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INTRODUCTION

The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) meets approximately every six weeks to determine the nation's monetary policy goals and, specifically, to set the target for the federal funds rate (fed funds rate). The fed funds rate is the interest rate at which banks lend their balances at the Federal Reserve to other banks, usually overnight.

This lesson focuses on the March 18, 2009, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

TASK

  • Explain the structure and functions of the U.S. Federal Reserve System and the Federal Open Market Committee.
  • Identify and explain the monetary policy tools of the Federal Reserve System.
  • Identify the current FOMC policy goals and actions.
  • Define the federal funds rate and how it is used as a monetary policy tool.
  • Determine the intended impact of the policy actions on price stability, economic growth, and employment.

PROCESS

$1,750,000,000,000 is a lot of money!

After it's March 18, 2009 meeting, the Federal Open Market Committee (FOMC) of the Federal Reserve System issued a press release that differed considerably from previous FOMC announcements.  Rather than begin with the standard statement about the federal funds rate target, the FOMC began with a rational for much more aggressive monetary policy actions.

The federal funds rate target, the commonly used indicator of monetary policy direction, had been reduced to a target of zero to 1/4 percent at the FOMC's January 2009 meeting.  With the fed funds target rate target so low and the effective rate (as traded in the market) as low as .18 percent, the potential impact of a target rate reduction would be minimal.  Here's what the FOMC said:

"Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract.  Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending.  Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment.  U.S. exports have slumped as a number of major trading partners have also fallen into recession.  Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth."

A second rational for aggressive action was the FOMC's feeling that there was little potential for a harmful level of inflation, despite aggressive expansionary policies. "In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued.  Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term."  Historically, the Fed has faced the perceived trade-off between the expansionary policy effects of growth and inflation.  Policies that increased the money supply and aggregate demand can have an inflationary impact.  Policies to counter inflationary pressures tend to also suppress growth

The federal funds rate was kept at the previous level. "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Then, the release announced new and unusually extreme actions to "support to mortgage lending and housing markets..." the purchase of up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.  Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. "


Federal Reserve Commitments to Provide Greater Liquidity

    $750 billion in new authorization for purchases of mortgage-backed securities
    $500 billion of previously authorized purchases of mortgage-backed securities
    $100 billion in new authorization to purchase of agency debt
    $100 billion of previously authorized purchases of agency debt.
    $300 billion to purchase longer-term Treasury securities over the next six months. 

    Total: $1.75 trillion.  That's $1,750,000,000,000! 


To implement these kinds of actions, the Federal Reserve had previously created the Term Asset-Backed Securities Loan Facility (TALF) program to "facilitate the extension of credit to households and small businesses..."   The FOMC suggested that the types of eligible collateral to be included in the TALF program will be expanded to include other financial assets.  The Fed has largely taken responsibility for removing the "toxic assets" that have plagued the financial system. 

The  FOMC added that it will "continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments."

Monetary Policy

The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.

The Federal Reserve controls three tools of monetary policy, open market operations, the discount rate and bank reserve requirements.  The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using these tools, the Fed influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

In an online publication, "The Federal Reserve's Response to the Financial Crisis," the Fed explains its recent expansion of policy actions. "The Federal Reserve has responded aggressively to the financial crisis since its emegence in the summer of 2007. The reduction in the target federal funds rate from 5-1/4 percent to effectively zero was an extraordinarily rapid easing in the stance of monetary policy. In addition, the Federal Reserve has implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These new programs have led to a significant change to the Federal Reserve’s balance sheet."

Figure 1 shows the recent history of the federal funds rate target.  Note that the target has been quickly decreased from 5 1/4 percent in 2007 and to the current 0 to 1/4 percent that was set in December 2008. 

Federal Reserve Figure 1

The three policy tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to banks and other depository institutions and other financial institutions.  The Fed also provides liquidity directly to borrowers and investors in key credit markets through the Term Asset-Backed Securities Loan Facility, the Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, and the Money Market Investor Funding Facility. 

Recently, the Federal Reserve has expanded its traditional tool of open market operations to support the functioning of credit markets through the purchase of longer-term securities for the Federal Reserve's portfolio. The March 18 announcement of the expansion of purchases of securities is an example of these actions.

Open Market Operations

According to the Federal Reserve, "open market operations (OMOs) -- the purchase and sale of securities in the open market by a central bank -- are a key tool used by the Federal Reserve in the implementation of monetary policy." Historically, the Fed has used open market operations to adjust the supply of reserve balances so as to keep the federal funds rate around the target federal funds rate established by the Federal Open Market Committee (FOMC). Open market operations are conducted by the Trading Desk at the Federal Reserve Bank of New York.

"Permanent OMOs are generally used to accommodate the longer-term factors driving the expansion of the Federal Reserve's balance sheet -- primarily the trend growth of currency in circulation. Permanent OMOs involve outright purchases or sales of securities for the System Open Market Account, the Federal Reserve's portfolio. Temporary OMOs are typically used to address reserve needs that are deemed to be transitory in nature. These operations are either repurchase agreements (repos) or reverse repurchase agreements (reverse repos). Under a repo, the Trading Desk buys a security under an agreement to resell that security in the future. A repo is the economic equivalent to a collateralized loan, in which the difference between the purchase and sale prices reflects interest."

The Fed explains recent changes in monetary policy actions, "The Federal Reserve's approach to the implementation of monetary policy has evolved considerably since 2007, and particularly so since late 2008. The FOMC has established a near-zero target range for the federal funds rate, implying that the very large volume of reserve balances provided through the various liquidity facilities is consistent with the FOMC's funds rate objectives. In addition, open market operations have provided increasing amounts of reserve balances. Specifically, to help reduce the cost and increase the availability of credit for the purchase of houses, on November 25, 2008, the Federal Reserve announced that it woud buy direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks and mortgage-backed securities (MBS) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae."

Proving Liquidity to Banks

The Fed uses the discount window to "relieve liquidity strains for individual depository institutions and for the banking system as a whole by providing a source of funding in time of need." The Fed provides three types of discount window credit--primary credit, secondary credit, and seasonal credit. In December of 2007, the Federal Reserve introduced the Term Auction Facility (TAF), which provides credit to depository institutions through an auction mechanism. All regular discount window loans and TAF loans must be fully collateralized to the satisfaction of the lending Reserve Bank - the value of the collateral must exceed the value of the loan." 

"Primary credit is a lending program available to depository institutions that are in generally sound financial condition. Because primary credit is available only to depository institutions in generally sound financial condition, it is generally provided with minimal administrative requirements; for example, there are essentially no usage restrictions on primary credit. Before the current financial crisis, primary credit was available on a very short-term basis, typically overnight, at a rate 100 basis points above the Federal Open Market Committee's (FOMC) target rate for federal funds. The primary credit facility helps provide an alternative source of funding if the market rate exceeds the primary credit rate, thereby limiting trading at rates significantly above the target rate."

"Secondary credit is available to depository institutions that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate 50 basis points above the primary credit rate. In contrast to primary credit, there are restrictions on the uses of secondary credit extensions. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return by the borrower to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower's assets. Moreover, the secondary credit program entails a higher level of Reserve Bank administration and oversight than the primary credit program."

The seasonal credit program "assists small depository institutions in managing significant seasonal swings in their loans and deposits. Eligible depository institutions may borrow term funds from the discount window during their periods of seasonal need, enabling them to carry fewer liquid assets during the rest of the year and, thus, allow them to make more funds available for local lending. The interest rate applied to seasonal credit is a floating rate based on market rates. Seasonal credit is available only to depository institutions that can demonstrate a clear pattern of recurring intra-yearly swings in funding needs. Eligible institutions are usually located in agricultural or tourist areas."

"On December 12, 2007, in view of pronounced strains in term bank funding markets, the Federal Reserve announced the creation of the Tern Auction Facility (TAF). Under the TAF program, the Federal Reserve auctions term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit discount window program are eligible to participate in TAF auctions. All advances must be fully collateralized with an appropriate haircut."

Note: A “haircut” is the difference between the value of a loan and the value of the collateral securing that loan – the spread or margin. An asset's market value may be reduced by this margin for the purpose of calculating a capital requirement, margin or level of required collateral.

How will the Fed Programs Help Consumers?

These Fed programs will not provide direct assistance to consumers.  The TALF program will provide loans to investment companies to purchase securities that are backed by consumer debt.  This will enable greater lending for purchases of automobiles, education loans, consumer credit purchases and small business loans. The loans will be to investors, such as hedge funds, private equity firms and mutual funds.  The investors will work with the large banks and securities firms - the "primary dealers" who purchase securities directly from the Federal Reserve.  As the securities are purchased, the banks and other firms that make consumer loans will have more available funds for loans directly to consumers - most likely at lower interest rates.

Thr current recession (beginnning in December 2008) is characterized by reduced personal consumption expenditures and decreased private investment by firms and households.  These problems are primarily a product of the frozen credit markets that resulted from the rapid decrease in housing prices and the resulting decrease in the value of the "mortgage-backed securities."  Because the true value of many of these securities cannot be determined and the secondary markets for them are not effectively determine market prices, they cannot be bought and sold.  Assets that have a value derived from an underlying security (a mortgage-backed security is based on the value of the pooled mortgages) are often referred to as "derivatives."

What Are Mortgage-backed Securities? 

According to the U.S. Securities and Exchange Commission, mortgage-backed securities (MBS) are "debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization."  Source:  Mortgage-Backed Securities
 
Other Key Terms Related to the Mortgage-backed Securities Problem

A security is a tradable contract that carries a spefified value.  A security represents ownership (i.e, a stock), a debt agreement (i.e. bonds), or the rights of ownership.is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by a collection of mortgages.

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by the value of a group of mortgages.

Derivatives are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security or index".  [Source: Derivatives ]  For example, a mortgage-backed security is a derivative because its value changes based on price changes of the underlying group of mortgages.” 

CONCLUSION

The March 18, 2009, FOMC announcement reaffirmed the Fed's intentions to quickly and seriously intervene in the banks and credit markets.   

"Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract.  Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending.  Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment.  U.S. exports have slumped as a number of major trading partners have also fallen into recession.  Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth."

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Also on March 18, the FOMC announced an additional $1 trillion in loan and investment programs intended to provide bank liquidity and increase lending.  With improved liquidity and lending, the intent is that personal consumption expenditures and private investment will increase, thus creating more jobs and increasing output (GDP). 

What do you think?

Will these Fed actions help to reverse the recent downward trend of the economy - negative growth and higher unemployment?  The Fed has pledged to do whatever it takes to provide liquidity and stimulate credit markets.  Ultimately, the success of these efforts depends on whether or not businesses gain enough confidence to increase their investments and hire more workers.  It also depends on whether or not consumers are confident enough in their jobs and future income to use their available credit to make large purchases.   The credit crisis may be as much a crisis of confidence as it is real problems in the banking system.
  • What will it take for consumers and businesses to be more confident?
  • Will more money or more liquidity solve the problems?
  • Will consumers have to change their behavior - use credit more carefully?
  • Should credit markets be more regulated so that "creative" credit instruments like zero-interest mortgages are used more thoughtfully?
  • Will we have learned from our past experiences with "bubbles " (dot.com, housing, etc.) to not rely on continuously increasing values as a basis for our investment and consumption decisions? 

ASSESSMENT ACTIVITY

Next, below answer the discussion question on the interactive notepad.

 

  1. What is liquidity?
     
  2. How will increasing liquidity help banks make more loans?

EXTENSION ACTIVITY

The Federal Reserve System includes twelve regional Federal Reserve Banks.  Click on this link for a map of The Twelve Federal Reserve Districts .  Click on the region where you live and you will go to the web site of your regional Federal Reserve Bank.

Each regional bank web site will have a variety of links to regional data, commentary on current conditions and historical economic data.  Take a look at the information about your region. 

  • What are the region's strengths and weaknesses? 
  • What industries are doing well and/or suffering? 
  • What are the policy concerns of the Fed and banks in the region?

Look at the region's economic indicators - employment and regional GDP growth.

  • How is your region doing compared to the nation?
  • How is your region doing compared to neighboring regions?