All posts by Dr. Douglas Rice

Function of the Fed: To Conduct Monetary Policy

February 4, 2003 Dr. Douglas Rice Leave a comment

The function of the Fed most discussed in the popular press is that of conducting monetary policy. In an ongoing process, the Fed tinkers with the availability of money, using several different tools described below.The Fed has the authority to set the reserve requirements observed by depository institutions.

In doing so, it proscribes the portion of a bank’s deposits which must be held in reserve, and not extended as loans to DSU’s. Because of the process of deposit expansion, where the reserve requirement determines how much of a deposited dollar remains available for a loan, higher requirements reduce the funds available for loans, and thus make money less available in the economy.

A lower reserve requirement frees up funds from unproductive reserves, and makes money more available in the economy. It is currently the view of the Fed that frequent tinkering with the reserve requirement would destabilize financial markets, and so it is the least frequently used tool of monetary policy.

A change in the discount rate is a change in the interest rate at which the Fed loans money to depository institutions, generally to tide them over short-term liquidity problems. Like the prices for anything else, banks will borrow more from the Fed if the discount rate has been lowered, and will borrow less if the discount rate has been raised. This tool is normally not used often, and is of limited efficacy because banks have other sources of loans besides the Federal Reserve. Because of this, a change in the discount rate has as much effect as a signal of Fed policy, as it does as a genuine price change.

Economics

Econ update

February 4, 2003 Dr. Douglas Rice Leave a comment

The Shuttle tragedy is likely to dominate the news for a little while at least. But Colin Powell, US secretary of state, is scheduled to appear before the United Nations Security Council on Wednesday to present the case for an early war against Iraq. The twin themes of Iraq and the US economy are set to continue holding investor attention this week. Data covering US manufacturing, the service sector and employment will keep markets focused on the health of the US economy, but any upside could be limited by continuing hawkish rhetoric on Iraq.

In general, economists see a weak first half of the year followed by accelerating growth once war clouds pass. But there appears to be an unusually large range of forecasts, in part because of split views over what is holding the economy back. Some analysts said the Fed’s phraseology of “reportedly” and “over time” suggested policymakers at the central bank see the recovery saddled with more than just war. Nevertheless, the central bank reiterated its view that economic risks were balanced between weakness and a possible rise in inflation. I think the threat of rising inflation is overstated by the Fed and their statement was designed to provide comfort to the markets.

The Commerce Department said Thursday that gross domestic product, the broadest measure of U.S. goods and services, expanded at a 0.7% annual rate in the fourth quarter of last year, down from 4% the previous three months. This number is still subject to two revisions which could reduce it further. While growth zigzagged all year, the performance was the most anemic since the third quarter of 2001, when the country was in recession. Overall, the economy grew 2.4% in 2002, compared with 0.3% in 2001 so the year wasn’t a total disaster.

John Snow got a grilling on Capital Hill last week as Democrats were eager to show they weren’t powerless to stop the Republican majority. They seemed stuck on the Cash Benefit plan revisions that could hurt seniors while easing the burden of pension obligations of big business. It should also be noted that the replacement for ousted SEC chairman Harvey Pitt has yet to be sent to the Hill for conformation even though the Bush Administration announced their intentions months ago. We will have much more on the SEC later.

The European Central Bank meets on Thursday, but analysts warn not to expect an interest rate cut. The Euro has gained about 15 per cent against the dollar and about 7 per cent against sterling in the past year making exports leaner for European manufacturers.

Friday’s US payroll figures are one of the most watched indicators but also the one with the widest variations in predictions although few economists expect a significant improvement.

Federal Reserve

Functions of the Fed: To Create (and Destroy) Money

February 4, 2003 Dr. Douglas Rice Leave a comment

The Fed is the source of the money supply of the United States. As the central bank of the United States, the Fed has the authority to credit or debit the reserves of banks holding reserves with it. In doing so, it is creating or destroying money in the economy. In the matter of cash, it has the legal authority to issue coin as well as Federal Reserve notes (paper money.)

The revenue the government gains from creating reserves and hard cash is technically known as seigniorage, defined as the revenue gained by the mint from the creation of money.In the days of commodity currencies (gold and silver), the minting of coins added value to each ounce of precious metal by putting it into a form (a coin, such as a sovereign, a ducat, a real or a dollar) which had a readily-recognized value. In other words, the precious metal had been assayed for value, purified and measured into units of a suitable size for commerce. In return for this service, the mint reserved a portion of the coins for itself.

The seigniorage (the profit or revenue from minting) represented the positive difference between the face value (or par value) of the coins, less the value of the metal used to make it.Today, there is no significant portion of United States coinage which is minted from precious metals, and so they have little commodity value.

The seigniorage for paper money is even higher; the value of the money printed in bills far exceeds the value of the linen it is printed on. The actual creation of bank reserves by the Fed is now conducted as an electronic accounting matter, without even the transfer of precious metals between vaults. For all of these (coins, paper, electronic reserves) the ratio of seigniorage to costs is quite high.Since 1971, the world’s major economies have used currencies based on inconvertible paper standards, more commonly known as fiat money. (Convertible paper standards use bills which are redeemable for gold or silver, such as the silver certificates of 35 years ago. “Fiat” is from the Latin for “let there be…”)

Currently, the U.S. government raises about 3% of its revenue from seigniorage. Other first world countries (such as Italy) have been known to raise as much as 10% of government revenue through the creation of money, though the European Union has been an important source of discipline on many central banks. Generally, destructive levels of inflation result from a government’s over-reliance on seigniorage for revenue.

Fed Funds are funds which banks lend each other on an overnight basis to meet the Fed’s reserve requirements. (Most banks must hold cash reserves equivalent to 10% of their transaction deposits, but day-to-day reserves fluctuate based on transactions activities.

Contrary to popular belief, the Fed does not actually set the Fed Funds rate. But it has great influence upon it through its open market operations. For example, if the Fed buys government securities (e.g. Treasuries) from dealers in the open market, the Fed will make payment by adding reserves to the banks where the dealers deposit their funds.

This operation increases the supply of bank reserves, pushing down the yield on Fed Funds loans. Similarly, if the Fed sells securities it will secure payment by reducing reserves of the banking system, putting upward pressure on the Fed Funds rate.When the Fed announces its monetary policy objectives, it sets a target for the Fed Funds rate. In then engages in daily open market operations to achieve that target.

If you follow the markets, you will notice that the Fed Funds rate fluctuates quite a bit around the target (currently 1.25%) on a daily basis.The main point here is that the Fed Funds rate is a market rate determined by the demand and supply of overnight Fed Funds loans between banks. You might say, however, that the Fed “owns” (and thus has ultimate control over) this market since the market is created because the Fed maintains bank reserve requirements.