A Very Practical Description of What the Fed Did Last Week

The article below from the WSJ's Real Time Economics site (8-12-07 posting) gives the nuts and bolts of what the Fed did last week to help stabilize the market. For those of you that are not up on your FOMC process here is a link to the Fed that gives a description of the process.

The Fed garnered attention last week by adding billions of dollars to the money market to relieve upward pressure on interest rates. How do these operations work? Here’s a primer.
The Fed influences growth and inflation by controlling short-term interest rates. It controls those rates in turn via its monopoly over the supply of reserves to the banking system.

All banks in the U.S. are required by law to set aside a portion of their demand deposits (such as checking deposits) as reserves. These reserves can be either currency in the vault, or reserves on deposit at the Federal Reserve. Banks can use reserves at the Fed to settle transactions with each other. Numerous factors affect the level of reserves: funds disbursed for new loans, funds coming in from loan repayments, clearing of checks with other banks, tax payments to the federal government, federal disbursements such as for social security. On any given day, some banks will have more reserves than they need, and others less. Those with an excess lend to those with a shortfall in the federal funds market. The Fed manipulates the federal funds rate by manipulating the supply of these reserves.

Its principal means of doing this is via open market operations. To put downward pressure on interest rates, the Fed would buy securities in the open market from a designated dealer (primary dealer). The Fed pays for the securities by crediting the account of the dealer’s bank at the Fed. The bank now has more reserves than it needs, and so it lends them out, pushing down the federal funds rate. This operation results in an expansion of the Fed’s balance sheet and thus the money supply. However, the Fed is not principally targeting the money supply but the short-term interest rate, which ripples out to all borrowers and lenders. To raise interest rates, the Fed sells securities to dealers.

The Fed has two principal types of open market operation. A permanent operation is conducted to adjust the Fed’s balance sheet to what it believes is the normal, long-term need for currency and reserves. To do so, it either buys (or, more rarely, sells) Treasury securities and adds them to its portfolio. A temporary operation is in response to short-term fluctuations in the supply and demand for reserves. To supply additional reserves, the Fed conducts a “repo” or repurchase operation. It offers to supply a fixed quantity of funds to primary dealers for 1 to 15 days in return for collateral consisting of either Treasurys, bonds issued by Fannie Mae or Freddie Mac (called agency bonds), or mortgage backed securities issued by Fannie Mae, Freddie Mac or Ginnie Mae. At the end of the repurchase agreement, the dealers repay the money with interest and the Fed returns the securities. The opposite operation is called a reverse repo. Last Friday’s repo was unusual in that the Fed encouraged dealers to submit only MBS as collateral, the first time it has done so since at least 2000 (after the Sept. 11, 2001 terrorist attacks, it did conduct a similar “single tranche” auction but that time accepted only Treasurys as collateral). It may have done so to help dealers finance their holdings of MBS, or possibly to avoid aggravating a potential shortage of Treasurys in dealer inventories that might be needed for other collateral purposes. The Fed only said it did so for “operational simplicity.”

Why might such a temporary operation be necessary? The federal funds rate could rise above the Fed’s target for several reasons: either unexpected high demand for reserves, or restricted supply. The precise reason for last week’s rise in short-term rates remains unclear. It may be that European banks, some of whom have U.S. units that participate in the fed funds market, faced an unexpected jump in loan demand, perhaps from issuers of commercial paper who could not roll the paper over and thus turned to back up lines of credit at banks. It may be that some banks holding excess reserves were reluctant to lend them out, anticipating a need for them for their own purposes or uncertain as to the safety of the counterparties to whom they might otherwise lend.