All you ever wanted to know about

the Fed . . . but were afraid to ask

Dr. Robert Kovacev

A history lesson -- Earliest
Central Banks
 Swedish Riksbank (1668)
 Lend government money
 Clearing house for commerce
 Bank of England (1694)
 Purchase government debt
 Banque de France (1800)
 Control hyper-inflation
 Aid government finance
 Other early central bank roles
 Issue currency
 Banking services for other banks
 Lender of last resort
A history lesson – American Central Banking
 1775 – 1791: Continental Congress
 Continental Congress printed “Continentals” currency to finance
the Revolutionary War
 Inflation rendered them worthless
 1791 – 1811: First Bank of the United States
 Founded by Treasury Secretary Alexander Hamilton
 Dominated by big banking and money interests
 Opposed by agrarian Americans
 20-year charter failed renewal in Congress by one vote
 1816 – 1836: Second Bank of the United States
 Killed by President Andrew Jackson
 Populist anger over banker-controlled power
 20-year charter failed renewal
A history lesson – American Central Banking
-2
 1836 – 1865: Free Banking Era
 State-chartered and unchartered “free banks”
 Banks issued their own currency, redeemable in gold
 Growth of demand deposits and checks
 New York Clearinghouse Association (1853)
 1863: National Banking Act
 During Civil War
 Nationally chartered banks with currency backed by U.S.
government securities
 State-issued bank notes were taxed
 State banks continued to thrive -- increasing popularity of demand
deposits
A history lesson – American Central Banking
-3
 1873 – 1907: Financial Panics
 1893 Panic – J.P. Morgan bailout
 1907 Panic – Wall Street speculation
 Populist call for reform
 Eastern “money trusts” v. “progressives”
 Consensus for central banking authority
 1908 – 1912: Central v. Decentralized Bank
 Aldrich-Vreeland Act (1908) – Emergency currency issued
 National Monetary Commission to find long-term solution
 Later killed by President Woodrow Wilson
 1913: Federal Reserve Act
 Based on proposal by Carter Glass and H. Parker Willis
 Established the Federal Reserve Bank (opened 1914)
A history lesson – American Central Banking
-4
 1914 – 1919: World War I
 Aldrich-Vreeland Act emergency currency provided wartime
financial stability in U.S.
 1920s: Fed Open Market Operations
 Fed purchase of government securities
 Monetary policy tool as alternative to gold-backed currency
 A history lesson – American Central Banking
-- 5
 1929 – 1941: Market Crash and Great Depression
 Market speculative bubble (forewarning by Glass)
 Bank holiday after 10,000 bank failures
 Glass-Steagall Banking Act (1933) – Expanded Fed powers
 Separates investment banking from commercial banking
 Requires using government securities as collateral for Federal Reserve Notes
 Established Federal Deposit Insurance Corp (FDIC)
 Fed oversight of bank holding companies
 FDR recalled all gold and silver certificates to eliminate gold and silver
currency standards
 Banking Act of 1935 -- Greater Fed political independence
 Created Federal Open Market Committee (FOMC)
 Remove Treasury Sec’y and Comptroller of Currency from Fed governing board
 Fed governors 14-year terms
 A history lesson – American Central Banking
– 5 – Bretton Woods
 1941 – 1945: World War II
 July 1944: Bretton Woods Agreement
 Meeting of all 44 Allied Powers to plan postwar financial order
 Stable exchange rates and process for currency exchanges
 Peg to US Dollar as world reserve currency
 Set price of gold at $35/oz
 Each nation set policies for full employment
 Eliminate practice of war victor economic retaliation
 International Monetary Fund (IMF) to secure int’l monetary cooperation
 Expand international liquidity
 Stabilize exchange rates
 World Bank to assist postwar economic recovery
 A history lesson – American Central Banking
– 5.5 -- Outcome of Bretton Woods
 1968 – 1976: Erosion of Bretton Woods
 Johnson’s Great Society and Viet Nam War spending created major dollar
glut overseas and severe demands for payment in gold reserves
 In 1970, the dollar gold backing dropped from 55% to 22%
 Dollar holders lost faith in U.S ability to cut budget and trade deficits
 Aug 15, 1971 Unilateral Nixon actions
 Froze wages and prices for 90 days
 Imposed 10% import surcharge
 “Closed the Gold Window”, making the dollar inconvertible to gold except on
the open market
 Major world currencies revalued
 Currency speculation ran rampant
 By March 1976, all major currencies were floating
 Exchange rates no longer principal method for managing monetary policy
 A history lesson – American Central
Banking -- 6
 Humphrey Hawkins Act (1978)
 Fed Chairman report to Congress twice/year on monetary
policy goals
 Fed-Treasury Accord (1951)
 Made Fed very independent in use of open market activity
 Gramm-Leach-Bliley Act (1999)
 Overturned Glass-Steagall
 Expanded com’l bank offerings of financial services
 Investment banking and insurance products
Anatomy of a cycle
Trough Recovery; Peak Decline;
Expansion Contraction;
Recession
Characteristics of cycles
 Demand for funds depend on where you are in the
cycle
 Recession – Demand declines; Rates fall
 Expansion – Demand rises; Rates increase
 True of business and consumer demand
 Government demand – counter-cyclical??
 Rates do not track the cycle exactly
 Time lag for short-term rates
 Longer lag for long-term rates
Types of business cycles
 Seasonality
 One year or less
 Corresponds to goods moving into and out of season\
 e.g. clothing; automobiles; holidays
 40-Month Cycle --“The Business Cycle”
 Corresponds to building up and working off inventories
 8-Year Innovation Cycle
 Corresponds to development of new innovations and their subsequent
replacement by newer ideas
 18 to 20-Year Construction Cycle
 Land developer Edifice Complex – Build until lenders stop lending on
new projects
 Heavy over-development saturates the market
 Recovery as the buildings age and need to be replaced
 Long-Wave Cycles
 Per Joseph Schumpeter – A composite of the shorter-wave cycles
 Leading Economic Indicators -- Examples
Leading indicators anticipate the direction of the economy

1. Average weekly hours, manufacturing

2. Average weekly initial unemployment claims
3. Building permits, new private residential
4. Standard & Poor’s 500 Stock Index
5. Index of Consumer Expectations
6. Manufacturers new orders, consumer goods
7. Manufacturers new orders, nondefense capital goods
8. Vendor performance, slower deliveries
9. Money supply, M2
 Currency + demand deposits + savings deposits (<$100K)
10. Interest rate spread between Treasury Bonds and Federal Funds Rate
 Measures Yield Curve
 Coincident and Lagging Economic Indicators
-- Examples
Coincident indicators show current status of the economy
1. Nonagricultural full time employees
2. Personal income less transfer payments
3. Index of industrial production
4. Manufacturing and trade sales
Lagging indicators help predict duration of current cycle
1. Average duration of employment
2. Average bank prime rate
3. Ratio of manufacturing and trade inventories to sales
4. Consumer installment credit outstanding to income
 Personal Debt Ratio
5. Change in labor cost per unit, manufacturing
6. Commercial and industrial loans outstanding
7. Change in consumer service price index
 The roles of the Fed
 Apply monetary policy and tools to control the money supply
 Inflation v. deflation
 Lender of last resort
 Fed Discount Window
 Supervision of the banking system
 Policy
 Field examinations
 Manage the payments mechanism
 Check clearinghouse
 Provide currency and coin to banks
 Provide banking services for the federal government
 Manage Treasury bank accounts
 Redeem Maturing Treasurysecurities
 Sell Treasury securities
 Lender of Last Resort for 2008-2010 Bailout and Recession
 “Too big to fail”
 Goals of Fed monetary policy – An exercise
in optimization of divergent goals
 Sustainable economic growth
 Neither too fast nor too slow
 Full employment
 Excessively low unemployment is inflationary
 NAIRU -- Non-Accelerating Inflation Rate of Unemployment
 Lowest unemployment that can be sustained given the structure of the economy
 Real gross domestic product (GDP) equals potential output
 Around 3% to 6% unemployment is normally considered acceptable in the U.S.
 Reasonably Stable Prices
 Low levels of inflation (1.7% to 2%) are acceptable for the forseeable future
 Avoid rampant inflation through strict monetary measures
 Absolutely avoid deflationary pressures
 Stable Balance of Payments with other countries
The Federal Reserve Bank Structure
 Means for achieving the goals
 Cost and availability of credit
 Money supply volume and growth rate
 Wealth Effect – Influence public perceptions of value
of investments
 The wealthier people feel, the more they spend; the poorer
they feel, the more they save
 Currency exchange rates
 Public expectations of future
 Money and credit conditions and currency values
Fed tools of monetary policy
 Open market operations
 Buying and selling U.S government securities
 Influence the Federal Funds Rate
 Discount rate
 The rate charged to depository institutions for short-term loans
from the Discount Window
 Bank reserve requirements
 Portion of deposits banks must keep in their vaults or on account at
their local Federal Reserve Bank
 Economic Analyses by Federal Reserve Banks
 Beige Book
 Where are we in the current economic cycle
 What is needed to be done to achieve monetary goals
 Federal Open Market Activities
 The Fed operates in several ways
 Regulatory power
 Open market operations
 Persuasion and coercion
 Political influence
 Open market activities are the fastest and most flexible tool
 Buying and selling U.S. government securities
 Affects both interest rates and legal reserves
 Used for fine-tuning the financial markets
 Membership
 Fed Chairman, Vice Chairman, and Board of Governors
 President of New York Federal Reserve Bank
 Presidents of four other Federal Reserve Banks (rotating basis)
Goals of Fed Open Market activities
 Overall Goal
 Achieve Fed’s overall monetary goals
 Daily activities are defensive
 Stabilize money and capital markets to avoid sudden
changes in interest rates and credit conditions
 Long Term
 Change money and credit conditions to meet the Fed’s
policy and economic goals
Federal Open Market Committee (FOMC)
 Meets every 4 to 6 weeks (eight times per year) – more
often if needed
 Secret sessions prevent profiting from “inside informatio
n”
 Decide on future course of monetary policy
 Decisions based on current economic and market conditions
 How Fed policy goals are being met
 How to best apply the Fed’s tools to meet the goals
 FOMC market-based decisions implemented by the
System Open Market Account manager (SOMA)
 FOMC and SOMA decisions are binding on the entire Fed
system
Fed Open Market activities affect both
interest rates and legal reserves
Effect of Open Market activities on interest
rates
 Fed buys securities
 Buys government securities on open market,
 Stimulates demand and lowers market supply
 Prices rise and yields drop
 General interest rates follow the trend
 Fed sells securities
 Sells government securities in open market
 Increases market supply
 Prices drop and yields rise
 General interest rates follow the trend
 Effect of Open Market Activities on Legal Reserves

 Outright (Straight) Transaction [BUY OR SELL]

 Purchase or sale
 Permanent title passes to buyer
 Legal Reserves change permamently
 Repurchase Agreement (Repo or RP) [BUY]
 Fed temporary purchase with promise to resell to seller
 Used to provide temporary increase in reserves
 Reverse Repo [SELL]
 Fed temporary sale with promise to buy back
 Used to temporarily soak up excess reserves
 e.g. weather causes imbalance in reserves in some parts of the country
 Effect of Open Market Activities on Legal Reserves
(cont)
 Runoff [BUY or NOT BUY]
 Direct transaction with Treasury in purchasing or redeeming securities
 Scenario 1: Buy
 Fed replaces maturing securities with those being offered in new treasury issue
 This removes some new securities from the open market auction, raising prices and
lowering yields
 The new issue is less attractive to investors and money stays in the bank
 Scenario 2: Not Buy
 Fed chooses NOT to replace maturing securities with those being offered in new treasury
issue
 Treasury must sell more securities to pay for the maturing ones
 This lowers prices and raises yields of the new issue auction
 Funds are drawn from bank deposits to invest in better-yielding Treasuries and bank
reserves go down
 Using Fed tools to affect Federal Funds Rate

Effect on Federal
Fed Action What this Does
Funds Rate
Open Market: Push securities into financial system and Increases
Sell Securities decrease aggregate reserves Federal Funds Rate
Open Market: Take securities from financial system and Decreases
Buy Securities increase aggregate reserves Federal Funds Rate
Increase Discount Makes borrowing reserves from Fed more Increases
Rate costly Federal Funds Rate
Decrease Discount Makes borrowing reserves from Fed less Decreases
Rate costly Federal Funds Rate
Increase Reserve Force banks to hold more reserves (less Increases
Requirements money to lend) Federal Funds Rate
Decrease Reserve Allows banks to hold less reserves (more Decreases
Requirements money to lend) Federal Funds Rate
 Influences on total reserves
 Heart of the monetary policy process is reflected in changes in
total reserves
 Factors supplying and factors absorbing reserves
 Net effect of these factors near-term and trends
 Several factors affect the level of total reserves (examples)
 Federal Reserve Operations
 Sale of securities Reduces reserves
 Loans to banks Increases reserves
 Actions of the public
 Increase currency holdings Reduces reserves
 Decrease currency holdings Increases reserves
 Actions of Treasury and foreign investors
 Increase in Treasury deposits Decreases reserves
 Decrease in Treasury cash held Increases reserves
 Gold purchases Increases reserves
Monetary v. Fiscal Policy
 Monetary Policy – Milton Friedman
 Power to regulate the supply of money
 Power to regulate the banking industry
 Influence reserves in the system
 Set and influence interest rates
 Liquidity in the system

 Fiscal Policy – John Maynard Keynes

 Power to tax and print money
 Tax increases v. tax cuts
 Deficit spending v. Balanced budgets
 National debt