Tools of the Federal Reserve

Tools of the Federal Reserve

Note

Data on this page was last updated on December 05, 2022

The Federal Reserve conducts monetary policy by influencing market interest rates. However, the means by which the Federal Reserve influences interest rates have changed over time. Prior to September 2008, the Federal Reserve primarily bought and sold relatively small quantities of Treasury securities in the open market, termed open market operations, to adjust the level of bank reserves and thereby influence the Fed Funds Rate (FFR). Bank reserves are the sum of cash that banks hold in their vaults and the deposits they maintain at Federal Reserve Banks.

This strategy worked when reserves were scarce, but following the financial crisis in 2008 that all changed when the Federal Reserve introduced quantitative easing, which made large-scale asset purchases between 2008 and 2014. The result of these asset purchases dramatically increased the size of the Fed’s balance sheet and the number of reserves in the banking system. The old way of controlling interest rates through the open market operation of the Federal Reserve needed an overhaul. The rate on reserves (now total reserves, not just excess) offers a safe, risk-free investment option to banks holding reserves at the Fed. Given this rate, banks will not lend reserves in the market for less than the IOR rate. But not every financial institution can hold reserves with the Fed, creating a ceiling on the FFR.

More types of financial institutions can participate in the overnight reverse repo program (ON RRP) than can earn interest on reserves. These institutions use the facility’s rate to arbitrage other short-term rates. In particular, because these institutions will never be willing to lend funds for lower than the ON RRP rate, the FFR will not fall below the ON RRP rate. As such, the rate paid on ON RRP transactions acts as a floor for the FFR.

The Repo & Reverse Repo Market

Beyond helping control the yield in the FFR, both the repo market and the reverse repo market carry some valuable information. Short for repurchase agreements, the repo market is a complicated, yet important, area of the U.S. financial system where firms trade trillions of dollars’ worth of debt for cash each day. The activities on this market keep the wheels turning on Wall Street and the broader economy.

The repo market is essentially a two-way intersection, with cash on one side and Treasury securities on the other. One firm sells securities to a second institution and agrees to purchase back those assets for a higher price by a certain date, typically overnight. The contract those two parties draw up is known as a repo. Essentially, it’s a short-term collateralized loan. And just as most loans come with an interest payment, you can think of the difference between the original price and the second, higher price, as the “interest” paid on that loan. It’s also known as “the repo rate.” On the flip side, when the Fed sells a security to a counterparty and then agrees to buy back that security, it’s a transaction known as a “reverse repo.”

Why would two parties want to participate in a process as antiquated as the repo market? Because it ultimately benefits them. Financial firms with large pools of cash would prefer to not just let that money sit around — it doesn’t collect interest, meaning it doesn’t make any money. On the other side, it allows financial institutions to borrow cheaply to fund short-term needs. There’s also (typically) not much risk involved.

Experts estimate that around 2 trillion to 4 trillion of debt are financed here each day, meaning it’s vital to the overall functioning of the financial system. The cash that institutions receive goes toward funding daily operations.

The Fed’s antidote to repo market dysfunction is stepping in as a key transactor, with the U.S. central bank conducting both repo and reverse repo operations to keep the federal funds rate in its target range. That process is spearheaded by the New York Fed, which leads the U.S. central bank’s open market operations. Just as quantitative easing (Q.E.) increases the amount of bank reserves in the system, the opposite process of the Fed selling off assets vacuums them out. When the Fed intervenes in the repo market, some important information can be gained.

First, when the Federal Reserve steps in and backs the repo market, there is typically insufficient liquidity in the plumbing of the money system. This should happen when monetary policy is tight, usually before a recession, preceding the 2008 financial crisis and the 2020 pandemic. Keep an eye out for Fed support in the repo market as an early warning sign of a recession. Without that much history to back this claim up, it would be safe to assume that this does not have to happen for a recession to occur.

The opposite occurs when there is too much liquidity in the market and/or a high demand for T-bills. The Federal reserve steeps in to ensure that the FFR stays above target and sells treasuries to the private sector needing a haven to park cash. This is kind of like a mini quantitative tightening removing liquidity to a saturated repo market, usually occurring when there are too many dollars chasing too few goods and inflation is running hot. When writing this in early 2022, there is a spike in reverse repo action from the Federal Reserve as inflation is making secular highs not seen since the 70s.

Federal Reserve Balance Sheet

Post financial crisis, it is important to monitor both if the fed is accomodative or restrictive and the expansion or contraction of the quantitative easing. The most effective method for monitoring the Fed’s policy towards quantitative easing is the Fed’s balance sheet.

How the Fed’s Balance sheet is impacting Money Supply?

The financial crisis and QE

The policy response to the 2008 financial crisis was a Great Experiment, and the United States was fortunate to receive the therapy that proved successful. Basically, while it may be surprising to those who believe that the Federal Reserve was irresponsibly printing money, the Fed supplied just enough monetary base (reserves) to the banking system to offset the collapse in the money multiplier, in order to maintain a stable growth rate in the money supply.

Thanks to Friedman’s insights, Bernanke knew what to do this time around when the multiplier fell to less than half its pre-crisis value (before the crisis, a dollar of base money in the banking system supported about 8 dollars of money supply in the economy; afterwards, it was closer to 3 dollars of money supply for each dollar of bank reserves). By creating an environment for a relatively orderly deleveraging process, the Fed’s extraordinary actions to offset the collapse in the money multiplier facilitated a much more benign adjustment process to the financial system shakeout.

For example, while uncomfortably high, unemployment peaked at 10 percent this time around instead of the roughly 25-percent rate in the 1930s collapse. Indeed, it could have been much worse.

The Covid-19 Pandemic

This time around, instead of having most of the money kept in banking reserves, fiscal policy impacted money supply and not the money multiplier. This, in turn, is creating a massive amount of inflation under the initial backdrop that the economy could use a little inflation. Today, the Federal Reserve sees their error in their ways and is behind the curve in a significant way, being forced to reduce Money Supply.