As I tried to read the Federal Reserve’s Coronavirus Crisis Actions notes here, I realized that I need to review my monetary policy knowledge and how the federal reserve works. This blog post is me summarizing (in a very non-exhaustive fashion) the fed’s toolbox, including some of the new tools introduced to help support the economy during this pandemic.

A friendly reminder:
Jerome Powell - The central bank’s role is to try to reach maximum unemployment and stable prices.

The four essential tools

Reserve Requirements

Every bank (depositary institution, to be precise) needs to have a certain amount of cash (“reserves”) kept with the Federal Reserve. This is done in-case there are large/sudden withdrawals from customers. Currently the minimum reserve ratio (the percentage of the amount of deposit liabilities the commercial bank owes to its customers) is at 10%, however some banks might have higher reserve ratios if they have a high liquidity preference. This type of system is known as the fractional-reserve banking system. Banks receive an interest on reserves (IOR), which is decided by the fed. This is done to to eliminate the opportunity cost that depositary institutions incur by not investing required reserves in interest-bearing assets.

A huge benefit of the reserve requirements is that the fed can use this to control money supply.The money multiplier = = 10. We can interpret the money multiplier as follows: $1 in reserves will lead to $10 in additional money. How does that happen? Well, banks don’t keep our deposits in cash just sitting. They lend out as much as possible, which in the case of the 10% reserve requirement, is 90% of it. Simply put (and grossly oversimplified), if I deposit $1, the bank will put $0.1 in it’s reserves with the Fed and lend out the rest of the $0.9 to someone else. Now that person who takes out the loan, will likely deposit the $0.9 (in a checking account, for example), and once again the bank will put $0.09 in the reserves account and lend out the rest. Continuing the process, there will be $1 + $0.9 + $0.81 + …. = $10 (This is a geometric series with a=1, r=0.9) additional money in the economy, for $0.1 + $0.09 + …. = $1 (geometric series with a = 0.1, r= 0.9) in reserves. Isn’t that beautiful? Now the Fed can increase this reserves requirement to decrease the money multiplier and vice versa. This way, it can control money supply in the economy.

Here’s a great video on the money multiplier.

When banks fail to meet these daily reserves requirements, they must borrow money from other banks (overnight), and the rate they are charged on that is known as the federal funds rate (Anther tool used by the Fed).

Federal Open Market Operations

The Federal Funds Rate is the overnight interest rate charged on (unsecured) loans between banks (very often to ensure reserves requirements are met). Federal Open Market Committee (FOMC) oversees the Fed’s open market operations to ensure that the effective fed funds rate is within the target range. The current target fed funds rate is 0-0.25%. This rate is crucial as it is used as the benchmark for various other important rates such as the savings deposit rates, home mortgage rates and credit card interest rates.

The question is: What exactly are open market operations, and how do they help ensure that the effective fed funds rate is within target? If the Fed wants to bring down the effective funds rate, it will go out in the open market and buy short-term treasuries. This will inject cash in the economy, driving up money supply and therefore driving down short-term interest rates (and the federal funds rate). Similarly, if the Fed wants to increase the effective funds rate, it will participate in the open market and sell short-term treasuries. This will take cash out from the economy, driving up the federal funds rate. This is a powerful way to keep the fed funds rate in target. So far so good.

However, during the 2008 financial crisis, the Fed was forced to purchase not only short-term treasuries but also longer term treasuries and risky assets such as MBS. This pushed the fed funds rate very close to 0. In fact, there was so much liquidity that it became a possibility for the fed funds rate to hit negative rates. To avoid this, the Fed introduced interest on reserves.

Interest on excess reserves

Recall our discussion on reserves requirements above. The Fed pays interests on required and excess reserves. The former interest rate is known as interest on reserves (IOR) and the latter as interest on excess reserves (IEOR). These are decided by the Fed (The board of governors, to be specific). As mentioned in the previous paragraph, this concept was introduced during the financial crisis when there was too much liquidity, and negative interest rates became a real possibility. By introducing the concept of IOR and IOER, the Fed was able to set a floor to the interest rates charged by banks. Let’s say the IEOR is set at 25 bps. Now, banks will not chose to lend money for anything lower than this, since they can make 25 bps by just keeping their money at the central bank (virtually risk-less). This helped elevate other short-term rates and mitigated the possibility of hitting negative interest rates.

However, this isn’t a perfect floor. There are institutions which do not qualify to receive interest on excess reserves, but are eligible to lend at the federal funds rate.

Discount Rate

This is the rate that is charged by the Fed on their ultra short-term, 24-hours or less, (collateralized​) loans to other financial institutions for their immediate liquidity needs or funding shortfalls.

The institutions which can borrow from the Fed at this rate are divided into three tiers: 1) Primary credit program (usually only for financially sound banks), and the rate tends to be set higher than other short-term borrowing options (such as the fed-funds rate). This is done so that the discount window is used only as a last resort by banks that need to borrow money to satisfy overnight reserves requirements.
2) Secondary credit program, offers similar loans to institutions that do not qualify for the primary rate and is usually set 50 basis points higher than the primary rate.
3) Seasonal credit program serves the smaller financial institutions which have higher variance in their cash flows, though the cash flows may be predictable to a good extent. From Investopedia: While the discount rates for the first two tiers are determined independently by the Fed and the rate determination process does not take into account any market-based inputs, the discount rate for the third tier is determined based on the prevailing rates in the market. Typically, an average of a select set of market rates of comparable alternative lending facilities is taken into account while arriving at the seasonal credit program discount rate.

This is yet another effective tool used by the fed. Lowering discount rates spreads over the fed funds rate, or increasing borrowing periods (like was done in the financial crisis) can help the inject more liquidity in the economy.

Other Important Rates