Understanding the Market

The primary monetary policy tool of the Federal Reserve is the Federal Funds rate (see here for a description of the package of tools the Fed can use).  This article briefly describes the nature of monetary policy

, the idea of targetting a rate and how the Fed actually conducts open market operations (for a fairly technical article about what the Fed does, written by the Fed, see this pdf).

The Fed is supposed to do many jobs (see here) that it tries to accomplish by changing the amount of money in the economy.  In the short run, the more money that is in the system, the more economic activity; but over longer horizons

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, more money results in more inflation.  The Fed has two policy choices: they can choose to either target the quantity of money or its price. These are two ways of targeting the same goal, but the difference is the feedback link.  A brief example may illuminate the distinction:

One can compare the Fed’s problem to the problem of maintaining a reasonable weight.  Someone who wants to maintain a particular weight could target their weight or the number of calories they eat every day.  If you target your weight, you could weigh yourself every day and on days when your weight is too high you could eat less and on days when your weight is too low you would eat more.  If you target calories

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, you would set a daily level of calories that you consume and adjust the number or calories that you consume when you see your weight rising or falling.  The idea is that if you target weight, you change your calorie levels more often, while if you target your calories, you allow your weight to vary before changing the number of calories you consume.  In principle these two strategies should lead to identical outcomes, but in practice there may be situations where one strategy leads to less variation than the other.

The Fed has experimented with both methods and has found that using an interest rate target works better than using a money supply target.  So the Fed sets an interest rate and then sees what is happening; if the economy is growing too quickly, they raise rates and if the economy is growing too slowly they cut rates.

The specific rate they target is the Fed Funds rate

, “the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight” (see here for a recent history of Fed Funds rates).  Without getting into too much detail (and if you want more detail, see the pdf cited above) the Fed can buy and sell Treasury securities to add or withdraw reserves from the banking system.  The Fed does not buy Treasury securities at auction

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, but instead buys them from Treasury dealers, being careful not too own too much of any particular issue.

Fed Funds rates are not a fixed price and vary throughout the day (like the price of stocks or commodities) changing as traders buy and sell.  The range of Fed Funds rates is available here; the Fed decides on the size of their daily transaction by observing the market and estimating how much is necessary to keep the Fed Funds rate around the target rate set by the FOMC.  There is a reasonable amount of daily volatility in the Fed Funds rate; from the pdf article (table 5), the standard deviation was around .20% per day and the range between the high and low daily Fed Funds rate was over 100 basis points.  In recent days (late November and early December 2008 that I found here) the standard deviation and the range were similar.  So while the Fed targets a particular rate, most Fed Funds transactions are within 20 basis points either way, occasionally ranging to 50 or more basis points above or below the target.

The Fed will ask dealers for the price at which they are willing to buy or sell certain Treasury securities and then execute the transactions.  These transactions can be outright (permanently changing the Fed’s position) or temporary (unwinding after a certain number of days).  When the Fed executes a purchase, it writes a check to the dealer that is deposited creating more reserves in the financial system; when the Fed executes a sale, there are less reserves in the system. The effect on the economy depends on how the reserves are used.  When there are more deposits in a bank (after a Fed purchase of Treasuries), the bank has to decide what to do with the extra cash.  The bank can make more loans (expanding the economy) or the bank can allow the cash to sit in its account at the Fed.  During normal times, banks use these additional deposits but during crises banks may prefer to allow the money to sit in their accounts.

On December 16, 2008 the Fed announced a target for Fed Funds rates between 0 and 0.25% (see here); the Fed will add reserves to keep rates very low until the economy shows signs of recovery.  In the context of the weight target example above, the subject has lost much weight and is being offered a huge amount of calories every day.  If the patient is fundamentally healthy

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, then weight should return to normal and the daily calorie allotment will be cut.  If not…

This entry was posted on Wednesday, December 17th, 2008 at 12:26 pm and is filed under Central Banks. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.