How the Fed Operates — And Why It’s a Problem

by | Mar 15, 2017

How the Fed Operates — And Why It’s a Problem

by | Mar 15, 2017

We are often asked about the mechanisms by which the US Federal Reserve Board (the Fed) influences the level of US interest rates and whether these mechanisms also influence the level of the US money supply. It has long been regarded that the Fed no longer inflates and contracts the money supply but rather simply acts to target interest rates. The purpose of this brief paper is to clarify how the Fed works and the impact that its operations have on the money supply.

The main market through which the Fed adjusts interest rates is the federal funds market. The federal funds market is, as the name implies, the market for federal funds. But what are federal funds?

Depository institutions such as commercial banks keep a portion of money that is deposited with them with the Federal Reserve banks. The money that commercial banks keep with the Fed is also labeled as reserves.

Banks require reserves in order to meet their reserve requirements and in order to be able to clear financial transactions. When checks written against a bank are presented, the bank must have the money to honor those checks.

On any particular day there are some banks that have more reserves than they require, i.e., they have excess reserves. Conversely, there are banks that have far too little reserves, i.e., they have deficiency of reserves.

The existence of excess and deficiency of reserves among various depository institutions sets a platform for a market for these reserves, which are also labeled as federal funds.

The interest rate charged for the use of federal funds is called the federal funds rate. This is the rate applied to short-term lending — mostly overnight loans.

The main vehicle that the US central bank employs to influence the quantity of money in the economy is the purchase and sale of assets. In the present set-up though, the Fed is not attempting to directly influence the money supply through the buying and selling of assets in the open market.

Rather, the US central bank aims at bringing the Federal funds rate to a particular level, or target, which it believes will enable it to achieve stable, non-inflationary economic growth.

Once the target is set it is the role of the Federal Open Market Desk to make sure that the target is maintained on a daily basis.

As a rule, once the target is announced the market tends to bring the interest rate toward the target in anticipation that the Fed will be successful in achieving the goal.

To succeed in keeping the rate at the target the Fed’s Open Market Desk monitors various factors that have the potential to disrupt the balance between the supply of and the demand for Federal funds.

Once these disruptive factors are identified, Fed operators counter them by means of buying or selling assets in the market.

Several factors have significant potential to act as major disrupters in this context.

Treasury Activity

The first of these is the activity of the US Treasury, which has an account with the Federal Reserve in which it maintains working balances for making and receiving various government payments.

When, for instance, individuals pay taxes to the Treasury this results in an increase in the Treasury account with the Fed. At the same time, however, this lowers reserve balances of depository institutions at the Fed by the amount of tax money paid to the Treasury (as these moneys are withdrawn from the commercial banks by taxpayers). Hence, what we see is a decline in the supply of Federal funds.

This fall in the supply of reserves, or the supply of Federal funds, all other things being equal, puts upward pressure on the Federal funds interest rate. Consequently, the Federal funds rate in the market will, in the absence of Fed intervention, tend to rise above its target. In order to keep the Federal funds rate at the target level the central bank is compelled to act in the market by buying assets such as Treasury securities.

Note that this payment of taxes causes a temporary decline in the supply of reserves in the Fed funds market. This decline in reserves however does not have any effect on the money supply. When a taxpayer pays $1,000 in tax to the Treasury his money, i.e., $1,000, is transferred to the Treasury — there is no change in the money supply. Yet the Fed, in order to protect its rate target in the face of money leaving the fed funds market, is adding new money.

Hence, the collection of taxes by the Treasury results in an increase in the money supply as the Fed intervenes to maintain the Fed funds rate target.

Conversely, when the Treasury spends the money — i.e., its deposits with the Fed decline — this raises commercial banks’ reserves and thus raises the supply of Federal funds. As a result, for a given demand this puts downward pressure on the Fed funds rate.

To prevent the Fed funds rate from falling below its target the central bank will initiate sales of assets, thereby removing money from the economy.

Changes in Demand for Cash

A second potential disrupter of the Fed funds target rate is changes in the demand for cash.

If individuals’ demand for cash increases then banks’ reserves held with the Fed are reduced.

Although this, of itself, does not change the money supply (as money simply leaves the banks and sits in the pockets of individuals) the reduced level of funds in the Federal funds market leads, all other things being equal, to upward pressure on the Fed’s target interest rate.

In response to this upward pressure the Fed is forced to pump money by buying assets.

An increase in the demand for cash therefore results in an increase in the money supply occasioned by monetary pumping (i.e., asset purchases in the open market) by the central bank.

Conversely, if individuals’ demand for cash falls, all other things being equal, the Fed is compelled to take money from the economy by selling assets in order to prevent the Federal funds rate from falling below the target level.

Strong Economic Activity and Crises

A third source of potential disruption to the Fed’s policy target rate is the situation of a strengthening in economic activity — for example, due to the expansionary business cycle impact of past loose monetary policy. The strengthening in banks’ lending as a result of the cyclical boom, and the consequent increase in demand deposits, now require more reserves, which in turn leads to a strengthening in demand for Federal funds.

In this situation the Fed needs to intervene to prevent the Fed funds rate from increasing, and it does so by buying assets — i.e., by inflating the money supply.

In addition, in times of economic crisis the chase for liquidity by financial institutions can put strong upward pressure on the fed funds rate. In this case, in order to prevent the rate from rising sharply above target, the Federal Reserve initiates significant buying of assets — it boosts the supply of federal funds in line with the strong increase in the demand.

Once again, the maintenance of the target rate requires the Fed to intervene and thereby inflate the money supply.

Note that once the interest rate target is set, absent some change in the supply of or demand for fed funds, any monetary pumping by the Fed will force the rate strongly below the target level, all other things being equal. In other words, in order for the Fed to increase the money supply via monetary pumping without upsetting the Federal funds rate, there must be a suitable trigger — e.g., an increase in the demand for currency by the public or an increase in Treasury’s tax receipts from the economy.

In both cases, the Fed would be compelled to pump money to prevent the Fed funds rate from overshooting the target.

Thus it appears that, in the current framework, the Fed performs a passive balancing act. It accommodates the demand for money and is not seen as actively engaging in monetary pumping. Indeed, it is officially stated by Fed officers themselves in the Federal Board of Governors papers that the US central bank is not printing money.

In an exchange with readers on Time magazine’s website on December 22, 2010, the Fed chief — at the time Ben Bernanke — when asked why the Fed is creating dollars “out of thin air,” replied that the Fed is not printing money.

In fact, for most economists and commentators the Fed’s accommodation of the demand for money is not regarded as money printing but, on the contrary, as necessary action in order to keep the economy on a path of economic and price stability. The Fed is therefore simply viewed as preventing disequilibria in the supply of and demand for money in the economy.

Note that following this logic the role of the central bank is always to accommodate the demand for money. Failing to do so will disrupt this equilibrium and potentially result in an economic crisis.

The reality, however, is that, irrespective of whether the monetary pumping is done passively (through mechanisms such as those described above) or actively, it is nonetheless just that — the artificial inflation of the money supply by the central bank.

As such it always sets in motion an exchange of nothing (newly created money out of “thin air”) for something. And as a result, this leads to the diversion of wealth from wealth generators to non-wealth generators — resulting in the menace of the boom-bust cycle.

Unrecognized Moral Hazard & Bank-Driven Monetary Expansion

It is important to note — and seldom acknowledged — that the Fed’s passive balancing act in the Fed funds market ensures that there is sufficient monetary liquidity to prevent banks from bankrupting each other during check-clearing (also called the exchange settlement) process.

In doing this the central bank is facilitating the continued expansion of credit by the commercial banks, which in turn results in an increase in the money supply.

Whichever way one looks at it, then, without the existence of the central bank, no sustained monetary expansion can take place.

Reprinted with permission from Mises.org.

Frank Shostak

Frank Shostak

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies.

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