratios of nominal GDP to M1 or M2.
(3) M2 opportunity cost is the difference between the 3-month Treasury
bill rate and the average rate paid on M2 components.
Figure 2-1
M2 Velocity and M2 Opportunity Cost
Level Percentage points
3-Month
Treasury
(Right Scale)
M1 Velocity
(Left Scale)
Average M1 Velocity
1986-95
Average M1 Velocity
1960-95
Average M1 Velocity
1980-89
7.6
Average M2 Velocity
1960-95
Average M2 Velocity
1986-95
Average M2 Velocity
1980-89
M2 Opportunity Cost
(Right Scale)
M2
Velocity
(Left Scale)
trade rules and regulations and in econom ic policies
abroad can low er or raise the contribution of the exter-
nal sector to the U .S. econom y.
The FO M C also m ust estim ate w hen, and to
w hat extent, its ow n policy actions w ill affect m oney,
credit, interest rates, business developm ents and prices.
Since the state of know ledge about the w ay the econo-
m y w orks is quite im perfect, policym akersunderstand-
ing of the effects of various influences, including the
effect of m onetary policy, is far from certain. M oreover,
the w orking of the econom y changes over tim e, leading
to changes in its response to policy and nonpolicy fac-
tors. O n top of all these difficulties, policym akers do not
have up-to-the-m inute, reliable inform ation about the
econom y, because of lags in the collection and publica-
tion of data. Even prelim inary published data are fre-
quently subject to significant errors that becom e evident
in subsequent revisions.
In all of this, there is no escape from forecasting
and from using judgm ent to deal w ith the uncertainties
of data and the policy process. Indeed, m onetary policy
form ulation is not a sim ple technical m atter; it is clearly
an art in that it greatly depends on experience, expertise
and judgm ent.
Operational Approaches
D eterm ining the appropriate reserve m arket condi-
tionsthat is, the desired degree of m onetary policy
restraintalso is very com plicated. In choosing an oper-
ating strategy, the FO M C attem pts to achieve a desired
degree of m onetary policy restraint, ease or tightness, by
focusing on the reserve supply relative to dem and, and
the associated level of the federal funds rate. The
D om estic O pen M arket D esk at the Federal R eserve
B ank of N ew York can com e reasonably close to m eet-
ing short-term objectives for nonborrow ed reserves
supply of reserves excluding discount w indow borrow -
ing. The contem plated reserve levels are based, of
course, on the FO M C s desire to induce short-run m on-
etary and financial conditions that w ill help to achieve
policy goals for the econom y.
In principle, the FO M C can aim for direct control
of the quantity of reserves by not accom m odating
observed fluctuations in the dem and for reserves.
H ow ever, this w ill result in free m ovem ents in the federal
funds rate. Alternatively, the FO M C can control the fed-
eral funds rate by adjusting the supply of reserves to
m eet all changes in the dem and for reserves; this w ill
allow the quantity of reserves to vary freely. O ver the
years, the actual approach has been adapted to chang-
ing circum stances. Som etim es the em phasis has been
on controlling the quantity of reserves; other tim es, the
federal funds rate.
W hile the FO M C generally has not aim ed at pre-
cise control of the quantity of reserves, the operating
strategy from O ctober 1979 to late 1982 w as closely
consistent w ith this approach. C oncerned over rapidly
accelerating inflation in the late 1970s, the C om m ittee
sought changes in its operating procedures in order to
control m oney stock grow th m ore effectively. In O ctober
1979, the C om m ittee began targeting nonborrow ed
reserves, allow ing the federal funds rate to fluctuate
freely w ithin a w ide and flexible range. U nder this
approach, the targeted path for nonborrow ed reserves
w as based on the FO M C s grow th objectives
for M 1currency, checkable deposits
and travelers checks of nonbank issuers.
M 1 grow th in excess of the C om m ittees
objectives w ould cause the depository
institutionsdem and for reserves to out-
strip the nonborrow ed reserves target,
putting upw ard pressures on the funds
rate and other short-term rates. The rise
in interest rates, in turn, w ould reduce
the grow th in checkable deposits and
other low -yielding instrum ents, bringing m oney stock
grow th back tow ard the C om m ittees objectives.
The reserve targeting procedure from 1979 to
1982 gradually cam e to provide assurance to financial
m arkets and the public at large that the Federal R eserve
w ould not underw rite a continuation of high and acceler-
ating inflation. R einforcing this procedures built-in effects
on m oney m arket conditions w ere judgm ental changes
in nonborrow ed reserve objectives and in the discount
rate. M onetary policy contributed im portantly to low ering
the inflation rate sharply, albeit not w ithout a significant
increase in interest rate volatility and a period of m arked
decline in output.
The historical relationship betw een M 1 and the
econom y broke dow n in the early 1980s, leading the
FO M C to de-em phasize its control of M 1 during 1982. In
late 1982, the C om m ittee abandoned the form al reserve
targeting procedure and m oved tow ard accom m odating
short-run fluctuations in the dem and for
reserves, w hile lim iting their effects
on the federal funds rate.
Subsequently, ongoing deregulation
and financial innovation precluded a
return to the use of num erical objec-
tives for M 1 and the nonborrow ed
reserve targeting procedure.
As a consequence, since 1982,
the Federal R eserves operating proce-
dures have focused on achieving a particu-
lar degree of tightness or ease in reserve m arket condi-
tions rather than on the quantity of reserves. Specifically,
the FO M C expresses its operating directives in term s of
a desired degree of reserve pressurethat is, the costs
and other conditions for the availability of reserves to the
banking system w hich is associated w ith an average
level of the federal funds rate. The approach for evaluat-
ing the degree of reserve pressure, how ever, has
Monetary policy
formulation is not a
simple technical matter;
it is clearly an art in
that it greatly depends
on experience, expertise
and judgment.
changed over tim e. As discussed in detail in C hapter 5,
discount w indow borrow ing targets w ere used as the
m ain factor for assessing reserve availability conditions
during 1983-87, but they have not played a significant
role through m uch of the subsequent period.
U nder the current approach, the FO M C uses the
federal funds rate as the principal guide for evaluating
reserve availability conditions and indicates a desired
level of the federal funds rate. This judgm ental approach
involves estim ating the dem and for and supply of
reserves, and accom m odating all significant changes in
the dem and for reserves through adjustm ents in the sup-
ply of nonborrow ed reserves. It allow s for only m odest
day-to-day variations in the funds rate around the level
intended by the C om m ittee.
Financial Markets
The m oney m arketw hich includes the federal funds
m arketprovides the natural point of contact betw een
the Federal R eserve and the financial system . The m oney
m arket is a term used for w holesale m arkets in short-
term credit or IO U s, com prising debt instrum ents m atur-
ing w ithin one year. The m arket is international in scope
and helps in econom izing on the use of cash or m oney.
B orrow ers w ho are the issuers of short-term IO U sgen-
erally, the U .S. Treasury, banks, business corporations
and finance com paniescan bridge differences in the
tim ing of receipts and paym ents or can defer long-term
borrow ing to a m ore propitious tim e. The m arket allow s
the lendersbusinesses, households or governm ental
unitsto offset uneven flow s of funds by allow ing them
to invest in short-term interest-earning assets that can
be readily converted into cash w ith little risk of loss. They
can also tim e their purchases of bonds and stocks to
their particular view s of long-term interest rates and
stock prices.
The m ain instrum ents of the m oney m arket are
federal funds, Treasury bills, repurchase agreem ents
(R Ps), Eurodollar deposits, certificates of deposits (C D s),
bankers acceptances, com m ercial paper, m unicipal
notes and federal agency short-term securities (see
Figure 2-2 for definitions of instrum ents). The stock-in-
trade of the m arket includes a large portion of the U .S.
Treasury debt and federal agency securities. The daily
dollar volum e in this m arket is very large, several tim es
that of the m ost active trading days on the N ew York
Stock Exchange.
B anks are at the center of the m oney m arket,
w ith their custom er deposits and their ow n reserve bal-
ances at the Federal R eserve serving as the core ele-
m ent in the flow of funds. Large banks borrow and lend
huge sum s of m oney, on a daily basis, through the fed-
eral funds m arket. They are also particularly active in the
m arkets for R Ps, Eurodollars and bankers acceptances.
M any banks act as dealers in m oney m arket securities,
w hile m any others offer short-term investm ent services.
Like other financial institutions, banks invest in short-
term instrum ents such as Treasury bills and com m ercial
paper. B anks also supply m uch of the short-term credit
that allow s nonbank dealers in m oney m arket paper to
buy and hold an inventory.
C hanges in borrow ing and lending in the m oney
m arket are reflected m ore or less continuously in the
dem and for nonborrow ed reserves relative to the avail-
able supply, w ith im m ediate consequences for the feder-
al funds rate. Thus, if the Federal R eserve increases the
reserve supply relative to dem andi.e. eases reserve
m arket conditionsthe funds rate w ill fall quickly, and
vice versa. Sustained m ovem ents of the federal funds
rate are transm itted alm ost fully to yields on Treasury
bills, com m ercial paper and other m oney m arket instru-
m ents.
The transm ission of m onetary policy actions to
capital m arketsm arkets for G overnm ent securities and
corporate bonds and stocks w ith m aturities exceeding
one yearand the foreign exchange m arket is m ore
com plex and less predictable. Insurance com panies,
pension funds and other investors in capital m arket
instrum ents seek rates of return that w ill com pensate
them , not only for expected future inflation, but also for
Figure 2-2
Glossary: Common Money Market Instruments
Federal Funds
N on-interest-bearing deposits held by banks and other
depository institutions at the Federal R eserve; these are
im m ediately available funds that institutions borrow or lend,
usually on an overnight basis.
Treasury Bills
Short-term debt obligations of the U .S. Treasury that are
issued to m ature in 3 to 12 m onths.
Repurchase Agreements
Short-term loansnorm ally for less than tw o w eeks and
frequently for one dayarranged by selling securities to
an investor w ith an agreem ent to repurchase them at a
fixed price on a fixed date.
Eurodollar Deposits
D ollar deposits in a U .S. bank branch or a foreign bank
located outside the U nited States.
Certificate of Deposit
A tim e deposit w ith a specific m aturity date show n on a
certificate; large-denom ination certificates of deposits can
be sold before m aturity.
Bankers Acceptances
A draft or bill of exchange accepted by a bank to guarantee
paym ent of the bill.
Commercial Paper
An unsecured prom issory note w ith a fixed m aturity of one
to 270 days; usually it is sold at a discount from face value.
Municipal Notes
Short-term notes issued by m unicipalities in anticipation of
tax receipts or other revenues.
Federal Agency Short-Term Securities
Short-term securities issued by federally sponsored agencies
such as the Farm C redit System , the Federal H om e Loan
B ank and the Federal N ational M ortgage Association.
uncertainty and forgone real return. In m aking invest-
m ent decisions, such investors take into account recent
experience w ith inflation and inflation expectations, as
w ell as num erous other factors, including the federal
budget deficit, long-term prospects for the econom y,
expectations about short-term interest rates and the
credibility of m onetary policy. These sam e considera-
tions are also im portant in the transm ission of m onetary
policy to the foreign exchange m arket.
G iven the w ide variety of influences on capital
m arkets, long-term interest rates do not respond one-
for-one to changes in the federal funds rate. In general,
sustained changes in the federal funds rate (and other
m oney m arket rates) lead to significant, but usually
sm aller, changes in long rates. Such interest rate
changes also m ay tend to strengthen or w eaken the dol-
lar against other currencies, other things rem aining the
sam e. For exam ple, a rise in U .S. interest rates relative to
interest rates abroad w ill tend to m ake dollar assets
m ore attractive to hold, increasing the foreign exchange
value of the dollar as long as U .S. inflation trends and
other forces are not w orking to offset the upw ard pres-
sures on the dollar.
Economic Effects of Monetary Policy
B y causing changes in interest rates, financial m arkets
and the dollar exchange rate, m onetary policy actions
have im portant effects on output, em ploym ent and prices.
These effects w ork through m any different channels,
affecting dem and and econom ic activity in various sectors
of the econom y. Figure 2-3 show s the m ain contours of
the transm ission of m onetary policy to the econom y (see
B ox for a brief description of the transm ission channels).
Private Spending and Output
C hanges in the cost and availability of credit, reflecting
changes in interest rates and credit supply conditions,
are the m ost im portant sources of m onetary policy
effects on the econom y. H igher interest rates tend to
reduce dem and and output in interest-sensitive sectors:
higher corporate bond rates increase borrow ing costs,
restraining the dem and for additional plant and equip-
m ent; higher m ortgage rates depress the dem and for
housing; higher auto and consum er loan rates reduce
purchases of cars and other consum er durables. O ther
(non-rate) restrictive provisions of loan agreem ents and
low er supplies of credit also restrain the dem and for
investm ent goods and consum er durables, especially by
those businesses and households particularly depen-
dent on bank credit.
C onsum ption dem and also is affected by
changes in the value of household assets such as stocks
and bonds. In general, asset values are inversely related
to m ovem ents of interest rateshigher interest rates
tend to reduce the value of household assets, other
things rem aining the sam e.
Figure 2-3 indicates that m onetary policy
actions influence output, em ploym ent and prices
through a num ber of com plex channels. These chan-
nels involve a variety of forces in financial m arkets that
cause changes in (1) the cost and availability of funds
to businesses and households, (2) the value of house-
hold assets or net w orth, and (3) the foreign exchange
value of the dollar w ith direct consequences for
im port/export prices. All these changes, in due course,
affect econom ic activity and prices in various sectors of
the econom y.
W hen the Federal R eserve tightens m onetary
policy for exam ple, by draining bank reserves through
open m arket sales of G overnm ent securitiesthe fed-
eral funds rate and other short-term interest rates rise
m ore or less im m ediately, reflecting the reduced supply
of bank reserves in the m arket. Sustained increases in
short-term interest rates lead to low er grow th of
deposits and m oney as w ell as higher long-term inter-
est rates. H igher interest rates raise the cost of funds,
and, over tim e, have adverse consequences for busi-
ness investm ent dem and, hom e buying and consum er
spending on durable goods, other things rem aining the
sam e. This is the conventional m oney or interest rate
channel of m onetary policy influence on the econom y.
A firm ing of m onetary policy also m ay reduce
the supply of bank loans through higher funding costs
for banks or through increases in the perceived riski-
ness of bank loans. Sim ilarly, non-bank sources of
credit to the private sector m ay becom e m ore scarce
because of higher lending risks (actual or perceived)
associated w ith tighter m onetary conditions. The
reduced availabilityas distinct from costsof loans
m ay have negative effects on aggregate dem and and
output. This is the so-called credit channelthat m ay
operate alongside the interest rate channel.
H igher interest rates and low er m onetary
grow th also m ay influence econom ic activity through
the w ealth channelby low ering actual or expected
asset values. For exam ple, rising interest rates general-
ly tend to low er bond and stock prices, reducing house-
hold net w orth and w eakening business balance
sheets. As a consequence, business and household
spending m ay suffer.
Finally, a m onetary policy tightening affects
econom ic activity by raising the foreign exchange value
of the dollarthe exchange rate channel. B y m aking
U .S. im ports cheaper and by increasing the cost of U .S.
exports to foreigners, the appreciation of the dollar
reduces the dem and for U .S. goods, and, therefore,
has adverse consequences for the trade balance and
output. O n the positive side, low er im port prices help in
im proving the U .S. inflation perform ance.
N eedless to say, all these effects w ork in the
opposite direction w hen the Federal R eserve eases
m onetary policy.
Monetary Policy Influence on the Economy
The outlook for the econom y and expectations
of households and businesses play a central role in the
m agnitude and tim ing of m onetary policy effects on the
econom y. H ouseholdsow n experience w ith the cyclical
rise and fall in interest rates m ay affect their actions. A
sustained sharp rise in interest rates, for exam ple, m ay
suggest m ore uncertain prospects for em ploym ent and
incom es, resulting in greater household caution tow ard
spending on consum er goods and house purchases.
C onversely, a significant fall in interest rates during a peri-
od of w eak econom ic activity m ay encourage greater
consum er spending by increasing the value of household
assets. Low er m ortgage rates, together w ith greater
availability of m ortgage credit, also m ay stim ulate the
dem and for housing.
B usinesses plan their inventories and additions to
productive capacity (i.e. capital spending) to m eet future
custom er dem ands and their ow n sales expectations.
Since internal resourcesretained earnings and deprecia-
tion allow ancesdo not provide all of their cash require-
m ents, businesses often are obliged to use the credit m ar-
kets to finance capital spending and inventories.
D uring business cycle expansion, the business
sectors need for external financing rises rapidly, as firm s
accum ulate inventories to ensure that sales w ill not be
lost because of shortages. At the sam e tim e, businesses
attem pt to finance additions to capacity. G reater busi-
ness dem and for funds tends to bid up interest rates in
The Transmission of Monetary Policy
Figure 2-3
Federal Open Market
Committee
Expectations of
Inflation & Output
State and
Local
Government
Spending
Business
Investment
Housing
Consumption
Spending
Import,
Export
Prices
Reserve Pressure,
Federal Funds Rate
Interest Rates:
Short-term and
Long-term
Supply of
Funds
Demand for Funds:
Federal Deficit
and Business
Investment
Credit Terms
and
Conditions
Deposits
and
Money
Bond and
Stock
Prices
Dollar
Exchange
Rates
Cost and Availability of Credit
Household
Net Worth
Trade
Economy: Output, Employment, Income, Prices
financial m arkets, but higher rates do not pose serious
problem s for businesses so long as sales are grow ing
and the econom y is expanding at a rapid pace. In this
environm ent, m onetary policy tightening w ill dam pen
capital spending and inventory building only slow ly, if the
strong outlook for business sales and the econom y per-
sists. Eventually, how ever, higher interest costs and
reduced credit availability contribute to a tem -
pering of the optim istic outlook, leading
to w eaker business sales, unw anted
accum ulation of inventories and low er
output.
W ith low er capital spending,
business credit dem ands fall during peri-
ods of business slow dow n, putting
dow nw ard pressure on m arket interest
rates. Actual and expected easing of
m onetary policy w ork in the sam e direc-
tion, accelerating the speed of decline in rates and
increasing credit availability to businesses. These condi-
tions gradually build up expectations of stronger dem and
and econom ic activity, setting the stage for an end to the
inventory runoff. Eventually, production levels needed to
m eet current sales are restored.
Government Sector
M onetary policy has only a m odest direct effect on cap-
ital spending by state and local governm ents. R ising
interest rates tend to trim or postpone som e state and
local governm ent capital spending projects, as private
investors bid aw ay financial resources from other users.
C onversely, a fall in interest rates tends to m ake som e
state and local G overnm ent projects viable.
In contrast, the discretionary spending and rev-
enue decisions of the federal G overnm ent are largely
im m une to m onetary restraint or ease. The U .S. Treasury
is, in fact, a m ajor independent force
in financial m arkets, com peting w ith
other borrow ers. To som e extent,
federal credit dem ands tend to run
counter to private credit dem ands:
they rise during recessions, w hen tax
receipts go dow n and cyclically induced
G overnm ent spendings go up; they fall
during expansions, reflecting favorable
effects on tax receipts and cyclical
G overnm ent spendings. Since the early 1980s, how ever,
federal credit dem ands have tended to rem ain very high,
even in good tim es, because of a sharp rise in structural
deficits. R ecent G overnm ent budget initiatives m ay
reverse this trend by reducing future structural deficits.
External Sector
U .S. m onetary policy exercises significant effects on the
econom y through the external sector. For exam ple, the
appreciation of the dollar associated w ith higher interest
Monetary policy has
significant effects on
employment and
output in the short run,
but in the long run, it
affects primarily prices.
rates reduces the dem and for U .S. goods by low ering
the cost of im ports to Am ericans and increasing the cost
of U .S. exports to foreigners. W ith Am ericans substitut-
ing cheaper im ports for dom estically produced goods
and people abroad buying few er Am erican goods, U .S.
production suffers and the trade balance w orsens.
O ther countries have to w eigh the benefits and
costs of changes in exchange rates resulting from U .S.
m onetary policy changes for their ow n econom ies. A
country m ay w elcom e the stim ulus from the depreciation
of its currencythe appreciation of the dollarif its
econom y is facing considerable slack and inflation is not
a serious problem . O n the other hand, if a country is
experiencing significant inflationary pressures at hom e, it
m ay attem pt to offset the depreciation of its currency by
tightening m onetary policy. O f course, the feedback on
U .S. exports and trade depends, not only on changes in
foreign and U .S. m onetary policies, but also on the pace
of econom ic grow th here and abroad.
Inflation
The drop in dem and and output induced by tighter m on-
etary policy tends to relieve pressures on econom ic
resources. Such relief is necessary to curb inflation in an
overheating econom y. B y contrast, in a depressed econ-
om y, m onetary ease helps increase em ploym ent of labor
and other econom ic resources by generating higher
dem and and output. M onetary policy has significant
effects on em ploym ent and output in the short run, but
in the long run, it affects prim arily prices. To sustain non-
inflationary econom ic grow th over tim e, therefore, the
Federal R eserve m ust aim at m aintaining price stability or
low inflation. Indeed, price stability is necessary, though
not sufficient, to m axim ize the long-run grow th potential
of an econom y.
M onetary restraint or ease affects the econom y
w ith considerable tim e lags that differ am ong sectors
and, perhaps m ore im portantly, betw een dem and/output
and prices. N orm ally, sales and production respond to
m onetary policy changes m ore quickly than do w ages
and prices. The econom y is characterized by m any for-
m al and inform al contracts and other rigidities that lim it
changes in prices and w ages in the short run. In addition,
inflation expectations, w hich influence decisions to set
w ages and prices, tend to adjust rather slow ly. O ver a
longer period, how ever, m onetary policy changes are
transm itted m ore fully to w ages and prices as adjust-
m ent of inflation expectations is com pleted and con-
tracts are renegotiated.
As background for understanding the m onetary policy
im plem entation process, this chapter, first offers a brief
description of the institutional setting under w hich
depository institutions hold and m anage their reserves. It
then review s a variety of influences on supply and
dem and conditions for reserves. The review em phasizes
the role of m arket factors in absorbing and supplying
reserves and its im plications for open m arket operations.
Depository Institutions Reserve Positions
All depository institutions in the U nited States, as in m any
other countries, are subject to reserve requirem ents on
their custom ersdeposits. C om m ercial banks and thrift
institutionsm utual savings banks, savings and loan
associations and credit unionsw hose checkable
deposits exceed a certain size are required to m aintain
cash reserves equal to a specified fraction of those
deposits (Figure 3-1). As of end-1995, com m ercial banks
held about 86 percent of checkable deposits, and thrift
institutions the rem aining 14 percent.
The bulk of the com m ercial bank share of
checkable deposits is accounted for by m em ber banks
of the Federal R eserve System . About 4,000 com m ercial
banks w ere m em bers of the System at the end of 1995.
These included just over 2,900 federally chartered
national banksw hich are required to be m em bers
and about 1,050 state-chartered banks. Approxim ately
6,000 state-chartered banks w ere not m em bers at end-
1995. B ut they and all other depository institutions have
access to the Federal R eserve System s lending facilities
on equal term s w ith m em bers, just as they are subject to
reserve requirem ents.
R eserve requirem ents are structured to bear
less heavily on sm aller depository institutions. At all
depository institutions, checkable deposits up to certain
levelsadjusted annually to reflect grow th in the banking
system either are exem pted or carry relatively low
requirem ents.
D epository institutions hold required reserves
either as cash in their ow n vaults or as deposits at their
D istrict Federal R eserve B ank. To provide banks and
thrifts w ith flexibility in m eeting their requirem ents, the
T H R E E
Monetary Stresses and Reserve Management
Federal R eserve allow s them to hold an average am ount
of reserves over tw o-w eek reserve m aintenance periods
ending on alternate W ednesdays, rather than a specific
am ount on each day. Large banks apply all of their vault
cash tow ard m eeting requirem ents, since their required
reserves exceed their vault cash. B ut m any sm all banks
and thrift institutions hold m ore vault cash than their
required reserves because they need m ore cash to m eet
custom er dem ands than they do to m eet reserve
requirem ents.
In contrast, over 3,000 depository institutions in
early 1996 had less vault cash than their required
reserves, obliging them to hold balances at R eserve
B anks. These so-called bound institutions accounted for
roughly three-quarters of total checkable deposits.
Coping With Reserve Pressures
In m anaging their reserve positions, depository institu-
tions attem pt to balance tw o opposing considerations.
As profit-seeking enterprises, they try to keep their
reserves, w hich produce no incom e, close to the
required m inim um . Yet they also m ust avoid reserve defi-
ciencies, w hich carry a penalty charge on the deficiency
at a rate that is 2 percentage points above the discount
rate. In addition, if a depository institution frequently fails
to m eet requirem ents, its senior m anagem ent is given a
w arning that continued failure w ould put the institution
under scrutiny. To clear their ongoing financial transac-
tions through the Federal R eserve and to m aintain a
cushion of funds in order to avoid penalty charges, m any
depository institutions arrange w ith their R eserve B anks
to m aintain supplem entary accounts for required clearing
balances. These additional balances effectively earn
interest in the form of credits that can be used to pay for
Federal R eserve services, such as check-clearing and
w ire transfers of funds and securities.
M anaging the reserve position of a depository
institution is a difficult job. The institutions reserve posi-
Figure 3-1
Required Reserves on Checking
Deposits in 1996*
D ollar Am ount
of D eposits R eserve R atio** O ther Provisions
D epository institutions hold
U p to 0 percent an average am ount of
$4.3 m illion reserves over a tw o-w eek
m aintenance period; they
are allow ed to carry forw ard
$4.3 m illion for one m aintenance period
to 3 percent any excess or deficiency of
$52 m illion up to four percent of their
requirem ents; reserve
deficiencies beyond the
Above 10 percent carry-forw ard am ount are
$52 m illion assessed a penalty equal
to tw o percentage points
above the discount rate.
* Tim e deposits and other bank liabilities are not subject to
reserve requirem ents at present.
** Fraction of deposits held as required reserves.
tion is affected by virtually all of its transactionsw hether
carried out for its custom ers or on its ow n account. A
bank or thrift institution, for exam ple, loses reserves w hen
it pays out cash or transfers funds by w ire on behalf of its
custom ers. C ustom er checks to pay out-of-tow n bills
funnel back through its Federal R eserve B ank and are
charged against its reserve or clearing account; custom er
checks to pay in-tow n bills also drain reserves,
on a net basis, as accounts am ong banks
are settled. A bank m ay also lose reserves
w hen it advances loans or buys securities.
O n the other hand, a bank gains reserves
from deposits of custom er checks and
currency, sales of securities and num erous
other transactions. At the end of each day,
after the close of w ire transfers of funds
and securities, a banks reserve position
reflects the net of reserve losses and gains
resulting from all of its transactions.
A depository institution facing a reserve defi-
ciency has several options. It can try to borrow reserves
for one or m ore days from another depository institution.
It can sell liquid, or readily m arketable assets, such as
G overnm ent securities, pulling in funds from the buyers
bank. It can bid for funds in the m oney m arket, such as
large certificates of deposits (C D s) or Eurodollars. U sing
G overnm ent securities or other acceptable collateral, a
depository institution also canas a last resortborrow
from its D istrict R eserve B ank at the prevailing discount
rate to com pensate for unforeseen reserve losses.
The Open Market Desk and Reserve Supply
W hile an individual institution can m eet its reserve short-
ages by purchasing or borrow ing reserves from other
banks or thrift institutions, depository institutions cannot
expand aggregate reserves (except by borrow ing at the
discount w indow ); they can m erely pass
around the existing reserves.
R eserve shortages or surpluses of
depository institutions are reflected
in the overall reserve supply and
dem and in the federal funds m arket.
W hen depository institutions, collec-
tively, seek m ore reserves than are
available in the m arket, they bid up the
federal funds rate. As the funds rate
rises, m ore banks and thrift institutions
are induced to borrow at the discount w indow , bringing
reserve supply back into line w ith reserve dem and. Thus,
w ithin a given reserve m aintenance period, the banking
system as a w hole has no practical alternative to bor-
row ing m ore reserves from the Federal R eserve if aggre-
gate reserve dem and exceeds the total supply of non-
borrow ed reserves.
O pen m arket operations allow the O pen M arket
D esk at the Federal R eserve B ank of N ew York to adjust
A banks reserve
position reflects the net
of reserve losses and
gains resulting from all
of its transactions.
the volum e of nonborrow ed reserves in the system
before depository institutions turn to borrow ing from the
discount w indow . O pen m arket operations involve the
buying and selling of G overnm ent securities in the open,
or secondary, m arket by the Federal R eservea pur-
chase adds to nonborrow ed reserves, w hile a sale
reduces them (see C hapter 5 for details). In this w ay, the
Federal R eserve can offset sw ings in reserves caused by
changes in the publics dem and for cash and num erous
other factors, sheltering the funds rate from the effects of
potential reserve changes. Alternately, the Federal
R eserve can choose not to offset, or even to reinforce,
m ovem ents in nonborrow ed reserves, inducing changes
in the funds rate.
B y m anaging the supply of nonborrow ed
reserves in relation to the dem and for them , the Federal
R eserve can adjust the cost and availability of reserves
to induce changes in the federal funds rate. W hen the
O pen M arket D esk adds m ore reserves than depository
institutions collectively dem and, the funds rate declines.
O ver tim e, higher reserves and a low er federal funds rate
stim ulate the expansion of m oney and credit in the econ-
om y, other things rem aining the sam e. C onversely, w hen
the D esk holds back on reserves relative to dem and, the
funds rate rises and the grow th of m oney and credit
tends to go dow n.
W hile open m arket operations allow the Federal
R eserve to exert control over the supply of nonborrow ed
reserves, m any factors outside the Federal R eserves
control influence that supply. Am ong the m ost im portant
such factors are changes in currency holdings of the
public, the Treasurys cash balances at the Federal
R eserve, short-term credit to banks resulting from the
Federal R eserves national check clearing arrangem ents
and foreign central bank transactions. As discussed in
C hapter 5, the Federal R eserve forecasts daily these and
other factors affecting reserves to assess the need for
open m arket operations. H ere, w e briefly sketch the
general im plications of these factors for reserve m ove-
m ents and open m arket operations.
Currency in Circulation
D epository institutions obtain currency from the Federal
R eserve B anks to replenish actual or anticipated cash
w ithdraw als by custom ers, and they pay for it through
debits of their reserve accounts at the Fed. O ver tim e,
currency dem and is the largest single factor requiring
reserve injections, because it has a strong grow th trend
w hich reflects, prim arily, the grow th trend of the econ-
om y. H ow ever, currency m ovem ents display significant
short-run variations. Such variations m ay result from
m any sources, including cyclical developm ents in the
econom y or changes in foreign dem and for U .S. cur-
rency, w hich usually expands in tim es of political and
econom ic uncertainty abroad. Indeed, in recent years,
foreign dem and for U .S. dollars, especially from high-
inflation econom ies of Eastern Europe and other regions,
has contributed significantly to the grow th of U .S. cur-
rency in circulation.
N orm ally, seasonal sw ings in the publics cur-
rency holdings are the dom inant source of short-run cur-
rency variations. Som e of these sw ings represent intra-
m onthly patterns reflecting such routine transactions as
paym ents of salaries and social security benefits. O thers
result from the effects of som ew hat longer seasonal
cycles on business activity during the year. For exam ple,
currency in circulation rises substantially during the w in-
ter holiday shopping season, from early N ovem ber to
year-end, and m uch of this bulge reverses in the follow -
ing m onth (Figure 3-2).
M ost short-term variations in currency m ove-
m ents are reasonably predictable, since they follow
recurrent seasonal patterns (Figure 3-3). The Federal
R eserve, through its open m arket operations, attem pts
to offset recurrent contractions and expansions in
reserves associated w ith seasonal sw ings in currency. If
the Federal R eserve did not do so, depository institutions
as a group w ould be obliged to adjust their reserve posi-
tions by low ering or raising their investm ents and short-
term loans. Such actions w ould cause significant fluctu-
ations in the federal funds rate and other short rates, and
could lead to serious m arket disturbances. Indeed, one
of the original reasons for creating the Federal R eserve
System w as to avoid the undesirable effects of seasonal
Figure 3-2
Changes in Currency Demand:
Winter Holiday Shopping Season*
Billions of dollars
* For each period, the first bar represents the cummulative increase over the
seven-week period from mid-November to the beginning of January, while
the second bar reports the cummulative decrease over the four-week
period from early January to end-January.
-14
-12
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
14
1993-94 1994-95 1995-96
9.3
-5.2
9.9
-7.9
11.4
-11.2
Currency in Circulation
Billions of dollars
320
340
360
380
400
420
440
Jan
1993
Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1994
1995
Weekly Average
Figure 3-3
sw ings in the publics currency holdings. B efore the
establishm ent of the Federal R eserve in 1913, financial
strains from seasonal increases in currency dem ands
w ere quite com m on and becam e so severe on a few
occasions that they touched off financial panics, causing
bankruptcies and recessions in business activity.
Treasury Balances
The U .S. Treasury m aintains its w orking balances at the
Federal R eserve for m aking and receiving pay-
m ents; increases in these balances absorb
reserves since they involve the transfer of
funds from the public and depository insti-
tutions to the Federal R eserve, w hile
decreases in these balances supply
reserves to banks and thrifts. The Treasury
attem pts to keep its balances reasonably
stable, generally around $5 billion, so as
not to com plicate the Feds job of m an-
aging reserves. It places additional cash in
Treasury tax and loan note option (TT&L) accounts at
depository institutions that have agreed to accept them ;
these accounts serve as collection points for tax
receipts. Each depository institution lim its the am ount of
TT&L account balances because it m ust pay interest on
those balances and m ust hold collateral against them .
W hen balances exceed the lim it, the excess is trans-
ferred to the Federal R eserve.
The Treasury can transfer funds into or out of the
TT&L accounts on a daily basis to keep its Federal
R eserve balances close to the target level. It can m ake a
callbefore 11 a.m . on the larger depository institutions
to transfer funds to the Fed on the sam e day, or the fol-
low ing day. It can m ake a direct investm entto m ove
funds from the Fed to the TT&L accounts.
B ecause of the difficulties in predicting the tim -
ing and size of the m yriad receipts and expenditures of
the federal G overnm ent, daily estim ates of Treasury bal-
ances at the Fed are subject to sizable
errors. It is not unusual for the bal-
ance to be $1 billion or so higher or
low er than expected. M ost of the
tim e such errors have only a m odest
effect on the average level of reserves
over the tw o-w eek m aintenance
period, since the Treasury can take
action the next day to bring the balance
back to the desired level.
H ow ever, a m ore serious reserve m an-
agem ent problem arises w hen Treasury tax receipts are
particularly heavyfor exam ple, follow ing som e of the
m ajor tax dates in January, April, June and Septem ber
(Figure 3-4). In this case, Treasury balances accum ulate
in excess of the com bined aggregate lim its on the TT&L
accounts set by depository institutions, lifting balances at
the Federal R eserve and draining reserves from the
One of the original
reasons for creating
the Federal Reserve
System was to avoid
the undesirable effects
of seasonal swings in
the publics currency
holdings.
banking system . At tim es, the excess in Treasury bal-
ances m ay last for up to tw o w eeks before they drop
below the aggregate capacity of the TT&L accounts.
Accordingly, on those occasions, the O pen M arket D esk
has to offset reserve drains by injecting large am ounts of
reserves.
Federal Reserve Float
H ouseholds and businesses m ake a significant portion of
their paym ents by w riting checks on their accounts at
depository institutions. The Federal R eserves national
check clearing system facilitates the m ovem ent of these
checks around the country. The R eserve B anks credit a
banks reserve account at the Fed for checks
depositedpresented for collectionby the bank and
debit its account for checks draw n on it and presented
by other banks. W hen a presenting banks reserve
account is credited before a corresponding debit is
m ade to the account of the bank on w hich the check is
draw n, tw o banks have credit sim ultaneously for the
sam e reserves, creating reserve float. This float arises
because R eserve B anks credit checks presented for col-
lection, under a preset schedule, to a banks reserve
account w ithin a m axim um of tw o business days, w hile it
som etim es takes m ore than tw o days to process those
checks and collect funds from the banks on w hich they
are draw n.
Since 1983, the Fed has actively discouraged
float by charging the banks explicitly for the float they
receive. As a result, float has declined dram atically in
recent years. Float also has becom e m ore predictable
because of increased inform ation flow s about delivery
and processing of checks. M ost of the tim e, therefore,
changes in float are not a significant consideration for
open m arket operations.
Still, how ever, float can vary w idely on a w eekly or
even m onthly basis (Figure 3-5), and occasionally, it show s
large increases w hen norm al check delivery is interrupted,
for exam ple, due to bad w eather. O n these occasions, the
O pen M arket D esk m ay be obliged to engage in significant
operations to offset the effects of large sw ings in float on
the supply of nonborrow ed reserves.
Treasury Balances at the Fed
Billions of dollars
Jan
1993
Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1994
1995
0
2
4
6
8
10
12
14
16
Weekly Average
Figure 3-4
Foreign Central Bank Transactions
M any foreign central banks and official international insti-
tutions m aintain w orking and short-term investm ent bal-
ances at the Federal R eserve to execute their dollar-
denom inated transactions. D raw ing dow n of these bal-
ances increases the reserves of depository institutions
receiving paym ents. M oving funds from depository insti-
tutions into these balances drains reserves of the bank-
ing system . At tim es, unexpected transfers into and out
of foreign central bank accounts can result in significant
increases or decreases in reserves, requiring sizable off-
setting open m arket operations.
Deposit Flows and Reserve Demand
O pen m arket operations are required, not only to offset
seasonal and other short-lived influences on the supply
of nonborrow ed reserves, but also to deal w ith changes
in depository institutionsdem and for reserves.
Specifically, in m anaging the supply of nonborrow ed
reserves, the O pen M arket D esk m ust m ake adjustm ents
for changes in the dem and for those reserves so as to
create m oney m arket conditions that are consistent w ith
the desired m onetary policy objectives. O pen m arket
operations, therefore, have both defensive and dynam ic
aspects.
D epository institutionsdem and for reserves has
tw o com ponents: required reserves and excess reserves
above requirem ents. Since banks and thrifts attem pt to
keep their reservesw hich yield no incom eclose to
the required m inim um , aggregate excess reserves in the
system are quite sm all. In 1995, for exam ple, excess
reserves averaged only about $1 billion, less than 2 per-
cent of total reserves.
R equired reserves are based on checkable
deposits, w hich serve as the principal m eans of paym ent
for transactions in the econom y. O ver tim e, the publics
dem and for checkable deposits is related to the grow th
of the econom y and developm ents in other m odes of
paym entssuch as cash, direct debit of accounts and
electronic transfersthat m ay encourage or discourage
the use of checks for m aking paym ents. B ut, in the short
Weekly and Monthly Average Float,
1993-1995
(Including As-Of Adjustments)
Billions of dollars
J
1993
F M AM J J A SON D
1994
0
1
2
3
4
J FMA M J J S O ND J FMAM J J AS OND
Monthly
Figure 3-5
Weekly
A
1995
run, the dem and for checkable deposits can be highly
variable, leading to large increases or decreases in
required reserves.
S hort-run variability of checkable deposits
results in part from the influence of cyclical and other
short-term developm ents in business activity; these
developm ents go hand-in-hand w ith short-run changes
in interest rates and affect credit flow s and the holdings
of various incom e-producing assetssuch as
bonds, stocks and tim e/saving deposits
relative to currency and dem and deposits
that yield no incom e. B ut it also reflects a
variety of recurring influences, including
tax paym ent cycles, regular payroll dis-
bursem ents and seasonal m ovem ents in
dem ands for credit and deposits. For
exam ple, businesses and households
norm ally keep checkable deposits at
m inim um levels because such deposits
pay low interest rates, if any at all. H ow ever, they shift out
of higher-yielding short-term investm ents into checkable
deposits w hen tax, payroll or other significant paym ents
are due. Around m ajor tax paym ent dates, for instance,
checkable deposits at banks and thrifts increase sub-
stantially, enabling businesses and households to m ake
their tax paym ents to the U .S. Treasury. R equired
reserves increase correspondingly on a tem porary basis,
and decline a few days later w hen the funds are trans-
ferred to the TT&L balances, w hich are not subject to
reserve requirem ents.
Bank Decisions and Monetary Policy
Seasonal adjustm ents and related procedures can be
applied to sort out recurrent patterns of deposit m ove-
m ents. B ut w hether short-term m onetary developm ents
are consistent w ith the Federal R eserves expectations
and policy goals also w ill depend on how the underlying
deposit flow s and the corresponding
reserve dem ands evolve in
response to ongoing econom ic and
financial trends in the econom y. The
actual behavior of deposits and credit
in the econom y reflects the interaction
of depository institutions, their cus-
tom ersbusinesses and households
and the Federal R eserve. The lending
and funding decisions of banks and
thrifts are influenced by current and
prospective custom er dem ands, the outlook for the
econom y and perceptions about m onetary policy. W ithin
this context, lenders m ust assess the loan dem and they
are likely to face and possible grow th of their ow n
deposits.
For exam ple, if a bank is facing rising loan
dem and at a tim e w hen the outlook for econom ic grow th
is strong, it m ay expect the Federal R eserve to tighten
In the short run, the
demand for checkable
deposits can be highly
variable, leading to
large increases or
decreases in required
reserves.
m onetary policy, putting upw ard pressures on interest
rates. In that case, if the banks ow n deposit grow th is
insufficient to m eet its loan dem and, it m ay fund loan
dem and by issuing dom estic C D s or by borrow ing in the
Eurodollar m arket at prevailing interest rates, rather than
risk having to roll over overnight borrow ings at higher
rates. O n the other hand, if the bank expects its ow n
deposit grow th to outrun its loan dem and, it m ay attem pt
to lend m ore to creditw orthy custom ers, w hile buying
additional securities. A turn in the outlook tow ard a slug-
gish econom y w ould accelerate such activities.
B ank decisions affect m oney and credit condi-
tions, as do developm ents in num erous other financial
and nonfinancial indicators. The Federal O pen M arket
C om m ittee (FO M C ), as described in the next chapter,
considers all these indicators in determ ining the course
of m onetary policy and in assessing the need for
changes in it. The D om estic O pen M arket D esk at the
Federal R eserve B ank of N ew York, w hich is responsible
for im plem enting the FO M C s decisions on a day-to-day
basis, focuses on achieving and m aintaining the FO M C s
desired degree of reserve pressure and the associated
federal funds rate (see C hapter 5 for details). The
M anager of the D esk and Federal R eserve staffs in N ew
York and at the B oard of G overnors in W ashington, D .C .,
track reserve supply and dem and conditions at banks
and thrift institutions, m ovem ents of various short and
long interest rates and deposit flow s into and out of M 1
and broader m onetary aggregates. They also w atch
closely the responses of financial and foreign exchange
m arkets to developm ents in m onetary policy, inflation
expectations and the econom y m ore generally. All this
inform ation helps in assessing w hether m oney and finan-
cial conditions in the econom y are developing in line w ith
those contem plated by the FO M C .
The decision-m aking process for U .S. m onetary policy
centers on the FO M C s annual policy objectives and
sem i-annual reports to C ongress. Each year, in February,
the C hairm an of the FO M C , w ho is also the C hairm an of
the B oard of G overnors, reports to the C ongress on the
FO M C s expectations about the perform ance of the
econom y and its m onetary policy plans for the current
calendar year. The report is based on a com prehensive
review of the econom ic and financial situation. It review s
a w ide range of indicators for determ ining the course of
m onetary policy and includes specific annual grow th
ranges for m oney and debt aggregates, consistent w ith
expectations for inflation and grow th of em ploym ent and
output. In July, after further consideration by the FO M C ,
the C hairm an reports any revisions to the plans for the
current year, along w ith prelim inary plans for the follow -
ing year.
In late January or early February, B oard m em -
bers and R eserve B ank presidents assem ble in
W ashington, D .C ., for the first FO M C m eeting of the year.
At present, they participate in seven other sim ilar m eet-
ings, roughly six w eeks apart, during the course of a
year. Each participant considers a variety of inform ation
sources on the econom ic and financial situation to pre-
pare for the FO M C m eeting. (Figure 4-1 provides a
schem atic description of the FO M C deliberations.) All of
them carefully exam ine the B oard staffs G reen B ook
forecasts of the econom y and the relevant policy and
other assum ptions underlying those forecasts. These
forecasts draw on large, com plex m odels that are based
on historical relationships am ong m ajor sectors, but the
projections presented are essentially judgm ental.
Participants also are fam iliar w ith m any other private and
public sector forecasts of the national econom y as w ell
as w ith R eserve B ank staffs B eige B ook com m entaries
on regional econom ic conditions. The R eserve B ank
presidents have considered their ow n staff forecasts for
the national econom y, and also have carefully review ed
the econom ic situation in their particular regions. B oth
B oard m em bers and R eserve B ank presidents also have
looked at various m onetary policy options presented in
the B oard staffs B lue B ook.
F O U R
Decisions of the Federal Open Market Committee
At FO M C m eetings, before the C om m ittee
begins the discussion of the econom ic outlook and m on-
etary policy, the M anager of the System O pen M arket
Account reports on (1) foreign exchange m arket devel-
opm ents, along w ith any System open m arket transac-
tions in foreign currencies since the last FO M C m eeting,
and (2) dom estic financial m arket developm ents and
System open m arket transactions in G overnm ent securi-
ties and federal agency obligations during the preceding
interm eeting period.
Annual Policy Plans
The discussion of the econom ic outlook and m onetary
policy is usually quite detailed, but it is particularly com -
prehensive at the first m eeting of the year, since that
m eeting precedes the C hairm ans testim ony to C ongress
on annual m onetary policy plans. The outlook review
begins w ith the B oard staffs presentation on how the
U .S. econom y and its trade and other external account
balances are likely to evolve over the current and follow -
ing years. The presentation covers a w ide range of key
econom ic variables and usually provides a com parison
of the B oard staffs forecasts for output, em ploym ent
and prices w ith those of the Adm inistration. The B oard
staff also presents an analysis of recent m onetary and
financial developm ents, and grow th ranges for m oney
and credit aggregates from the fourth quarter of the year
just ended to the fourth quarter of the current year that
The FOMC Deliberations
Figure 4-1
Preparation for the FOMC Meeting
Decisions/Outcomes of the Meeting
1 Revisions of annual and short-term policy plans
2 The Directive to the Open Market Desk
3 Announcement of policy changes
Reserve Bank Presidents Board Members
1 Reserve Bank staff briefings
on the U.S. economy, District
business conditions, and
developments in financial
markets and the international
economy
2 Contacts with District business
leaders and advisory groups
3 Green Book (Board staff)
4 Blue Book (Board staff)
5 Beige Book (Reserve Bank staff)
6 Other public and private sector
forecasts/contacts
1 Board staff briefings on the
U.S. economic and financial
developments and the
international economy
2 Green Book (Board staff)
3 Blue Book (Board staff)
4 Beige Book (Reserve Bank staff)
5 Other public and private sector
forecasts/contacts
FOMC Meeting
1 The Open Market Account
Manager s report
2 Board staff presentations
on the economic and financial
outlook, and policy options
3 Members discussion of the

outlook and policy options
4 Developing a consensus and
voting on policy options

w ould be consistent w ith the C om m ittees broad policy
goals. Estim ates of appropriate m onetary grow th ranges
involve considerable judgm ent about the future evolution
of m onetary velocitiesratios of nom inal G D P (gross
dom estic product) to m onetary aggregatesw hile tak-
ing into account their recent behavior and past business
cycle experience.
In considering m onetary policy options, policy-
m akers discuss a w ide range of issues. They usually
consider the likelihood that econom ic grow th or inflation
w ill turn out to be higher or low er than the m ost likely out-
com es in the staff forecasts. The discussion brings out
the range of participantsview s and concerns about
prospects for the econom y. Policym akers m ay differ on
the econom ic outlook for a variety of reasons: different
expectations about the spending and saving behavior of
businesses and households; different view s on the w ork-
ings of labor and product m arkets; different regional per-
spectives; different perceptions of the im pact of m one-
tary policy on key sectors of the econom y.
M indful of potential instability in m onetary veloc-
ities, policym akers consider alternative m onetary grow th
ranges and the consistency of each w ith desirable out-
com es for econom ic perform ance. In considering alter-
natives, policym akers also are keenly aw are of the diffi-
culties of specifying the relationship betw een m onetary
grow th ranges and the O pen M arket D esk operations in
reserves. Thus, even if all participants agreed that a par-
ticular outcom e for the econom y is both attainable and
desirable, they m ay differ significantly on the m onetary
grow th ranges and on the reserve m arket conditions
needed to achieve those policy goals.
G iven such w ide-ranging issues, it is obviously a
challenge for FO M C m em bers to find a com m on ground
on m any aspects of m onetary policy. Yet, the C hairm an
attem pts to forge a reasonable consensus on the back-
ground considerations; efforts to build a consensus are
helped by the fact that there is a collegial desire to be as
united as possible in approaching policy decisions. Even
after agreem ent, how ever, FO M C m em bers m ay hold
different expectations about future inflation and econom -
ic perform ance.
Against this background, and in keeping w ith
the requirem ents of the H um phrey-H aw kins Act, the
FO M C establishes annual m onetary grow th ranges. At
present, grow th ranges are specified, on a fourth-quar-
ter-to-fourth-quarter basis, for the broader m onetary
aggregates, M 2 and M 3. (M 2 consists of M 1currency,
checkable deposits and travelers checks of nonbank
issuersplus savings and sm all tim e deposits, and
retail-type m oney m arket m utual fund balances, w hile
M 3 is m ade up of M 2 plus large tim e deposits, institu-
tion-only m oney m arket m utual funds, repurchase agree-
m ents and Eurodollars.) The C om m ittee expects these
m onetary grow th ranges to be consistent w ith achieving
its broader policy goals for inflation and econom ic
grow th. The C om m ittee also sets an annual m onitoring
range for the grow th of aggregate debt of all nonfinancial
sectors.
W hile the FO M C continues to set annual m one-
tary grow th ranges, it has not found them to be reliable
guides for m onetary policy over the past several years.
The C om m ittee evaluates the behavior of the m onetary
aggregates in conjunction w ith progress on m eeting its
broader policy goals, m ovem ents of m onetary velocities
and other developm ents in the econom y and
financial m arkets. N evertheless, annual
m onetary grow th ranges play a useful role
in policy deliberations and in com m uni-
cating m onetary policy intentions.
Short-Term Policy Directives
C oncerning the im plem entation of short-
term policy actions, at each of the eight
FO M C m eetings during the year, partic-
ipants review m onetary policy operations
since the last m eeting, discuss the econom ic and finan-
cial outlook and consider the im plem entation of policy
over the interm eeting period ahead.
In form ulating policy strategy for the near term ,
the C om m ittee review s various options presented by the
B oard staff in the B lue B ook. Typically, each option spec-
ifies a level of the federal funds rate. Also included is an
assessm ent of the expected evolution of financial condi-
tions and possible m onetary grow th rates over the near
term that are consistent w ith each option.
Individual policym akers, including the C hairm an,
indicate w hich option seem s m ost appropriate to them ,
given their view s on the econom ic outlook and the
C om m ittees long-run policy objectives. After extensive
discussion, the C hairm an usually is able to present an
option w ith appropriate specifications that com m ands
w idespread support am ong m em bers. H e also m ay out-
line the conditions under w hich the policy m ight be m od-
ified betw een m eetings, i.e., before the
next form al m eeting. At tim es, fur-
ther discussion m ay result in m odifi-
cations of the option presented by the
C hairm an. Finally, the vote on policy is
taken by the 12 voting m em bers.
At the conclusion of the m eet-
ing, the C om m ittee issues the dom estic
policy directive to the Federal R eserve
B ank of N ew York. If there is a change in
the FO M C s stance on m onetary policy, it is
announced to the public shortly after the m eeting, on the
sam e day. The announcem ent gives the new intended
average level of the federal funds rate, along w ith a brief
rationale for the change in policy stance.
The directive provides instructions to the O pen
M arket D esk on the FO M C s desired degree of pressure
on reserve positions until the next FO M C m eeting,
While the FOMC
continues to set annual
monetary growth
ranges, it has not
found them to be
reliable guides for
monetary policy over
the past several years.
against the background of short-run developm ents in the
econom y and financial m arkets. This degree of reserve
pressure is associated w ith the intended average level of
the federal funds rate during the interm eeting period;
greater reserve pressure im plies a higher level of the
funds rate, w hile sm aller reserve pressure m eans a low er
level of the funds rate. The directive also offers guidance
on the FO M C s inclination to m ove policy before the next
m eeting, and includes the C om m ittees qualitative
expectation about the im plications of the contem plated
reserve conditions for short-run grow th in the m onetary
aggregates.
1
In its im plem entation of policy for the
im m ediate future, the C om m ittee seeks to rem ain con-
sistent w ith its general long-run policy objectives.
1
A sum m ary of the FO M C m eeting, along w ith the directive, is released to the public shortly after the next FO M C m eeting. A com plete transcript of the record
is m ade available to the public about five years later.
The dom estic policy directive, discussed above, guides
the O pen M arket D esks daily operations in the m arket
for reserves to achieve and m aintain the FO M C s
intended average level of the federal funds rate. For
exam ple, if the federal funds rate is persistently above
the intended level, the D esk m ust expand the supply of
reserves to restore the appropriate reserve m arket con-
ditions, thereby bringing dow n the funds rate to the
intended level. B ut know ing how m uch reserves to add
requires, am ong other things, inform ation about the lev-
els of reserve supply and dem and in the m arket, and the
expected level of reserves that w ould be consistent w ith
m aintaining the intended federal funds rate. In other
w ords, to conduct its open m arket operations, the D esk
needs not only daily estim ates of reserve supply but also
a reserve target, or a reserve path, that is based on the
FO M C s intended level of the federal funds rate over the
relevant tim e horizon.
To im plem ent policy, therefore, the M anager of
the O pen M arket Account m ust translate the FO M C s
directive into operating objectives. To this end, Federal
R eserve staffs in N ew York and at the B oard in
W ashington, D .C . develop reserve objectives consistent
w ith the directives instructions. B ased on detailed fore-
casts of the dem and for reserves and the anticipated
level of discount w indow borrow ing, they create a non-
borrow ed reserve (N B R ) path, or objective, for each tw o-
w eek reserve m aintenance period. This path is updated
continuously during the period as projections of the
dem and for reserves are revised. The nonborrow ed
reserve objectives, together w ith estim ates of the supply
of nonborrow ed reserves, serve as the core elem ents for
judging reserve conditions and for conducting day-to-
day open m arket operations.
Nonborrowed Reserve Objectives
The starting point for constructing the N B R objective is
the projection of required reserves. R equired reserves
are based on checkable deposits held by depository
institutions over the tw o w eeks ending on the M onday
tw o days prior to the end of the reserve m aintenance
period. This m eans that through m uch of the period
F I V E
Implementing Monetary PolicyI
required reserves for the current m aintenance period are
not know n and m ust be estim ated. Staffs at the Federal
R eserve B ank of N ew York and at the B oard of
G overnors project required reserves for the current and
tw o succeeding m aintenance periods, using estim ates of
the underlying deposit trends, seasonal and technical
factors, and the average required reserve ratios
for sm all and large depository institutions.
This process of projecting required
reserves considers, am ong other things,
recent trends in various checkable
deposits as w ell as the effects of interest
rates and other developm ents in the
econom y on the publics dem and for
those deposits.
R equired reserve projections for
the current m aintenance period are
m arked by considerable uncertainty. D aily reports of
deposits from large banks and w eekly reports from a
sam ple of other institutions help in revising projections of
required reserves during the tw o-w eek period. B ut even
on the last day of the period, the D esk faces som e
uncertainty regarding required reserves because of the
lags in reporting and verifying deposit data.
The next step in developing the N B R objectives
is to obtain estim ates of total reserve dem and by adding
projections of required reserves to estim ates of excess
reservesam ount of reserves in excess of requirem ents.
Since banks attem pt to keep their reserves, w hich yield
no incom e, close to the required m inim um , the dem and
for aggregate excess reserves does not show significant
changes from one reserve m aintenance period to
another. The staff generally uses a norm alallow ance for
excess reserves. B ut the staff does keep track of actual
and expected variations from the norm al level of excess
reserves during the period, and adjusts
its estim ates of the dem and for total
reserves w hen excess reserves are
expected to be significantly different
from the norm al level.
In the final step, the am ount of
borrow ed reserves (i.e., seasonal and
adjustm ent borrow ings from the dis-
count w indow ) anticipated to be associ-
ated w ith the FO M C s intended average
level of the funds rate, given the discount
rate, is subtracted from estim ates of total reserve
dem and. This step creates tentative N B R objectives for
the current and tw o succeeding m aintenance periods.
The staff routinely revises the N B R objectives during the
period as incom ing data produce changes in estim ates
of required or excess reserves. The allow ance for bor-
row ing from the discount w indow also m ay be adjusted
during the period if actual borrow ing deviates from its
assum ed relationship w ith the federal funds and discount
rates.
To conduct its open
market operations, the
Desk needs not only
daily estimates of
reserve supply but
also a reserve target,
or a reserve path.
The Managers Task
In seeking to attain the FO M C s desired degree of pres-
sure on reserve positions and the associated average
level of the federal funds rate, the M anager aim s at bring-
ing the actual level of nonborrow ed reserves into line w ith
the N B R objective over the current tw o-w eek reserve
m aintenance period. (Figure 5-1 outlines the m ain steps
in the decision-m aking process for day-to-day open
m arket operations.) This involves com paring the objec-
tive w ith projections of the supply of N B R m ade each
business day to see w hether the O pen M arket D esk
needs to add or drain reserves. At the operational level,
the gap betw een the objective and the estim ated supply
of N B R m easures the approxim ate extent to w hich open
m arket operations w ill be needed over the period to
m aintain the desired reserve conditions.
Projections of the supply of N B R require a close
exam ination of the behavior of various factors affecting
reserves. O f those factors, the Federal R eserve System s
portfolio of Treasury and federal agency securities supply
by far the bulk of nonborrow ed reserves; by changing the
size of this portfolio through open m arket operations, the
D esk can adjust the supply of N B R . H ow ever, as dis-
cussed in C hapter 3, m any factors outside the control of
the Federal R eserve drain or add reserves and are sub-
ject to substantial short-run variations. Each business
day, the staff responsible for conducting open m arket
operations receives tw o sets of estim ates of the factors
Daily Decisions for Open Market Operations
Figure 5-1
The FOMC Directive
Estimates of NBR Path
NBR Surplus/Deficiency
Projections of
NBR Supply
Judgmental Factors
Actual Open Market
Operations
Required Reserves
on Checkable
Deposits
Discount Window
Borrowing
Assumptions
Excess Reserves
Currency in
Circulation
Federal Reserve
Float
Treasury Balances
Foreign Balances
Other Factors
1. Uncertain
Bank Behavior
2. Possible
Revisions
to NBR Path
3. Other Factors
NBR Path
1. Forecast Errors
2. New Information
and Data
3. Other Factors
NBR Supply
affecting the supply of N B R , one from the N ew York staff
and the other from the B oard staff in W ashington, D .C .
These projections form the basis for com parison w ith
the N B R objective; in judging the need for day-to-day
open m arket operations, the D esk norm ally assigns
equal w eights to the tw o sets of estim ates.
W orking out daily plans for adding or draining
reserves to achieve the nonborrow ed reserve objective
m ay sound a bit m echanical. B ut, in fact, it is not.
D ecisions are m ade in an environm ent of uncertain bank
reserve behavior m arked by continuous changes in the
outlook for reserves. The forecasts are subject to w ide
m argins of error, and change on a daily basis in
response to incom ing data. Every day, as new inform a-
tion flow s in, the projection staffs learn how various
reserve dem and and supply com ponents turned out the
day before and w hat new developm ents m ay affect
them in the im m ediate future. The resulting revisions to
the objective and the estim ated supply of nonborrow ed
reserves underscore the uncertainty in determ ining the
size of open m arket operations needed to m aintain the
desired reserve conditions.
R eserve levels have increased significantly over
tim e, reflecting the long-term trend grow th of currency
dem and. B ut short-term variability in reserve supplies
and dem ands caused by factors outside the Feds con-
trol generally dom inates the longer term grow th trend for
reserves. W hile the predictability of recurrent seasonal
patterns helps in m anaging short-term variations in
reserve supply and dem and, the difficulties of forecast-
ing the reserve effects of seasonal variations in num er-
ous factors rem ain a significant source of operational
uncertainty.
All this calls for considerable judgm ent in w ork-
ing out plans for open m arket operations. In considering
reserve estim ates, the M anager and the D esk staff m ust
w eigh the various factors affecting reserve supplies and
dem ands and the duration of such effects. They also
m ust allow for possible revisions to the estim ates. The
decision for daily operations attem pts to balance the
action indicated by the reserve estim ates against the
w ide m argin of projection error and against other possi-
ble considerations bearing on reserve m arket conditions,
including recent and prospective trading ranges for the
federal funds rate.
In im plem enting the directive, the D esks pri-
m ary focus is to keep federal funds trading centered, on
average, on the FO M C s intended rate level. To do so,
the D esk aim s at achieving the N B R objective on aver-
age over the reserve m aintenance period, but its actions
also take account of the day-to-day pattern of reserve
shortages or excesses as w ell as current m arket condi-
tions. The size and nature of actual operations on any
given day are alm ost alw ays determ ined in the context of
possible actions both for the m aintenance period as a
w hole and for the days im m ediately ahead. The M anager
and the D esk staff also m ust consider w hether reserve
shortages or excesses are expected to be short-lived or
likely to persist over several future periods. Accordingly,
a decision m ust be m ade w hether to add or drain
reserves on a tem porary or perm anent basis.
To get a m ore concrete sense of the day-to-day
im plem entation of m onetary policy, w e w ill focus on open
m arket operations in the context of the changing reserve
outlook and related conditions during the tw o-w eek
m aintenance period ending April 26, 1995. B ut, first, it
m ay be useful to provide a brief description of the tools
of open m arket operations.
Tools of Open Market Operations
O pen m arket operations by the Federal R eserve involve
the buying and selling of G overnm ent securities in the
secondary m arket in w hich previously issued securities
are traded. W hen the Fed buys securities from a dealer,
it pays by crediting the reserve account of the dealers
bank at a Federal R eserve B ank; in effect, the Fed pays
for its purchase by w riting a check on itself. Since this
transaction involves no offsetting changes in reserves at
other depository institutions, the rise in the reserves of the
dealers bank increases the aggregate volum e of reserves
in the m onetary system . W hen the Fed sells securities to
a dealer, the reserve consequence is exactly the oppo-
sitethe paym ent by the dealer reduces reserves of the
dealers bank and of the m onetary system .
The Federal R eserve norm ally conducts its open
m arket operations in the U .S. Treasury securities m arket,
w hich is the broadest and m ost active of U .S. financial
m arkets, w ith overall trading at present averaging m ore
than $150 billion a day.
1
The breadth and depth of this
m arketas evident in its capacity to accom m odate all
types of transactions w ithout distortions and disrup-
tionsare essential for the effectiveness of open m arket
operations. These characteristics of the G overnm ent
securities m arket enable the D esk to buy and sell quickly,
at its ow n convenience, and in any am ount that m ay be
required to keep the supply of nonborrow ed reserves in
line w ith policy objectives.
The O pen M arket D esk uses tw o general
approaches to add or drain reserves through changes in
the System s portfolio of securities. W hen significant
reserve shortages or excesses are expected to persist
for a relatively long period, the D esk m ay m ake outright
purchases or sales (and redem ptions) of securities that
perm anently affect the size of the Federal R eserve
System s portfolio and the supply of reserves. The D esk
generally conducts outright transactions in the m arket
1
This dollar am ount excludes financing transactions by prim ary dealers, and refers to purchases and sales of U .S. Treasury securities, including inter-dealer
trades.
only a lim ited num ber of tim es each year, to accom m o-
date long-term reserve needs. In recent years, because
of expanded currency issuance and the associated long-
term increases in reserve dem and, outright purchases
have been m uch m ore com m on than sales or deliberate
redem ptions, and have resulted in a considerable
enlargem ent of the System s portfolio of securities.
Aside from the long-term upw ard trend, m ost of
the tim e reserve surpluses or deficiencies are
expected to be short-lived, either because
seasonal and other technical factors are
expected to be reversed or offset, or
because the outlook for reserves is uncer-
tain. In these cases, the D esk undertakes
transactions that only tem porarily affect the
supply of reserves. As described below ,
the D esk uses repurchase agreem ents to
add reserves and m atched-sale purchase
transactions to drain reserves on a tem po-
rary basis. Such tem porary transactions are designed to
m inim ize fluctuations in the overall supply of reserves,
and they are used routinely and m uch m ore frequently
than are outright transactions.
Outright Purchases and Sales
N orm ally the D esk conducts outright transactions in the
m arket through auctions in w hich dealers are requested
to subm it bids to buy securities from the Federal R eserve
or offers to sell securities of a particular type and m atu-
rity, generally either Treasury billsshort-term discount
securities w ith a m axim um m aturity of one yearor
Treasury coupon securitiescurrently debt instrum ents
w ith m axim um m aturities of tw o to about thirty years. In
considering propositions on any given security, the D esk
selects bids w ith the highest prices (low est yields) for its
sales, and offers w ith the low est prices (highest yields) for
its purchases. Typically the outright operations are
arranged for delivery of the securities
w ithin the next day or tw o. The
tim ing of outright transactions is
driven prim arily by the expected
persistence of excesses or deficien-
cies in reserves; the exact tim ing of
such operations also considers m ar-
ket conditions, as the Federal R eserve
attem pts to avoid rapidly rising or falling
m arkets, and other possible events that
m ay add to m arket volatility or im pede
price m ovem ents.
In late 1995, the D esk adjusted its m ethod for
outright operations in Treasury coupon issues. Instead of
a single, large transaction aim ed at the entire range of
the yield curve, the D esk began using a series of sm aller
operations, focusing on segm ents of the yield curve. The
change w as designed to speed the turn-around tim e on
outright operations, and had no policy significance.
In implementing the
directive, the Desks
primary focus is to
keep federal funds
trading centered,
on average, on the
FOMCs intended
rate level.
The D esk also m ay conduct outright transac-
tions in Treasury securities directly w ith foreign official
accounts on any day w hen those accounts are buying or
selling securities that m atch the D esks needs. These
custom er trades allow the D esk to add or drain relatively
m odest am ounts of reserves in a tim ely m anner.
U sually, the Federal R eserve replaces m aturing
securities in its portfolio by rolling them over at Treasury
auctions so as to avoid unw anted reserve drains.
2
O ccasionally, how ever, if the D esk w ants to reduce
reserve levels, it redeem s a m odest portion of m aturing
securities from the Federal R eserve System s holdings.
The D esk generally keeps redem ptions m odest in size to
avoid com plicating the Treasurys debt m anagem ent
plans. R edem ptions have the sam e effect on reserves as
outright sales. W hen the D esk redeem s a security, the
Treasury pays the Fed by draw ing dow n its account; this
leaves few er reserves in the banking system as the
Treasury transfers funds from TT&L accounts into the
Fed account to m aintain the norm al target level of around
$5 billion.
Repurchase Agreements (RPs)
The D esk uses short-term R Ps w ith dealers to add
reserves on a tem porary basis. U nder the R P arrange-
m ent, the D esk buys securities from dealers w ho agree
to repurchase them at a specified price on a specified
date. The added reserves are extinguished autom atically
w hen the R Ps m ature. It is m uch m ore convenient for the
Fed to inject large am ounts of reserves on a tem porary
basis through R Psor System R Ps as they are usually
calledthan through outright purchases. R Ps allow the
D esk to respond quickly w hen reserves fall short of
desired levels and they can sm ooth the pattern of
reserves for the m aintenance period by m eeting needs
for particular days. M oreover, transaction costs for R Ps
are very low , and acceptable collateral is broadly based
to include Treasury bills, notes and bonds and certain
federal agency securities held by both dealers and their
custom ers.
The D esk can conduct R Ps on an overnight
basis or on a term basis. W hile the D esk is authorized to
arrange term R Ps for up to 15 days, m ost term R Ps are
arranged to m ature w ithin seven days. The distribution of
R P transactions am ong dealers is determ ined by auction
in w hich dealers bid for a dollar am ount of R Ps at a spec-
ified interest rate. W ith all the offers arranged in descend-
ing order of interest rates, the D esk accepts offers that
carry the highest rates up to the desired dollar am ount.
The D esk also has arranged custom er-related
R Ps w ith dealers on behalf of foreign official accounts,
generally to m eet relatively m odest reserve needs. These
2
The Federal R eserve is prohibited by law from adding to its net position by direct purchases of securities from the Treasurythat is, the Federal R eserve
has no authority for direct lending to the Treasury. As a consequence, at m ost the D esks acquisition at Treasury auctions can equal m aturing holdings.
custom er R Psas distinguished from System R Ps
described abovehave been arranged to m ature on the
next business day, w ith their volum e being lim ited by the
total funds available from foreign accounts for invest-
m ent. In D ecem ber 1996, the D esk announced that it is
likely to use custom er-related R Ps m uch less frequently
in the future than it has in the past.
Matched Sale-Purchase Transactions (MSPs)
The D esk arranges M SPs w ith dealers to drain reserves
on a tem porary basis. In an M SP, the Fed m akes a con-
tract for im m ediate sale of securities to a dealer and a
sim ultaneous m atching contract to buy them back from
the dealer on a specified date. The initial sale drains
reserves and the subsequent purchase reverses the
drain. M SPs are typically arranged for one to seven days.
They w ork just like the reverse of R Ps in term s of their
effects, and offer a convenient m echanism for respond-
ing quickly to tem porary excesses in reserves and for
sm oothing fluctuations in the supply of reserves.
In arranging an M SP, the D esk selects a
Treasury bill in w hich the System has am ple holdings and
invites dealers to specify interest rates at w hich they are
w illing to purchase the bills for sam e-day delivery and to
sell them back for delivery on a particular subsequent
date. The D esk accepts the m ost favorable propositions
(low est rates) up to the desired am ount of reserves it
w ants to w ithdraw from the m onetary system .
Reserve Conditions and Open Market Operations
Figure 5-2 outlines the basic data bearing on the
M anagers task on M onday, April 17, 1995, the third
business day of the reserve m aintenance period.
R equired reserves w ere estim ated at a daily average level
of $58.3 billion for the tw o-w eek period ending April 26.
G iven the discount w indow borrow ing allow ance of $100
m illion and assum ing norm al excess reserves at $1 bil-
lion, the N B R objective w as set at $59.2 billion ($58.3b.
+ $1b. - $0.1b. = $59.2b.). The N ew York staff projection
for the supply of N B R w as $54.6 billion a day, indicating
a need for the D esk to add about $4.6 billion of reserves
on average per day for the tw o-w eek period. (A sim ilar
B oard staff forecast indicated a reserve need of about
$4.7 billion.) Tentative N B R objectives and supply pro-
jections for the tw o subsequent m aintenance periods,
show n in the figure, also suggested significant reserve
needs. N ote that, at this early stage, the reserve projec-
tions for the tw o subsequent m aintenance periods w ere
considerably m ore uncertain than those for the current
period.
Seasonal increases w ere expected in required
reserves and currency during the m aintenance period
then in progress, contributing to large reserve shortages.
C orporate and individual nonw ithheld Federal incom e
taxes w ere due that M onday, and w ere expected to yield
heavy, though uncertain, inflow s to the Treasury balance
at the Fed for several days.
O n that M onday, the m onetary system faced
large projected reserve deficiencies for the day and for
several days thereafter (bottom part of Figure 5-2).
B anks had experienced m oderate reserve deficiencies
on the previous Friday w hen there had been no interven-
tion by the D esk, as the securities m arkets w ere closed
for the G ood Friday holiday. O n M onday m orning, excess
reserves for the period-to-date w ere running negative,
and banks had significant cum ulative reserve deficien-
cies, in part because the Treasury balance had turned
out to be higher than expected over the w eekend.
C onfronted w ith large reserve deficiencies for
the day, banks had bid up the federal funds rate to the
6 1/8 - 6 3/16 range that M onday m orning, som ew hat
above the FO M C s intended 6 percent level. O ther short-
term interest rates also experienced m odest upw ard
pressures. The firm ness in the m oney m arket likely
reflected the reserve pressures stem m ing from federal
tax paym ent flow s.
Against this background, the D esk supplied
about $7.7 billion in reserves by arranging three-day
System R Ps on that M onday; as explained above,
System R Ps offer a very convenient m echanism for
injecting large am ounts of tem porary reserves. This oper-
ation lifted the tw o-w eek average reserve level by about
$1.65 billion ($7.7b. x 3 14 = $1.65b.). The D esk paid
Figure 5-2
Estimates of NBR Supplies and Objectives on Monday, April 17, 1995
Millions of Dollars
Path Assum ptions O pen M arket O peration
Tw o W eek R eserve R equired R eserves Excess R eserves B orrow ing N B R Path N B R Projected Supply to H it Path
Period Ending (1) (2) (3) (4)=(1)+(2)-(3) (5) (6)
April 26 58,347 1,000 100 59,247 54,649 4,598
-594e 114e
M ay 10 56,870 1,000 100 57,770 55,023 2,747
M ay 24 56,102 1,000 100 57,002 51,654 5,348
Projected Daily Reserve Surplus/Deficiency*
M onday Tuesday W ednesday Thursday Friday
(4/17) (4/18) (4/19) (4/20) (4/21)
-6,925 -5,925 -7,464 -5,974 -3,659
* Surplus/D eficiency is equal to N B R supply minus required reserves on a tw o-w eek basis.
e Estim ate for the period through the previous day.
the dealers by giving im m ediate credits to their banks
reserve accounts, thereby supplying an equivalent
am ount of reserves to the financial system . In the
absence of such a large tem porary reserve injection, the
funds rate m ost likely w ould have com e under additional
upw ard pressures, m oving further above the
C om m ittees intended level as banks w ould have strug-
gled to keep on track tow ard m eeting their
reserve requirem ents and avoid ending
the day w ith reserve shortages.
W ithin the context of uncertain
reserve estim ates, the D esks decision
w as based partly on the sizable esti-
m ated average need to add reserves over
the m aintenance period, and partly on the
even larger anticipated needs for that
M onday and the im m ediate days ahead.
Accordingly, the addition to reserves w as
intended to sm ooth the reserve situation for that day, but
also to influence the profile of reserve supplies and
dem ands over the com ing days and the w hole m ainte-
nance period.
Managing Reserve Conditions
O pen m arket operations from one day to the next are
closely related. In its daily actions, the D esk responds to
m arket factors affecting reserve supplies and dem ands,
but also takes into account the im plications of its ow n
im m ediate past operations. W ith uncertain reserve esti-
m ates and possible projection errors, the D esk faces
considerable risk that it m ight add or drain m ore reserves
on any given day than m ay be w arranted, causing the
federal funds rate to m ove aw ay from the desired level. To
m inim ize this risk, the M anager responds cautiously to
projections of large uncertain reserve shortfalls or
excesses. N onetheless, at tim es, the D esk does add or
drain reserves that are show n, by subse-
quent data, to be out of line w ith
reserve needs. U sually, the conse-
quences of any such actions can be
rem edied quickly, since revised infor-
m ation and operations of the previous
day are routinely factored into the daily
reserve picture. Late in the m aintenance
period, how ever, it can be difficult to off-
set large revisions.
To look m ore closely at the continuity
and dynam ics of the D esks operations, let us follow the
m ain developm ents in the reserve outlook and open
m arket operations after M onday, April 17 through the
end of the m aintenance period. O ver the next tw o days,
the reserve estim ates continued to indicate a large defi-
ciency for the period, though considerably sm aller than it
appeared in M ondays estim ates. H ow ever, these
reserve estim ates w ere subject to greater-than-norm al
uncertainty because unexpected changes in the pattern
The Desk faces
considerable risk that
it might add or drain
more reserves on any
given day than may be
warranted, causing the
federal funds rate to
move away from the
desired level.
of incom ing tax receipts w ere m aking the Treasury bal-
ance particularly hard to estim ate. M eanw hile, on both
days, federal funds traded com fortably close to the
C om m ittees intended level of 6 percent. W ith the three-
day System R Ps from M onday still on the books, the
daily pattern of reserves indicated no significant reserve
deficiencies on either of the tw o days. In this setting of
considerable uncertainty about the reserve need for the
period and little im m ediate pressure on the federal funds
rate, the D esk added only about $1.5 billion in overnight
reserves through custom er-related R Psw hich are quite
suitable for dealing w ith m odest reserve deficiencies on
an overnight basison Tuesday and took no action to
affect reserves on W ednesday.
D ifficulties in estim ating tax receipts and
Treasury balances continued to cause problem s for
reserve projections, but those difficulties seem ed to
dim inish som ew hat in the latter part of the w eek. O n
Thursday and Friday, the reserve estim ates w ere som e-
w hat less uncertain and still show ed large needs to add
reserves for the period; on Thursday, the estim ated aver-
age reserve need for the period w as about $3.8 billion,
indicating a daily average add need of about $7.6 billion
($3.8b. x 14 7 = $7.6b.) for the rem aining seven days
of the m aintenance period. B anks had only m odest
am ounts of excess reserves to date on both days. In
view of the continuing large estim ated reserve shortfall
for the period, the D esk supplied over $5 billion of
reserves on Thursday through four-day System R Ps, and
another $2.3 billion on Friday through six-day System
R Ps. B y using these relatively longer duration R Ps, the
D esk injected reserves on the day of the operation as
w ell as on each of the rem aining days of the period. O n
both Thursday and Friday, federal funds, presum ably
cushioned by open m arket operations, traded com fort-
ably close to the FO M C s intended rate level.
B y the second M onday, April 24, tw o days
before the end of the period, the cum ulative effect of the
various open m arket operations (R Ps), together w ith
som e partially offsetting revisions to required reserves
and m arket factors, had low ered the estim ated rem ain-
ing reserve needs significantly. Figure 5-3 show s projec-
tions of the N B R objectives and supplies on that
M onday; these num bers are com parable to those in
Figure 5-2. W ith upw ardly revised required reserves, the
N B R objective for the current period w as now estim ated
to be about $220 m illion higher than it had been on the
previous M onday. And the average need to add reserves
for the period had dropped to $1.2 billion from $4.6 bil-
lion on the previous M onday. Still, w ith only three days
rem aining in the period, this am ount represented a sig-
nificant reserve shortage, and im plied an average need
to add reserves of about $5.6 billion ($1.2b. x 14 3) for
each rem aining day. Projected reserve deficiencies on
M onday and the next tw o days w ere also considerable
(bottom part of the figure), but did not appear to be a
cause for im m ediate concern since banks had com fort-
able levels of w orking balances for supporting paym ent
transactions at the Fed on M onday, and had ended the
previous business day w ith significant am ounts of
excess reserves.
N o unusual pressures seem ed evident in the
m oney m arket on that M onday, w ith federal funds trad-
ing at or very near the intended 6 percent level. In this
environm ent, taking account of possible uncertainty in
reserve estim ates tw o days before the end of the reserve
m aintenance period, the D esk supplied about $4 billion
in reserves through 3-day System R Ps, m eeting about
70 percent of the estim ated rem aining daily need of
about $5.6 billion.
The m oney m arket changed little betw een
M onday and Tuesday, w ith federal funds continuing to
trade at or near the desired level. M eanw hile, the N B R
path w as again revised upw ard by about $330 m illion
due to higher estim ates of required reserves. W ith the
upw ardly revised N B R objective, Tuesdays reserve sup-
ply estim ates indicated that the D esk w ould need to sup-
ply significant am ounts of reserves on the last tw o days
of the period. B ecause the D esk w as som ew hat uncer-
tain about the banksdem and for excess reserves, it
opted to m eet m ost, but not all, of the rem aining esti-
m ated need by injecting reserves of about $3 billion
Figure 5-3
Estimates of NBR Supplies and Objectives on Monday, April 24, 1995
Millions of Dollars
Path Assum ptions O pen M arket O peration
Tw o W eek R eserve R equired R eserves Excess R eserves B orrow ing N B R Path N B R Projected Supply to H it Path
Period Ending (1) (2) (3) (4)=(1)+(2)-(3) (5) (6)
April 26 58,567 1,000 100 59,467 58,272 1,195
637e 143e
M ay 10 56,765 1,000 100 57,665 53,367 4,298
M ay 24 55,839 1,000 100 56,739 50,145 6,594
Projected Daily Reserve Surplus/Deficiency*
M onday Tuesday W ednesday
(4/24) (4/25) (4/26)
-2,062 -3,969 -3,866
* Surplus/D eficiency is equal to N B R supply minus required reserves on a tw o-w eek basis.
e Estim ate for the period through the previous day.
through custom er-related R Ps on Tuesday and another
$5.4 billion through overnight S ystem R P s on
W ednesday; the excess reserves w ere allow ed to be
m odestly low er relative to the original expected level. O n
the final day of the period, the funds rate traded firm ly
before the D esk entered the m arket, and experienced
only m odest upw ard pressures in the afternoon as banks
sought to m eet their rem aining reserve needs.
O verall, the results for the m aintenance period
ending April 26, 1995 w ere generally consistent w ith the
operating objectives established at the beginning of the
period to im plem ent the FO M C s directive. The federal
funds rate averaged 6.03 percent for the period, essen-
tially the sam e as the FO M C s intended level of 6 per-
cent. N onborrow ed reserves ended the period about
$160 m illion below the form al path set tow ard the end of
the period, although the path itself underw ent relatively
significant revisions over the period.
The D esk m et large reserve needs for the period
through a series of tem porary operations, m ostly System
R Ps. Even though significant reserve needs w ere pro-
jected to persist beyond the m aintenance period, the
D esk did not add reserves through outright purchases of
securities. It had bought sizeable am ounts of Treasury
coupon securities in the previous m aintenance period
and did contem plate further outright purchases. B ut the
needs beyond the tax processing period w ere not suffi-
ciently certain to lead it to act.
Recent Changes in the Conduct of
Open Market Operations
Figure 5-4 offers a brief overview of changes in operating
procedures since the early 1980s. Throughout the period
since 1982, the FO M C s operational strategy has contin-
ued to focus on the costs and other conditions for reserve
availability to depository institutions. B ut the actual oper-
ating procedures have changed som ew hat over tim e, and
the approach for evaluating reserve availability conditions
is different today from w hat it w as in the m id-1980s.
From 1983 through early O ctober 1987, bor-
row ed reserves w ere used as the principal guide for
assessing reserve conditions. Specifically, the degree of
reserve pressure sought by the C om m ittee w as esti-
m ated to be associated w ith an intended level of adjust-
m ent plus seasonal borrow ing at the discount w indow .
The m echanism depended on the banks being reluctant
to borrow from the discount w indow to a reasonably pre-
dictable degree. Thus, the m ore the banks w ere forced
to satisfy their reserve dem and by discount w indow bor-
row ing, the higher they w ould bid the federal funds rate
relative to a given discount rate. The reluctance to bor-
row arose from Federal R eserve guidelines lim iting
access to the w indow .
In im plem enting this approach, the D esk used
nonborrow ed reserves to satisfy m ost of the dem and for
reserves, w ith the balance to be m et at the discount w in-
dow a balance that w as effectively equal to the
intended level of borrow ed reserves. At a given discount
rate, the borrow ed reserve approach resulted in a rea-
sonably close relationship betw een discount w indow
borrow ing and the federal funds rate, although the rela-
tionship w as less than precise.
To be sure, the borrow ed reserve procedure w as
im plem ented in a w ay so as not to lose control over the
federal funds rate. In its day-to-day operations, the D esk
considered not just the assum ed level of discount w in-
dow borrow ing, but also the degree of uncertainty sur-
rounding the reserve estim ates, as w ell as other signals
about reserve m arket conditions, including m ovem ents
of the funds rate. And, occasionally, the funds rate w as
given the dom inant position in assessing the reserve
pressures.
O n average, how ever, the FO M C and the D esk
used the intended level of discount w indow borrow ing as
the m ain factor for evaluating reserve availability condi-
Figure 5-4
Changes in Operating Procedures, 1979-1996
O perating Procedures Im plications
Period Key Elem ents N B R Path Federal Funds R ate O ther
1979-82 Target for N B R quantity B ased on the FO M C 's H igh levels of volatility; N o significant accom m odation
desired m oney grow th autom atic m ovem ents in of short-run fluctuations in
the funds rate over a w ide reserves dem and; operations
and flexible range could signal policy shifts
1983-87 D egree of reserve pressure; C onsistent w ith the FO M C 's M odest am ount of volatility Partial accom m odation of
targets for borrow ed reserves intended levels of discount w ithin and betw een short-run fluctuations in
w indow borrow ing and the m aintenance periods reserves dem and; operations
funds rate could signal policy shifts
1989-93 D egree of reserve pressure; C onsistent w ith the FO M C 's Lim ited variations w ithin N early com plete
assum ed initial borrow ing intended federal funds rate m aintenance periods accom m odation of short-run
allow ance around the intended level fluctuations in reserves dem and;
operations could signal
policy shifts
1994-96 D egree of reserve pressure C onsistent w ith the FO M C 's Lim ited variations w ithin N early com plete
and associated federal funds intended federal funds rate m aintenance periods accom m odation of short-run
rate target; new policy around the intended level fluctuations in reserves dem and;
disclosure procedures operations do not signal
policy shifts
N ote: N B R = nonborrow ed reserves
tions during 1983-87, w ith short-run m arket expectations
being allow ed to play a relatively m odest role in determ in-
ing the funds rate. In this setting, the funds rate had con-
siderable leew ay to fluctuate w ithout changes in the
desired policy stance. Through m uch of the 1983-87
period, it w as not unusual for the average effective federal
funds rate to vary by 20 to 40 basis points even betw een
those m aintenance periods in w hich the FO M C had not
sought to change the degree of reserve pressures.
After the O ctober 1987 plunge in stock prices,
the FO M C tem porarily abandoned the borrow ed reserve
approach and relied heavily on an intended level of the
funds rate to assure adequate liquidity and to calm finan-
cial m arkets. In 1988, the FO M C returned to the borrow -
ing approach for a w hile, but found that the relationship
betw een borrow ed reserves and the federal funds rate
had becom e m ore uncertain and less reliable, largely
because the reluctance of banks to borrow from the dis-
count w indow w as increasing, and no longer pre-
dictable. This greater reluctance w as associated, not
w ith any changes in Federal R eserve rules, but instead
w ith the publics identification of borrow ing at the w in-
dow w ith the possibility that a bank w as suffering finan-
cial difficulties. The relationship betw een borrow ing and
the funds rate continued to deteriorate over the next tw o
years, as the average level of borrow ing fell steadily but
unpredictably. In fact, by 1989, it w as no longer possible
to estim ate a m eaningful range of the federal funds rate
consistent w ith a particular allow ance for discount w in-
dow borrow ing. As a consequence, the FO M C and the
D esk w ere obliged to place less w eight on an intended
level of discount w indow borrow ing in im plem enting
m onetary policy. The deviations of borrow ing from its
assum ed level w ere routinely accepted as long as they
w ere consistent w ith m aintaining the m oney m arket con-
ditions expected by the FO M C .
The operating procedures begun in the late
1980s have been used throughout the subsequent
period. W hile the FO M C continues to express its policy
stance in the directive in term s of the degree of pressure
on reserve positions, the federal funds rate is now the
principal guide for evaluating reserve availability condi-
tions, and has therefore becom e the day-to-day policy
objective for open m arket operations. The D esk still uti-
lizes an anticipated level of discount w indow borrow ing
in constructing the N B R path, but it com pensates for
deviations from that anticipated level by m odifying the
N B R reserve objective, form ally or inform ally, so as to
m aintain the C om m ittees intended funds rate. O n aver-
age, changes in the dem and for reserves during the
m aintenance period are now m ore fully accom m odated
by adjusting the supply of nonborrow ed reserves than
w as the case in the 1983-87 period. As a result, the
average level of the funds rate during the period is m ore
closely associated w ith the intended degree of reserve
pressures than before. The funds rate does fluctuate
during the m aintenance period, but its average value
from one period to the next rem ains essentially the sam e
as long as there is no change in the intended stance of
m onetary policy.
New Disclosure Procedures
Another, m ore recent, developm ent that has affected the
conduct of open m arket operations considerably w as
the FO M C s change in procedures, initiated in early 1994
and form alized in early 1995, for disclosing m onetary
policy decisions im m ediately after they are m ade. U ntil
the end of 1993, the C om m ittees policy decisions w ere
announced w ith a five-to-eight w eek lag, through the
release of its m inutes, w hich contain the dom estic policy
directive. H ow ever, any changes in the stance of m one-
tary policy w ere quickly com m unicated to financial m ar-
kets through open m arket operations as the D esk im ple-
m ented the policy directive. U nder the new procedures,
w hich are now standard, changes in the FO M C s stance
on m onetary policy, including any interm eeting changes,
are announced on the day they are m ade. The FO M C
continues to release its directive for each m eeting w ith a
delay, on the Friday after the next m eeting.
B efore the recent disclosure procedures for pol-
icy decisions w ent into effect, m arket participants closely
w atched the D esks operations to detect policy signals.
The use of open m arket operations to signal policy
changes created, at tim es, considerable com plications
for the D esk, especially w hen the funds rate and the
reserve estim ates gave conflicting signals. Just as im por-
tantly, the D esk also faced considerable risks that its
day-to-day technical or defensive operations w ould be
view ed as indicators of policy m oves. Such risks w ere
heightened during periods w hen m arket participants
expected shifts in policy.
The recent disclosure procedures have essen-
tially freed the D esk from the risk that its norm al techni-
cal or defensive operations w ould be m isinterpreted as
policy m oves. O pen m arket operations no longer convey
any new inform ation about changes in the stance of
m onetary policy. In im plem enting the directive, the D esk
carries out a policy that is already know n to financial m ar-
kets and the public at large, and is no longer concerned
about using a particular type of operation to signal a
change in policy. O f course, m arket participants specu-
late, just as they alw ays did, about possible future policy
m oves, especially in the period im m ediately leading up to
the FO M C m eetings. B ut, in general, they no longer
closely w atch day-to-day open m arket operations to
detect policy signals.
Primary Dealers
The Federal R eserve im plem ents m onetary policy
through the purchases and sales of U .S. G overnm ent
securities in the secondary m arket, in w hich previously
issued securities are traded. Its private sector business
counterparties, know n as prim ary dealers, are able to
handle large orders efficiently, quickly, and safely. In
recent years, the num ber of prim ary dealers has ranged
betw een 37 and 46.
To m inim ize the credit, delivery and settlem ent
risks associated w ith its transactions, the Federal
R eserve has developed criteria for selecting trading
counterparties for its open m arket operations. Prim ary
dealers m ust be either com m ercial banking organiza-
tions subject to official supervision by U .S. federal bank
supervisors or brokers/dealers registered w ith the
Securities and Exchange C om m ission. They m ust m eet
the m inim um capital standards of their prim ary regula-
tors, and also m ust have certain m inim um am ounts of
capital.
All prim ary dealers are expected to engage in
substantial trading w ith the D esk, provide the D esk w ith
m arket inform ation and analysis that m ay be useful for
form ulation and im plem entation of m onetary policy and
participate m eaningfully in Treasury auctions. If a dealer
fails to m eet these standards, the D esk has the authority
to discontinue its trading relationship w ith that dealer.
The D esk arranges its open m arket transac-
tionsR Ps, M SPs, and outright purchases and sales
w ith prim ary dealers through an autom ated processing
system . For R Ps and M SPs, an electronic announce-
m ent is sent to prim ary dealers and, typically, they are
asked to respond w ithin 10 to 15 m inutes. The D esk
notifies all dealers of the propositions accepted and
rejected, usually w ithin about 5 m inutes of the closing
tim e for the response, again using its autom ated pro-
cessing system .
The D esk does not have a fixed tim e for its out-
right purchase and sale operations. It tim es its outright
transactions during the day w hen m arket participants are
not preoccupied w ith other developm ents, because
these transactions can be som ew hat m ore tim e con-
S I X
Implementing Monetary PolicyII
sum ing than R Ps and M SPs. B ut recent changes in the
m ethod of outright coupon operations involving a series
of sm aller transactions, as described earlier, have signif-
icantly reduced the turnaround tim e on operations.
As part of its business relationship, the D esk
m aintains extensive contacts w ith all prim ary dealers.
O ver the course of each day, traders at the D esk talk to
m ost dealers, using direct telephone lines, about the
activity in the securities m arkets and the financing of their
securities positions. Each afternoon, one or m ore m em -
bers of the D esk staff hold brief m eetings, usually
arranged over the telephone, w ith representatives of tw o
prim ary dealers. O ver a four-w eek period, the D esk staff
has the opportunity to talk to representatives of all pri-
m ary dealers. D iscussions at these m eetings cover a
broad array of topics; m any topics are com m on to all
dealers, w hile others vary depending on the dealers
business interests.
O ngoing contacts w ith prim ary dealers inform
the D esk staff about the w ide-ranging forces at w ork in
financial m arkets: changing dem ands of the dealerscus-
tom ers in the securities m arkets and their interest in par-
ticular types of securities; the econom ic and interest rate
outlook that various dealers are presenting to their clients;
financing of the dealerssecurities positions; special
developm ents influencing reserve conditions; the dealers
expectations about Treasury financing in the period
ahead, and potential custom er interest in com ing financ-
ing; the strength of business loan dem and at banks asso-
ciated w ith prim ary dealers, and any issuance of w hole-
sale m arket instrum ents to fund lending at those banks.
Informing the FOMC
The M anager and the D esk staff keep the FO M C fully
inform ed about evolving reserve m arket conditions and
their daily plans for open m arket operations, as w ell as
about the feedback on policy from financial m arkets. The
D esks m ain channels for com m unicating w ith the FO M C
are (1) a daily conference call, (2) tw o daily reports, (3) a
w eekly report on financial m arket developm ents and a
biw eekly report on open m arket operations for each
m aintenance period, (4) an interm eeting period report on
operations and financial m arket developm ents prepared
for each FO M C m eeting, (5) the M anagers reports at the
regular FO M C m eetings, and (6) an annual report on
m onetary policy operations; som e consideration is now
being given to replacing this annual report w ith quarterly
or sem i-annual reports. In addition, the M anager and the
D irector of the D ivision of M onetary Affairs at the B oard
m ake sure that the C hairm an is fully inform ed at all tim es
about significant developm ents relating to open m arket
operations and financial m arkets. W hen appropriate, the
M anager, the D irector and the C hairm an discuss unfold-
ing events that m ay have im portant im plications for the
C om m ittees directive or its im plem entation.
The Conference Call
Each business day, at present about 10:20 a.m ., the
M anager and several other D esk staff m em bers gather in
an office near the trading room at the Federal R eserve
B ank of N ew York to participate in a telephone confer-
ence call. The call links the M anager and other N ew York
staff w ith the D irector of the D ivision of
M onetary Affairs and other staff m em bers
at the B oard, and w ith one of the four
R eserve B ank Presidents outside of N ew
York currently voting on the FO M C . The
call, w hich usually lasts about 15 m inutes,
offers the D esks review of reserve condi-
tions and financial m arket developm ents,
and the M anagers plan for open m arket
operations. It also enables the D esk to
consult, on a daily basis, w ith one of the
C om m ittee m em bers concerning the im plem entation of
the directive. D esk staff m em bers report on financial
m arket developm ents and the reserve outlook. At tim es,
other participants m ay m ake brief com m ents on special
aspects of econom ic and financial m arket developm ents
that m ay be of interest on a particular day. The financial
m arket review includes price and rate m ovem ents in the
U .S. G overnm ent securities m arkets and the m ain influ-
ences on m arket m ovem ents. M ention is m ade of the
effects of any data releases and other events on activity
in the securities m arkets. D esk staff m em bers describe
the situation in the federal funds m arket, providing the
latest inform ation on rates and on the reserve needs and
the funding activity of m ajor banks. They also note key
developm ents in the foreign exchange m arkets.
The D esk staff review of the reserve outlook pre-
sents the estim ated reserve needs, and explains revi-
sions to the outlook from the previous day. Finally, the
proposed program for open m arket
operations is read and the R eserve
B ank President is asked for com -
m ents. N orm ally the president w ill
concur w ith the M anagers plan, but
occasionally m ay ask questions about
the plan or other possible options.
Form al presentations are concise and
leave room for conference participants
to ask questions and m ake other brief
com m ents. A lso, the D irector of the
D ivision of M onetary Affairs at the B oard m ay occasion-
ally use the call to provide the latest inform ation on devel-
opm ents in m onetary aggregates.
Daily Reports
A sum m ary of the conference call, put together by the
B oard staff, is delivered to each B oard m em ber shortly
after the call and im m ediately transm itted to each
R eserve B ank president. After the securities m arkets are
effectively closed around 5:00 p.m ., the D esk staff
Ongoing contacts
with primary dealers
inform the Desk staff
about the wide-ranging
forces at work in
financial markets.
sends, electronically, a sum m ary of the days develop-
m ents in the financial m arkets to R eserve B ank presi-
dents and M onetary Affairs staff at the B oard in
W ashington, D .C .
Weekly and Biweekly Reports
Every Friday, the D esk staff sends a w eekly report to the
FO M C on developm ents in the dom estic securities and
foreign exchange m arkets. Every other Friday,
the w eekly report contains a com prehen-
sive review of open m arket operations for
the m aintenance period ended on the pre-
ceding W ednesday. The biw eekly portion
of the report describes the conduct of
operations and the reserve m arket condi-
tions over the m aintenance period, and
includes the latest inform ation on m one-
tary aggregates.
Prior to each FO M C m eeting, the
D esk staff subm its a background report to the FO M C on
open m arket operations and financial m arket develop-
m ents in the latest interm eeting period. A brief descrip-
tion of reserve operations also appears in the B lue B ook,
prepared by the B oard staff, in advance of the FO M C
m eeting. At the regular FO M C m eetings, the M anagers
presentation also covers operations and m arket devel-
opm ents during the interm eeting period. Finally, in the
first quarter of the year, the D esk staff prepares an
annual report on m onetary policy im plem entation and
financial m arket developm ents for the preceding year. A
m odified version of this report is published in the annual
report of the Federal R eserve B ank of N ew York.
A Day at the Open Market Desk
The w orking day at the D esk begins soon after 8:00
a.m ., although one person is usually in the trading room
about an hour earlier to contact people from overseas
m arkets w here U .S. G overnm ent secu-
rities are traded. The early part of
the day is occupied w ith inform a-
tion-gathering activities and m eet-
ings that help the M anager and other
D esk staff prepare the daily plan for
open m arket operations. Traders track
early trading and related developm ents
in U .S. financial m arkets. They talk to
dealers about their expectations for
business activity in the securities m arkets
and to the large m oney center banks about their funding
plans in the federal funds m arket. O ther staff m em bers
collect inform ation on econom ic and financial develop-
m ents by looking at headlines from new s services and
reading inform ation screens. Such inform ation includes,
am ong other things, econom ic data releases, com m ents
of various analysts on recent econom ic and m onetary
developm ents, trading of U .S. G overnm ent securities in
The Manager and
the Desk staff keep the
FOMC fully informed
about evolving reserve
market conditions and
their daily plans
for open market
operations.
Asia and Europe, and reports of any event that m ight
influence early trading in U .S. financial and foreign
exchange m arkets.
The Treasury Call
Each w eekday m orning, at present about 10:00 a.m .,
several D esk staff m em bers, including staff from the
D esks reserve projections unit, gather in an office near
the trading room for a telephone conference w ith repre-
sentatives of the Treasury. B efore the call, the assem bled
group quickly looks at prelim inary estim ates of nonbor-
row ed reserves and its com ponents over the m ainte-
nance period and in the days im m ediately ahead. W hen
the estim ates of the N ew York Fed and Treasury staffs
suggest that the Treasury balance is likely to m ove aw ay
from the desired levels on the current and upcom ing
days, the Treasury staff w ill, if possible, take action to
bring it back into line by transferring funds to or from
depository institutions.
After the Treasury call, w hich usually lasts only a
few m inutes, the senior D esk staff begin a discussion of
the plan of action for the day. The starting point of the
discussion is the estim ated need to add or drain reserves
for the m aintenance period, but as described in C hapter
5, the range of issues involved is quite broad; som e of
the subjects are sim ilar from one day to the next, w hile
others differ w ith circum stances. As they m ove tow ard a
decision on the plan for the day, the M anager and D esk
staff call the D irector of the D ivision of M onetary Affairs to
get a reading of the B oard staffs assessm ent of the
reserve situation and to provide a prelim inary indication
of w hat sort of operation is being contem plated.
W hile w ork on the days action plan is still in
progress, the reserve forecasters deliver tables contain-
ing the revised estim ates of the N ew York Fed staff as
w ell as those of the Federal R eserve B oard staff. If these
estim ates are significantly different from the prelim inary
estim ates, the action plan m ay need to be m odified. As
the discussion reaches a conclusion, one of the partici-
pants w rites a program of action for the day. The pro-
gram review s the reserve situation, the trading in the fed-
eral funds m arket that m orning and other factors that
have influenced the proposed action.
As described earlier, the proposed program for
open m arket operations is read during the daily three-
w ay conference call that links the D esk staff, the B oard
staff and a R eserve B ank president. If the action plan of
the day involves tem porary transactions, R Ps or M SPs,
they are carried out im m ediately after the conference
call. The D esk staff norm ally com pletes its operations
w ithin a few m inutes. O nce the transactions are exe-
cuted, including receipt of collateral, the reserve
accounts of the dealersbanks are credited or debited
accordingly, altering the supply of nonborrow ed reserves
in the m onetary system .
O ver the rem ainder of the day, the trading room
continues to m onitor rates and prices in the securities
m arkets, trading in the federal funds m arket, and other
financial m arket developm ents. In addition, each after-
noon, the D esk staff holds brief telephone conferences
w ith representatives of tw o prim ary dealers as part of
its ongoing efforts to gather inform ation on the w ide-
ranging forces at w ork in financial m arkets. O n a regular
basis, D esk staff m em bers visit w ith m arket participants
and dealers at their offices in N ew York C ity to learn
about m arkets and dealer operations; these visits fre-
quently take place in the afternoons. Tow ard the end of
the day, as m entioned earlier, the D esk staff sends,
electronically, a sum m ary of the days financial m arket
developm ents to the B oard staff and R eserve B ank
presidents.

3 - Lectura Complementaria - Understanding Open Market Operations by M.A. Akhtar FRB of NY

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3 - Lectura Complementaria - Understanding Open Market Operations by M.A. Akhtar FRB of NY

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The Federal R eserve B ank of N ew York is responsible for

day-to-day im plem entation of the nations m onetary pol-

3 Members discussion of the

Understanding Open Market Operations / 27

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