Central Bank Case

Nick I, Herbert A, Zachary C
10/8/14
Financial Markets and Institutions
Central Bank Case

1) The federal funds rate is the term coined to describe the interest rate at which depository institutions lend and borrow overnight funds, which are maintained at the Federal Reserve, to one another. The official website of the Fed states that “By trading government securities, the New York Fed affects the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight.”
Essentially, institutions that possess surplus end-of-day balances lend the excess funds to institutions that are facing shortfalls in their respective account balances. The federal funds rate has an important influence on the market due to its impact on monetary and financial conditions; thus, it has a significant bearing on macroeconomic factors i.e., employment, inflation and growth.
The FOMC is the governmental organization that monitors the federal funds rate and manipulates it by conducting open market operations. Open market operations (OMO) are activities by the Federal Reserve in the buying and selling of government securities on the open market. Through the execution of OMO’s, the Federal Reserve primarily aims to influence the short-term interest rates in the economy. Hence, the federal funds rate is a mechanism that allows the FOMC to regulate the supply of available funds and thus other interest rates and the level of inflation in the economy.
In simplistic terms, if the FOMC seeks to increase the federal funds rate, they will take the action of selling securities on the open market thus effectively taking out money from the economy and reducing the supply of money. Citrus paribus, the interest- rates, which are basically the cost of borrowing money, rise. Inversely, if the FOMC seeks to reduce the federal funds rate, they will implement a repurchase agreement (the sale of a government security with an agreement for the seller to purchase the bond at a later date), which essentially is an injection of additional money supply into the economy. Citrus paribus, this has the effect of reducing interest-rate levels.
The Federal Reserve is unable to establish a specific federal funds discount rate, but it does set a federal funds target rate at the FOMC meetings. The Committee sets this target rate at a level that it deems will be aligned to its responsibility of attaining monetary policy objectives and amends it depending on financial and economic developments.
While many of the crisis-related programs have expired or been closed, the Federal Reserve continues to take actions to fulfill its statutory objectives for monetary policy: maximum employment and price stability. Over recent years, many of these actions have involved substantial purchases of longer-term securities aimed at putting downward pressure on longer-term interest rates and easing overall financial conditions.
These charts below plots the federal funds rate and the rate after adjusting for the annual change in the price index for personal consumption expenditures excluding food and energy prices.

The Federal Reserve responded aggressively to the financial crisis that emerged in the summer of 2007. The reduction in the target federal funds rate from 5-1/4 percent to effectively zero was an extraordinarily rapid easing in the stance of monetary policy. In addition, the Federal Reserve implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These programs led to significant changes to the Federal Reserve's balance sheet. On December 16, 2008. After an FOMC meeting, the federal funds rate saw a 75 to 100 basis point cut from 1.0% to a scope of 0% to 0.25%. Where it has remained in that zone for the past 6 years.

The FOMC, in setting monetary policy, aims to minimize the deviations of inflation from its longer-run goal and deviations of employment from its assessment of its maximum level. The Committee’s policy decisions are often specified in terms of a target for the federal funds rate. This short-term interest rate serves as a benchmark for market rates of interest paid by consumers and businesses. By adjusting this rate, the Federal Reserve can promote financial conditions supportive of its dual mandate.
Next we take a look at the EQTA – Equity to Asset ratio that we have seen in banks since the beginning of 2007. This ratio focuses on the solvency of financial institutions. During the financial crisis that percentage dropped from around 10.20% to 9.35% by the end of 2008. From there those levels increased a full percentage in the course of a year, where it now fluctuates at levels between 11% and 11.30%. The reason this percentage has increased post-recession is reflected in the points we have made so far and will make throughout this case. Banks are now holding more reserves thus providing them with more funds in case they need to cover debt at any point.

2) Four decades ago, Milton Friedman recommended that central banks like the Federal Reserve pay interest to depository institutions on the reserves they are required to hold against their deposit liabilities. This proposal was intended to improve monetary policy by making it easier to hit short-term interest rate targets. However, the Fed didn’t have the authority to pay this kind of interest until 2008.
The fed paying interest on reserve balances was designed to broaden the scope of the Fed’s lending programs to address conditions in credit markets while maintaining the federal funds rate close to the target established by the Federal Open Market Committee (FOMC), the Fed’s monetary policy decision makers.
In 2007, required reserves averaged $43 billion, while excess reserves averaged only $1.9 billion. This relationship was typical for the past 50 years when the Fed did not pay interest on reserves. The banks reacted to the fed paying interest on reserves by putting in more excess reserves. Through September and October of 2008, excess reserves rose from $2 billion to $281 billion. In November there was a further increase in the excess reserves deposited by member banks sending the figure to $363 billion.

The central bank can eliminate the tension between its conflicting policy objectives by paying interest on reserves. When banks earn interest on their reserves, they have no incentive to lend at interest rates lower than the rate paid by the central bank. The central bank can, therefore, adjust the interest rate it pays on reserves to steer the market interest rate toward its target level. The Federal Reserve began paying interest on reserves, for the first time in its history, in October 2008.

3) After the financial crisis occurred, the Federal Reserve began lowering their rates toward the zero bound levels. With the hope to motivate people to take out loans. But, consumer confidence was and still is very low. So even though banks have the supply of excess reserves, the demand just isn’t there due to a lack of faith in the economy. Even if they barely pay any interest in order to take out loans, people are nervous in our economical state and shy away from taking out money. So, as a bank manager you had many options on what to do with your current money and reserves. As previously noted, the Federal Funds Rate has been lowered drastically. So, banks now have the ability to borrow at that rate which is currently around .1%, and at the end of 2008 was at .2%, soon decreasing to around the current rate. Once the bank has the money, they can choose to keep them as reserves and lend them out to people who request loans. But, it has become evident that people aren’t taking out loans. The banks have the opportunity to hold the required amount of reserves (10% for the most part) and could use the rest to seek other investment opportunities. According to the graph below, in October of 2008 a 1-month investment in the Eurodollar saw a return of 6%, even peaking at 7% for a short time (Which dropped dramatically soon after). Even with the drop the return the banks could see if they invested in the Eurodollar would leave them with a huge spread resulting in a very large profit.

On top of choosing another investment plan, banks also are being rewarded for keeping reserves with them. The Fed came up with the idea to spur borrowing which will lead to more consumer spending to result in growth back in our economy. To allow this to happen banks would need to carry a high amount of reserves to be capable of loaning money out. So, banks continued to hold onto excess reserves. Whether it is due to a lack of demand in taking loans or banks keeping the excess reserves because they collect money on them could be interpreted either way. Meaning that since the Federal Reserve now pays an Interest on Excess Reserves which peaked at 1% during the end of November 2008 into the beginning of December, then began declining to the rate of .25% which is where it has been for the last 5 years. As a bank manager we could take a loan for a very low interest rate, then choose to either investment in other securities such as the Eurodollar, or keep the money within the bank and collect the lesser return, but provides no extra risk or work, because the banks just have to keep the money on hand.

4) Time-inconsistency is when you choose something at a certain date in the past (in this case could be a specific monetary policy) but at the current time (could be days or weeks later) that certain thing no longer applies to the current situation, and you end up picking a different choice. Moral hazard is when certain institutions take risks because they are backed by a “safety net” if anything goes wrong and they lose their investment. Both of these ideas play into situations that occurred during the financial crisis. It ranges back to before the whole financial meltdown, when banks were lending out to subprime borrowers, everyone had no regrets due to the large profits they were making giving out loans to anyone who asked in order to purchase a home. No one figured that eventually people wouldn’t be able to pay their mortgages and their houses would fall to foreclosure. When everything started to go wrong huge companies began to go under. The prime example was Lehman Brothers who after making their risky investments began to fall into bankruptcy. The thing was everyone including Lehman Brothers never thought they would go bankrupt. They thought the government would be their last resort. AIG was the largest insurance company out there and even being the powerhouse they were fell during the financial crisis. But they were fortunate enough to be saved by the government because they feared the domino effect would be catastrophic if they fell. On the other hand they figured if Lehman Brothers fell the effect wouldn’t be too big, but they had holdings all over Wall St. eventually leading to the market plummeting. By the end of this crisis the government had to get across the fact that they weren’t a safety net. Meaning that these banks could no longer make risky loans because the government wouldn’t be there for them. Since in the past banks were making out loans to risky borrowers, with no fear of the repercussions. Looking into where we are currently, many new families are having trouble taking out loans for mortgages because these banks know based on what happened in 2008-2009 that the government may not be there for them if they go under. Which essentially has strongly discouraged the idea of moral hazard because banks will now only make loans to borrowers who have a high chance of paying it back. Making sure similar steps that occurred in 2007 don’t happen again.