The Fed's new tools (I)

By popular demand, I improved and expanded the notes I published a couple of weeks ago about the new tools of the Federal Reserve. I have added instruments that are not in place yet but the Fed considers using. I have ended up with a very long post, so I have broken it down into two parts. The second part will come out next week.

(I thought somebody would like to use these posts as a refresher, a summary, or even class notes. Jim Hamilton has a few great posts on the subject: September 23, December 14, December 16, March 15. The New York Federal Reserve made its own pocket version. And Greg Ip wrote a rather educational piece. Enjoy.)

UPDATE (4/13/2008): The link to the New York Fed's pocket version does not work any more. But you can find that document here now. Sorry about that.

* * *

The central bank has a balance sheet, as any other bank. As assets, it holds primarily securities issued by the government and loans to banks. As liabilities, it has currency (the cash in your pockets) and reserve balances. Reserves are deposits that regular banks keep at the central bank. When a bank needs currency it withdraws from its deposit, effectively turning it into notes and coins that you and I can use. As you will see in a minute, reserves are a key element in monetary policy.

This was the balance sheet of the Federal Reserve on August 15, 2007:

Federal Reserve's balance sheet, $ millions (Aug. 15, 2007)
Assets	US government securities	789,601
	Repurchase agreements	24,000
	Reverse repurchase agreements	-31,941
	Direct loans	264
	Other assets	37,058
Liabilities	Currency in circulation	813,085
	Reserve balances	5,897

Source: Federal Reserve, H.4.1 release.

(For the moment, regard “repurchase agreements” as loans to banks.)

The sum of currency in circulation and reserve balances is the monetary base (M0). The Federal Reserve’s target, however, is not M0 but the federal funds rate.

Banks keep deposits at the Fed to meet reserve minimums required by the Fed and to clear financial transactions. Institutions with balances in excess of reserve requirements lend reserves to institutions that don't have enough. The interest rate on those loans, typically overnight, is called the federal funds rate. That’s a market rate, determined by the supply and demand of such funds. The more reserves, the lower the fed funds rate, and vice versa.

Source: Federal Reserve Bank of New York
The Fed does not set the federal funds rate. When you read in the newspapers that “the Fed cut interest rates by 25 basis points,” what they mean is that the Fed reduced its target for the federal funds interest rate by 0.25%, not the actual rate. But the Federal Reserve can push the actual rate close to its desired target by affecting the amount of reserves available.

Until now, macroeconomics textbooks have been telling us that central banks use two tools to affect the federal funds rate. Looking at them through the balance sheet will help us understand what the U.S. central bank has been up to recently:

• Open market operations (OMO). This is an outright purchase of Treasurys (government securities): the Fed takes securities from banks and credits the banks’ reserve balances. A higher level of loanable reserve balances mean lower interest rates. Voilà: the Fed just "cut" interest rates. Eventually, banks withdraw from their reserves at the central bank and turn them into cash. So an open market operation amounts to withdrawing Treasurys from the hands of banks and replacing them with cash. That would be an expansionary move of monetary policy. The central bank can also reduce the amount of cash in circulation, by doing just the opposite: selling government securities and absorbing cash.

Suppose that the Fed pumps $1,000 million in the banking system through an open market operation. The Fed’s balance sheet would experience the following changes, once banks have withdrawn the new funds from their reserve accounts:

Changes in the Fed's balance sheet after a $1,000M open market operation
Assets	US government securities	+1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	+1,000
	Reserve balances	0

• Direct loan. We usually refer to this tool as the discount window. The central bank simply lends money to a bank, at a set interest rate. The central bank increases its balance of loans, and simultaneously credits the reserves that the borrowing bank holds at the Fed.

The loan is secured by collateral, i.e. the Fed would seize assets in the event of default. But there is no flow of securities from the bank to the Fed or vice versa —just cash from the Fed to the bank. There is a long list of assets that banks can use as collateral. The term of the loan is generally one day, but sometimes it’s longer for small banks.

This is what happens to the Fed’s balance sheet when it extends a loan through the discount window (and once the borrower has withdrawn its new reserves):

Changes in the Fed's balance sheet after a $1,000M discount window loan
Assets	US government securities	0
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	+1,000
	Other assets	0
Liabilities	Currency in circulation	+1,000
	Reserve balances	0

Even though the price of a such loan is set by the Fed, not the market, a discount-window loan can affect the federal funds interest rate by increasing the amount of available reserves.

Asking for a direct loan usually means that the bank was not able to obtain liquidity any other way. For that reason banks that request discount window loans are subject to scrutiny by the central bank, and watched closely by other banks. And the interest rate charged for direct loans is higher than the federal funds rate. For those reasons, the discount window is used rarely and in small amounts.

A tool that is more frequently used than OMOs but that textbooks often don't mention is:

• Repurchase agreements (or “repos”). A repurchase agreement is a loan from the Fed to a bank. The Fed credits the bank’s reserves and increases its entry of repo claims on banks.

This is what happens to the Fed’s balance sheet:

Changes in the Fed's balance sheet after a $1,000M repurchase agreement
Assets	US government securities	0
	Repurchase agreements	+1,000
	Reverse repurchase agreements	0
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	+1,000
	Reserve balances	0

From a financial point of view a repo is not that different from a discount window loan.

The effect of a repo loan on reserves is “self-reversing.” Unlike open market operations, repos automatically restore reserve balances to their original level: at the maturity of the loan, the Fed debits reserve balances and removes the repo loan from its assets.

The loan is guaranteed by assets pledged by the borrower. The set of acceptable collateral is called General Collateral. It includes things other than US government securities (agency obligations and mortgage-backed securities) but not as many as the list of discount window collateral .

Many textbooks don’t mention repos because they are considered a type of open market operation (OMO). The New York Federal Reserve itself calls them “temporary OMOs” sometimes. By nature, however, a repo is a collateralized loan, not a purchase or sale of Treasurys.

Sometimes the Fed does not want to increase the amount of reserves in the banking system, because it estimates that the amount available is appropriate. Still, for some reason, banks can’t get enough liquidity from their peers in the federal funds market and keep coming to the Fed for loans.

As an example, last summer some U.S. banks started experiencing losses from their portfolios of mortgage-related securities. Nobody knew who those banks were, or how large those losses could be. So banks started hoarding reserve balances rather than lending them out. Some institutions were unable to find as much liquidity as they wanted because nobody would lend it to them (at a reasonable price).

In those situations the Fed conducts moneyless monetary policy, acting as counterparty without actually changing the amount of cash in the economy. How? It enters repurchase agreements, which create new reserves. Then it offsets those new reserves by selling some of its own government securities (or letting them mature without purchasing more), and thus withdraws cash from the banking system.

Here’s how a repurchase agreement would change the Fed’s balance sheet, after offsetting it with an open market operation:

Changes in the Fed's balance sheet after a $1,000M repurchase agreement, offset by an open market operation
Assets	US government securities	-1,000
	Repurchase agreements	+1,000
	Reverse repurchase agreements	0
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	0 (-1,000 + 1,000)
	Reserve balances	0

In that case the repos don’t have any bottom-line effect on liquidity: they merely change the composition of the Fed’s assets and provide temporary cash to the borrowing banks.

In the second half of 2007 these offsetting operations became more frequent, and his is why Jim Hamilton writes that the Fed has been doing monetary policy using the asset side of the balance sheet. Another way to see it is that the Fed took the money out of monetary policy, because its actions barely affected the monetary base (reserves plus currency in circulation).

Also in the summer the Fed introduced the first of its new tools:

• Term Discount Window Program (TDWP). The first innovation introduced by the Fed doesn’t really deserve a name of its own. Under the TDWP, announced on August 17, the Fed makes discount-window loans for as long as 30 days. On March 16 it prolonged the maximum maturity to 90 days. The range of collateral at this facility is exactly the same as at the discount window, and so are the changes in the Fed's balance sheet. These loans are restricted to institutions eligible for primary discount-window credit —basically, banks with a strong balance sheet.

Many institutions didn’t want to use the discount window or its sister the TDWP because of the stigma that it carries. But liquidity was still dear, so on December 12 the Fed stepped up to the plate, with the

• Term Auction Facility (TAF). The TAF represents an improvement with respect to repos in their capacity to provide liquidity. First, it widens the range of collateral it accepts, from General Collateral to discount window collateral. Second, it provides funds for a longer term, eliminating the need to roll over the loans every day or every week. And third, unlike discount window loans, the interest rate is determined in the marketplace, so the money goes to the institutions that value it most.

By themselves, TAF loans would increase both assets and liabilities of the Fed, just like open market operations and repos. But once again the Fed offset those loans by selling securities and withdrawing cash from the system. Example:

Changes in the Fed's balance sheet after a $1,000M TAF loan, offset by an open market operation
Assets	US government securities	-1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	TAF loans	+1,000
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	0 (-1,000 + 1,000)
	Reserve balances	0

The Fed extends the loan, which is an asset for the lender, and credits the bank's reserve account. (In the table I assume that the borrower withdraws the funds from the reserve account, so they're turned into currency in circulation.) Just like a repo, loans through the new facility require borrowers to use assets as collateral for the duration of the loan. But the collateral doesn't show up in the balance sheet, because the Fed does not take ownership of it. At the same time, the Fed sells $1,000M worth of government securities, absorbing that same amount of cash from the banking system.

And here’s the simplified balance sheet on December 26 and August 15:

Federal Reserve's balance sheet, $ millions
Assets		Aug. 15, 2007	Dec. 26, 2007
	US government securities	789,601	754,612
	Repurchase agreements	24,000	42,500
	Reverse repurchase agreements	-31,941	-40,542
	Term Auction Facility loans	0	20,000
	Direct loans	264	4,535
	Other assets	37,058	52,869
Liabilities	Currency in circulation	813,085	829,193
	Reserve balances	5,897	4,781

Source: Federal Reserve, H.4.1 release.

The balance of TAF loans grew from $20bn to $100bn between December 26 and April 9.

To be continued...

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