Federal Reserve Wanted to Reduce the Amount of Liquidity in the Banking System

Mary Kraszewski May 14, 2013
National University
Finance 440- Financial Institutions

If the Federal Reserve wanted to reduce the amount of liquidity in the Banking system, how would they accomplish this via open market operations?
The Federal Reserve uses three methods to influence the money supply in the United States. Their tools are: open market operations, discount lending and the reserve requirement but open market operations are the most essential to the control of the monetary policy. An open market purchase increases not only the monetary base but also the money supply. This in turn lowers short-term interest rates. To accomplish this expansion of the open market the Federal Reserve typically purchases Treasury securities for two reasons. These investments are not only capable of assuming large transactions but when the Federal Reserve purchases these securities from the public it circumvents making the loan to the public directly by making the loan to the Treasury. An open market purchase of Treasury securities by the Federal Reserve has no effect on resources of non-financial institutions but will increase the assets of the Federal Reserve and increase the credit available to the public.
Conversely, the Federal Reserve has numerous standard guiding principles it uses to implement a contractional effect within the monetary system. These tools are conventionally instituted when the Federal Reserve suspects inflation is becoming uncontrollable. To create a reduction in liquidity, the Federal Reserve will sell assets into the marketplace. The monies received are then destroyed. The term given to this course of action is “mopping up” the liquidity. The Federal Reserve is, in essence, slowing economic growth by limiting the amount of credit available, loans become more expensive and in turn commodity prices eventually decline. The Federal Reserve can also raise the Reserve requirement. The Reserve requirement is the amount of funds that banking institutions must hold back at the end of each business day. When the Fed raises this reserve obligation it places restrictions on the amount of money in circulation. However, The Federal Reserve is typically disinclined to use reserve requirements to control the money supply because of their overly-powerful impact on the money supply, their potential to create liquidity problems for banks with low excess reserves and the mere fact that frequent changes in reserve requirements complicate liquidity management for commercial banks. Lastly, The Federal Reserve can raise the discount rate. According to the Monetary Policy section on the Board of Governors of the Federal Reserve System website the discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank 's lending facility known as the discount window. A higher discount rate means it will be more expensive for banks to borrow which decreases the money supply. The discount rate is reviewed every fourteen days. Regardless which monetary policy, contractional or expansionary, is put into motion the supply of credit in the financial market increases or decreases as the monetary base increases or decreases, it does not matter if the change is due to Federal Reserve lending or open market operations.
In March of 2013 Simon Potter, the head of the New York Federal Reserve’s open market operations, stated to the Forecasters Club of New York “that if we are directed to sell, we 'll be able to sell”. Mr. Potter was referring to a possible step in the execution of the Federal Reserve’s Quantitative Easing Program. A quantitative easing program is when a central bank, such as the Federal Reserve, creates money and then purchases bonds or other financial assets from banks providing them with ample amounts of cash to loan to the public. The objective of these agendas is to increase employment and provide opportunities for economic growth. When the Federal Reserve makes purchases it drives up the price of bonds and reduces their supply. This causes bond yields to fall and lowers the cost to borrowers. As Mr. Potter addressed the Forecasters Club of New York he made sure to mention that the Federal Reserve would “minimize any market disruptions” in attempts to alleviate worries as the Fed prepares to continue further into the third round of the program. The current quantitative easing program originated on November 25, 2008 and comprised of the Federal Reserve buying $45 billion in Treasuries and $40 billion in mortgage-backed securities a month.
Although the program has been extended through 2015, spending is supposed to ease up before the end of 2013. As of early evening today, May 14, 2013 Treasury 10-year note yields reached a two-month high due to the speculation that the Federal Reserve may consider reducing its bond-purchase program sooner than expected. The Federal Reserve Bank of Philadelphia’s President Charles Plosser is adamant about the Federal Reserve restrain from making further bond purchases as early as June 18th. The managing director of government-debt trading at R.W. Pressprich & Co. admitted that the grapevine news about the Federal Reserve tapering its bond purchasing has been the catalyst for the market drive over the last week. During his speech in Stockholm today Plosser said that "Until we see something concrete with respect to Fed action, we 'll continue to trade in this range. The economic numbers will be the key determinant." When asked about the purchasing of bonds worldwide by central banks and the effects of cutting interests rates to delay deflation Plosser said, "should inflation expectations begin to fall, we might need to take action to defend our inflation goal, but at this point, I do not see inflation or deflation as a serious threat in the near term”.
With the Federal Reserve 's balance sheet reaching the $3 trillion mark the United States could see the largest sell-off of a portfolio in history. If the Fed does execute an over-sized contractional release of assets into the market, there will be a severe reduction of liquidity. The Federal Reserve will slow economic growth because they will be limiting the amount of credit available.

REFERENCES
Boesler, Matthew. “The Fed Could Engineer A Major Sell-Off In The Bond Market When It Exists”. Business Insider. April 26, 2013. Web edition released 2:37 PM. Retrieved from: http://www.businessinsider.com/fed-may-engineer-bond-market-sell-off-2013-4 Unknown Author. “Will be operationally easy to sell assets: Fed official”. Reuters New York. March 27, 2013. Web edition. Retrieved from: http://www.newsdaily.com/article/cdf98a2d5d1221f15355dffeb3dadf8c/will-be-operationally-easy-to-sell-assets-fed-official

Unknown Author. “Yields Rise As Market Mulls End To Quantitative Easing”. Bloomberg News. May 14, 2013. Web edition released 5:55 PM. Retrieved from: http://news.investors.com/investing-bonds/051413-656016-yields-rise-as-market-mulls-end-to-quantitative-easing.htm
http://www.federalreserve.gov/

References: Boesler, Matthew. “The Fed Could Engineer A Major Sell-Off In The Bond Market When It Exists”. Business Insider. April 26, 2013. Web edition released 2:37 PM. Retrieved from: http://www.businessinsider.com/fed-may-engineer-bond-market-sell-off-2013-4 Unknown Author. “Will be operationally easy to sell assets: Fed official”. Reuters New York. March 27, 2013. Web edition. Retrieved from: http://www.newsdaily.com/article/cdf98a2d5d1221f15355dffeb3dadf8c/will-be-operationally-easy-to-sell-assets-fed-official Unknown Author. “Yields Rise As Market Mulls End To Quantitative Easing”. Bloomberg News. May 14, 2013. Web edition released 5:55 PM. Retrieved from: http://news.investors.com/investing-bonds/051413-656016-yields-rise-as-market-mulls-end-to-quantitative-easing.htm http://www.federalreserve.gov/