Federal Reserve System
Outline of Research Paper
This paper briefly explains the functioning of the Federal Reserve System as an instrument of monetary policy. After a brief introduction, the paper elaborates the functions of the Federal Reserve System, as also how the Fed through different instruments like open market operation and changing reserve requirement regulates the money supply in the economy. Fed’s inflation targeting policy is also dwelt upon. The paper is also a reflection of the Fed’s influence on the monetary policy of the U.S. over the years.
The Federal Reserve System or “the Fed” as it is called was established in 1913. It consists of a seven-member board of Governors serving by appointment of the President and confirmed by the senate, is a powerful spokesperson of the Fed and serves for four years renewable terms.
The Federal Reserve Board is an independent agency, free of Presidential or congressional control. Its chairman during the 1990s, Allen Greenspan, was very effective and influential in setting monetary policy. There are more than 6000 member banks that are affected by Fed policy and then influence monetary policies of other banks, ultimately having an impact on the interest rates consumers pay (Lader, p.327).
Function of the Federal Reserve System
The Federal Reserve System regulates the money supply through its three main functions namely the open market operation, reserve requirements and through discount rates. The central bank through open market operations carries out buying and selling of government securities, which affects the money supply and cost of money. The Fed establishes legal limitations on money reserves that bank must keep against the amount of money they have deposited in Federal Reserve Banks through reserve requirements. These limits affect the ability of the banks to loan money to consumers because actions in this area can increase the availability of money for credit. The Federal Reserve also regulate money supply through discount rates whereby it determines the rate at which banks can borrow money from the Federal Reserve System. If rates are raised, interest rates for consumers also rise. The Federal Reserve System uses this tactics to keep inflation in check. This is one of the most publicised actions of the Fed (Lader, p.327). Discount rate changes are often made at substantial intervals and represent a rather discontinuous tool of monetary policy. The discount rate is an administered rate that is moved in discrete steps ranging from 25 to 100 basis points. The Federal Reserves Board of Governors establishes the discount rates ( Jensen, Johnson & Mercer, 2000, p. 8).
In most countries, the central bank performs an important role in the management of the financial system. However, since the main task of the central bank is to maintain price stability, the assignment of other “optional tasks,” such as bank supervision, has been subject to debate amongst academics and policymakers for several years. For example, policymakers in the United Kingdom, Japan, and several Scandinavian countries recently removed their central bank from its role in bank supervision, while (after a long debate) the European Central Bank was given no supervisory responsibilities. In the United States, where the Federal Reserve System has only partial responsibility for the supervision of banks, there were various proposals to the Congress to consolidate all supervisory duties under a new single federal regulator, separate from the Federal Reserve (Ioannidou, 2005).
Since the establishment of the Federal Reserve System (Fed), member banks have been required to hold reserve assets in proportion to their deposit liabilities.1 Reserves must be held as deposits with the Fed or as vault cash.2 To ensure that banks regularly meet their reserve requirements, the Fed requires periodic reconciliation of each bank’s reserves, which is referred to as settlement. In order to meet settlement requirements, institutions manage their reserve balances through trades in the federal funds market (Kotomins & Winters, 2007).
Periodic settlement occurs every 2 weeks on Wednesday. The 2-week period is referred to as a reserve maintenance period and each reserve maintenance period consists of
14 calendar days, 10 of which are usually trading days. Actual reserves (deposits and vault cash) are counted for reserve maintenance purposes at the close of each day with balances on non-trading days set equal to the balances on the most recent trading day. At the end of each reserve maintenance period, the 14 daily actual reserve positions are accumulated and compared to the total required reserves for the reserve maintenance period. A bank has successfully settled if its total actual reserves are within the allowed range of total required reserves (Kotomin & Winters, 2007).
Controlling rate of inflation
Determined to avoid a repeat of the great inflation of the 70s, central bankers around the world have worked hard over the last two decades to achieve price stability. The U.S. Federal Reserve has reduced inflation from more than 13 percent in 1979 to the low single digit today. As a part of anti inflation campaign, many central banks have adopted inflation objectives, including several banks such as European Central Bank that do not formally classify themselves as “inflation targeters” (Bernanke, 2003, p. 74).
Beginning over a decade ago, a number of central banks have adopted the technique of “inflation
targeting” in an effort to improve their performance. Under this approach, an agreement between a nation’s government and its central bank commits the latter to achieve a quantitative inflation target by a certain date. Typically, the target is specified as a low but positive rate of inflation. In 1990, New Zealand became the first industrialized country to institute a formula regime of inflation targeting. Next in line were Canada (1991), the United Kingdom and Israel (1992), and Australia and Sweden (1993). Switzerland took the step in 1999. Finland and Spain adopted inflation targeting prior to joining the European Monetary Union. The U.S. Federal Reserve has debated inflation targeting but has refrained from adopting it (Brimmer, 2002).
Low and stable inflation in many countries is an important accomplishment that will continue to bring significant benefits. But de facto, price stability has another effect, which is now forcing the central bankers to rethink inflation. After a long period in which the desired direction for inflation was always downward, the industrialized world’s central banks should try to avoid major changes in the inflation rate in either direction. This “symmetric inflation risk”, as is termed by the Central Bank is at the moment is the greater risk. Allowing inflation to fall too low to where it might morph into actual deflation would highly undesirable from the point of view of the Federal Reserve or any central bank for that matter (Bernanke, 2003, p.75).
Role of Federal Reserve in controlling monetary policy of the U.S
The Federal Reserve Bank can be viewed as a trader with private information. This information is revealed to the market in many different ways: remarks by the Chairman of the Federal Reserve, testimony before the House and Senate Banking Committees, the release of the Beige book, the minutes of the Federal Open Market Committee (FOMC) meetings, changes in reserve requirements, changes in the discount rate, and open market operations. The last method is, by far, the primary and most actively employed policy tool of the Federal Reserve Bank in implementing its monetary policy (Harvey & Huang, 2002).
During the 1990s, a number of the Federal Reserve adopted a framework that is called inflation targeting, combining a hierarchical mandate and an explicit inflation objective. In the United States, it took quite some time for the Congress to establish a precise set of objectives for monetary policy. In fact, remarkably little about policy objectives was included in the original Federal Reserve Act in 1913. The only policy objectives identified in that statute were to furnish an elastic currency to afford means of rediscounting commercial paper. The absence of any mention of price stability undoubtedly reflected confidence that the gold standard, under which the United States was operating, would promote price stability. The intent of providing an elastic currency and of rediscounting commercial paper was to expand the supply of money and credit to accommodate increases in production and the accompanying demand for credit. Given that the immediate impetus of the founding of the Federal Reserve was the Panic of 1907, promoting financial stability was a clear focus. The framers’ intention was that the Federal Reserve would provide banks with a source of liquidity through rediscounting to meet deposit withdrawals (Meyer, 2002).
Federal reserve act in its original form actually contemplated use of the discount window as the principle tool of monetary policy and did not envision reliance on open market operations in government securities for implementing policy. Indeed, in its first decade of operations, the Federal Reserve System relied primarily on discounting for extending credit (Orphanides, 2002, p.885). Fed’s monetary policy in the post-1914 environment was supposed to maintain gold convertibility by the passive rediscounting of self-liquidating real (commercial) bills and use of the discount rate, to counter movements in the gold reserve ratio. In response to the changing environment (World War I and its aftermath) and especially heavy Congressional criticism of its performance following the severe recession of 1920–1921, the Fed shifted to a more activist stance based more on the use of open market operations rather than discount policy and a new policy framework (Bordo, 2006).
Federal Reserve holdings of U.S. government securities grew gradually and never exceeded half of total Federal Reserve credit outstanding during the first fifteen years of the system. If due to shrinking supply of government debt, it becomes necessary for the Federal Reserve to make a gradual move out of treasury securities over the next two decades, it could essentially be viewed as the mirror image of the gradual increase in the Federal Reserve holdings of government securities during the system’s first two decades of operations (Orphanides, 2002, p. 885).
A necessary and sufficient and a sufficient condition under which a monetary-policy rule is a good policy can only be stated in terms of the bias-free effects on the federal funds rate of all the determinants of this rate including the Fed’s expectations about future inflation, the future gap between actual and potential output, and the future foreign exchange value of the dollar (Swamy et al, 2005).
Monetary policy has a relatively direct leverage over very short-term interest rates. To steer the behavior of economic agents, however, it is necessary to affect longer-term interest rates, where the central bank influence is much more indirect. Bernanke (2004) emphasize the importance for communication as a means for central banks to influence these asset prices, provided that the central bank has acquired a credible reputation. In that respect, communication is an important tool for the effectiveness of monetary policy implementation (Eijffinger and Hoeberichts 2004). It is important that communication manages to influence the expectations of economic agents, such that the desired reaction of longer-term interest rates is achieved.
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