Federal Reserve Operations: A Six-Month Review

A lot has changed over the last six months in terms of how the Federal Reserve conducts its operations. We are still learning how to interpret the data that are available to us in order to discern what it is the Federal Reserve is attempting to do, and whether or not it is succeeding. This post represents my attempt to present some analysis as to what has been achieved.

The three major factors occurring over the past six months, and the items that have garnered the most press coverage, are the liquidity crises that peaked in March 2008, the dramatic lowering of the Fed’s target Federal Funds rate, and the dramatic rise in the price of oil. Not getting so much press but of equal importance has been the introduction of new Federal Reserve tools such as the Term Auction Facility [TAF] and the Primary Dealer Credit Facility. The conduct of monetary policy has to be put within the context of these events.

In order to try to put everything into context, let me start out be examining the supply and demand for money. Generally, in a liquidity crisis there is a sudden increase in the demand for money. The central bank attempts to ease the strain on the money markets by throwing open its lending window, supplying funds to the market in other ways, and maintaining or lowering interest rates. By doing these things, the Fed supplies liquidity to the market and facilitates the selling of securities so that banks and other institutions can meet their obligations. As a result, the total reserves in the banking system increase.

We know that, in several successive moves, the Federal Reserve dramatically lowered its target for the Federal Funds rate. But, what happened to bank reserves? In January and February of this year, the year-over-year rate of growth of total reserves in the banking system (not seasonally adjusted) was just above zero. In March, the year-over-year rate of growth jumped to 4.7%, dropping off to 2.2% and 2.4% in April and May. Obviously, there was some growth in total reserves to help resolve the liquidity pressures in the money markets. (One can note that the year-over-year rate of growth in total reserves for June dropped back to a 0.7% rate of increase.)

The Fed was supplying reserves during the March-April-May period. Did this have any real effect on money stock growth? If we look at the narrow measure of the money stock, M1, we see that its year-over-year growth rate from January through May varied around 0.0% - it didn’t seem to grow at all. However, the broader measure of the money stock, M2, experienced a rise in it’s year-over-year growth rate going from a rate of growth in the fourth quarter of 2007 of about 5.5% to a rate of growth of 6.8% in February 2008, 7.1% in March 2008 before dropping off to 6.5% and 6.4% in April and May, respectively. (One can note that in June the rate of increase had fallen to 6.0%)

One can conclude that during the period of greatest market stress, the Federal Reserve oversaw and increase in the growth rate of total bank reserves that was accompanied by an increase in the growth rate of the M2 money stock. Thus, the Fed underwrote the lowering of its target rate of interest by supplying reserves to the banking system, thereby causing an increase in money stock growth. This is classic central bank behavior.

The question then becomes how the Federal Reserve accommodated the problems in the money markets by its operational actions. For this, we have to go to the Federal Reserve’s Factors Affecting Reserve Balances, the H.4.1 statistical release. This is where things get messy. Because of limited space, I am only going to deal with aggregate movements at this time. (If you would like more detail in another post, dates as well as accounts, please let me know.)

From the banking week ending January 2, 2008 through the banking week ending April 2, 2008, the Federal Reserve supplied reserves to the banking system through Repurchase Agreements ($37.8 billion), Other Loans ($39.4 billion) and the Term Auction Facility ($60.0 billion). That is, the Fed supplied the market with $137.2 billion in reserves during the first quarter of the year. However, the Fed’s holdings of securities fell by more than this, removing $156.5 billion in reserves from the banking system. This indicates that the Fed actually allowed reserves to flow out of the banking system during the first quarter of the year, which is something that you would not expect in the period a liquidity crisis was taking place.

What happened? Well, on the other side of the sources and uses statement we see that currency in circulation declined by $13.6 billion and other deposits at the Federal Reserve fell by $3.5 billion. These are regular seasonal swings as currency in circulation builds up in the fourth quarter of a year for the holiday season and then declines in the first quarter of the next year as needs for currency are reduced. The swing in other deposits at the Federal Reserve has to do with Treasury deposits and relates to tax dates. Therefore, factors supplying reserves declined by $16.3 billion (incorporating other minor changes in accounts) while factors absorbing funds declined by $15.6 billion (incorporating other minor changes in accounts). As a result, reserve balances at Federal Reserve banks actually fell during the first quarter of 2008.

However, as indicated above, the growth rate of total bank reserves actually increased throughout the quarter. How can this be explained? Well, the decline in reserve balances actually decreased less this year than it did last year and so total reserves increased, resulting in a year-over-year increase in the rate of growth of total reserves. The Federal Reserve actually eased the pressure on the money markets while seeing reserve balances at the Fed fall. These technical factors can be so problematic!

My interpretation is that the Fed got $60.0 billion to the banks that needed reserves through the TAF, and a further $39.4 billion to the market through its lending facility. In the first quarter, the major increase in Fed lending came through the Primary Dealer Credit Facility, the borrowing window available to dealers in securities. The Fed continued to supply needed liquidity to the money markets through Repurchase Agreements. These efforts got funds to the organizations that needed them and did not force them into selling securities at losses, which are both good results.

In the second quarter, the Fed directly supplied reserves to the banking system and continued to support the year-over-year growth in total bank reserves but not at the peak rate through March 2008. The Fed’s holdings of securities continued to decline, falling $110.2 during the quarter. In addition, Fed lending declined by $28.4 billion in the second quarter as both banks and securities dealers repaid borrowings. These declines were partially offset by an increase of $50.0 billion of TAF funds and an increase of $32.8 billion in Repurchase Agreements.

There were new factors supplying reserves to the banking system during this time. Other Federal Reserve Assets increased by $40.9 billion. This increase was due to the drawing down of the Fed’s Currency Swap line established with the European Central Bank, the Bank of Switzerland, and other central banks. In addition, the Fed supplied $29.8 billion in reserves related to the Bear Stearns (BSC) bailout. (This appears in a line item labeled “Net portfolio holdings of Maiden Lane LLC.”)

Factors supplying reserves to the banking system netted out to a +$14.5 billion, while factors absorbing reserves during the second quarter netted out to +$13.1 billion (the largest factor absorbing reserves was the seasonal increase in Currency in Circulation which increased by $11.1 billion.) Taking much of the seasonal swing out of the change in total reserves resulted in a decline in the year-over-year rate of growth of total reserves, which dropped to just a 0.7% increase by June.

The conclusion: The Federal Reserve seems to have gotten through the period of the credit crisis in good shape. The crucial thing is that it lubricated the market when it was in the greatest need of liquidity and then seemed to back off as the money markets stabilized. The bottom line to this is that the Fed seems to have backed off in continuing to supply liquidity after the liquidity crisis abated.

I would argue that money stock growth [M2] is still too high and under the present circumstances points to a rate of inflation of around 4% per year, but the central bank had to deal with the liquidity crisis first before it could move on to other objectives. However, I must add that we are just getting used to the new tools and institutional arrangements and so any analysis must be tentative.

Comments

[flow5:]

"supply and demand for money" This mis-statement is an old Keynesian throwback & its meaning is just the opposite of how the author used it

member bank "free-gratis" legal reserves are no longer "binding/restrictive" But they still demonstrate (as you pointed out) an "easier" or "tigher" monetary policy

So the rates-of-change in legal reserves, its expansion coefficient, and the resultant increase in the money stock are imperfect, but still correlated

a large portion of M2 is savings (savings that have already been spent) and does not represent means-of-payment money (so what are we saying? don't save money as it adds to m2, and thus has an inflationary bias? i don't think so)

anyway, nowadays the "money supply" is unknown, unknowable, and uncontrollable

this is absolutely the best article, ever written, on the FEDs monetary policy, on seeking alpha

2008 Jul 21 10:44 AM

[flow5:]

"year-over-year rate of growth of total reserves in the banking system (not seasonally adjusted)"

One should always ignore the seasonally mal-adjusted data. If the FED wants to save some money, instead of eliminating data series, they should eliminate their seasonal computations

and everyone should take note that the "monetary base" is not a base for the expansion of money and credit. Mason has it right.

2008 Jul 21 11:20 AM

[flow5:]

Mason didn't tell you but he uses the St. Louis Federal Reserve's figure for legal reserves:
research.stlouisfed.or...

See: Alternative Measures of the Monetary Base: What Are the
Differences and Are They Important?
research.stlouisfed.or...

See: A reconstruction of the Monetary Base & Reserves
research.stlouisfed.or...

See: Monetary Base - by the guru Richard Anderson
research.stlouisfed.or...
research.stlouisfed.or...

2008 Jul 21 11:36 AM

[yuman:]

A great article indeed.
I have a gap in understanding M2 growth related to inflation, however. The article quotes M2 growth data:
5.5%, 07Q4
6.8%, February 2008
7.1%, March
6.5%, April 2008
6.4%, MAy 2008
6.0%, June 2008
Then in the last paragraph, it concludes that this "points to a rate of inflation of around 4%". Is this prediction from some quantitative model or rule? What is the time lag from M2 growth to PPI/CPI?

2008 Jul 21 02:12 PM

[flow5:]

What goes for M2 also goes for M3. M2 erroneously includes MMFs in its definition (a sizable #). MMFs are the customer's of the commercial banks. They are financial intermediaries/transmi... Monetary savings are never transferred from the commercial banks to the intermediaries; rather are monetary savings always transferred through the intermediaries. Whether the public saves or dis-saves, chooses to hold their savings in the commercial banks or to transfer them to intermediary institutions will not, per se, alter the total assets or liabilities of the commercial banks; nor alter the forms of these assets or liabilities.

Financial intermediaries (MMFs) lend existing money which has been saved, and all of these savings originate OUTSIDE of the intermediaries (depend on an inflow of savings to finance loans). The utilization of these loan-funds, or the activation of monetary savings held by these financial intermediaries, is captured thru the velocity of their deposits (bank debits/withdrawals), and not thru the volume of their bank deposits. I.e., from the standpoint of the economy, MMF deposits never leave the MCB System. And the growth of the MMFs is prima facie evidence that existing funds/savings have already been saved/invested/spent, i.e., transferred/transmitte... by their owners/savers/creditor... to borrowers/debtors.

I.e., this currently, (but not forever), represents a double counting, and will continue to be so, as long as these intermediary financial institutions don’t run a transaction’s deposit business.

2008 Jul 21 06:09 PM

[flow5:]

Using bank credit as a proxy: it’s rate-of-change, continues its inflationary path. Since 1942, money creation is a system process. No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand. Thus bank credit proxy (in this case loans-deposits) is an accurate measure of the degree of “ease” or “restraint” being pursued by the FOMC.

Just as Milton Friedman said “inflation is always and everywhere a monetary phenomenon”.

It seems interest rates have pinched speculation in the housing market. Now monetary flows MVt have been siphoned out of housing, and hot money has been re-directed or channeled back into another segment of the economy - commodities speculation.

I think that the rates-of-change in (MVt) are still colossal. Bank credit proxy (the flip side, i.e., loans-deposits), has been running at a + 10% annual clip since c. mid 2005. Though recently, in May 2008, has finally fallen to 8.5%.

“Bank credit proxy” (total member bank deposits) used to be an FOMC target: “The Federal open market committee’s strategy remained essentially unchanged for more than three years, from Sept 66, when the committee first began including a “bank credit proviso” clause in its directive until Dec 1969.”

Some people prefer the devil theory of inflation: “It’s (Peak Oil’s) fault." This approach ignores the fact that the evidence of inflation is represented by actual prices in the marketplace. The “administered” prices of the oil producing countries would not be the “actual” market prices were they not “validated” by (MVt).

Thus, bank credit proxy is the most accurate measure of the money stock.

2008 Jul 21 06:12 PM

[flow5:]

yuman:

M2's lag? Well if it were fixed and predictable then the FED would still be providing its money growth target once required by the Humphrey Hawkins bill.

The Full Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act, required the Fed to set one-year target ranges for money supply growth twice a year and to report the targets to Congress.

Chairman Alan Greenspan remarked in Congressional testimony that "if the historical relationships between M2 and nominal income had remained intact, the behavior of M2 in recent years would have been consistent with an economy in severe contraction." Chairman Greenspan added, "The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place."

In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money supply growth expired, the Fed announced that it was no longer setting such targets, because money supply growth does not provide a useful benchmark for the conduct of monetary policy

www.newyorkfed.org/abo...

As I stated: The money supply is unknown, unknowable, & uncontrollable.

LAG????? well your applying it to the wrong variable. an increase in legal reserves affects all of the money stock classfications, just as bank credit proxy does.

cepa.newschool.edu/het...

The analysis of lags was begun by Clark Warburton in the 1940s (see Warburton, 1966) and followed up by Friedman (1948, 1958, 1961) and Friedman and Schwartz (1963). He found the lags to be not only quite long, sometimes up to eighteen months, but also highly variable.

2008 Jul 21 06:34 PM

[flow5:]

First, there is no ambiguity in forecasts. In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;

Friedman became famous using only half the equation, leaving his believers with the labor of Sisyphus.

The lags for monetary flows (MVt), i.e. proxies for real GDP and the deflator are exact, unvarying, respectively. Roc’s in (MVt) are always measured with the same length of time as the economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).

Not surprisingly, adjusted member commercial bank "free gratis" legal reserves (their roc’s) corroborate/mirror both lags for monetary flows (MVt) –-- their lengths are identical. They are as Plancks constant in physics.

The lags for both monetary flows (MVt) & "free gratis" legal reserves are indistinguishable. Consequently it has been mathematically impossible to miss an economic forecast. There are no inaccuracies, just some non-conforming & unavailable data This is the “Holy Grail” & it is inviolate & sacrosanct.

The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.

Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard. They should represent a rolling moving average.

Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets (housing being most notable), it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.

2008 Jul 21 06:35 PM

[flow5:]

Real-GDP Inflation

11/1/1999 1.73 0.50
12/1/1999 3.24 1.09 Sell Stocks
1/1/2000 1.54 0.62
2/1/2000 -0.32 -0.08
3/1/2000 -0.43 -0.22
4/1/2000 -0.13 -0.08
5/1/2000 0.21 -0.01
6/1/2000 -0.36 0.06
7/1/2000 -0.53 0.07
8/1/2000 -1.81 -0.01
9/1/2000 -3.23 0.06
10/1/2000 -1.56 -0.05
11/1/2000 0.22 -0.07
12/1/2000 0.55 -0.11
1/1/2001 0.56 0.16
2/1/2001 -0.37 -0.1
3/1/2001 -0.34 -0.11
4/1/2001 -0.33 -0.21
5/1/2001 0.13 -0.04
6/1/2001 -0.03 -0.01
7/1/2001 0.18 0.08
8/1/2001 -0.13 -0.16
9/1/2001 0.11 -0.08
10/1/2001 -0.02 -0.57
11/1/2001 0.61 -1.19
12/1/2001 0.95 -0.36
1/1/2002 1.13 0.4 Sell the Dollar
2/1/2002 0.4 0.31
3/1/2002 0.35 0.19
4/1/2002 0.28 0.11
5/1/2002 0.37 0.14
6/1/2002 -0.15 0.07
7/1/2002 -0.08 0.15
8/1/2002 -0.09 0.11
9/1/2002 -0.16 0.23
10/1/2002 -0.3 0.18 Buy Stocks
11/1/2002 0.26 0.19
12/1/2002 0.74 0.27
1/1/2003 0.71 0.56
2/1/2003 0.36 0.43
3/1/2003 0.41 0.38
4/1/2003 0.48 0.3
5/1/2003 0.6 0.38
6/1/2003 0.34 0.3
7/1/2003 0.53 0.45
8/1/2003 0.47 0.34
9/1/2003 0.17 0.35
10/1/2003 0.03 0.32
11/1/2003 0.52 0.26
12/1/2003 0.72 0.21
1/1/2004 0.67 0.41
2/1/2004 0.23 0.33
3/1/2004 0.25 0.28
4/1/2004 0.14 0.36
5/1/2004 0.07 0.43
6/1/2004 0.09 0.42
7/1/2004 0.12 0.41
8/1/2004 -0.05 0.3
9/1/2004 0.13 0.39
10/1/2004 -0.14 0.24
11/1/2004 0.32 0.15
12/1/2004 0.39 0.15
1/1/2005 0.25 0.31
2/1/2005 0.16 0.33
3/1/2005 -0.05 0.19
4/1/2005 0 0.16
5/1/2005 -0.09 0.12
6/1/2005 -0.2 0.09
7/1/2005 -0.02 0.04
8/1/2005 -0.07 0.05
9/1/2005 0.04 0.16
10/1/2005 -0.18 0.02
11/1/2005 0.05 0.05
12/1/2005 0.31 0.04
1/1/2006 0.59 0.31
2/1/2006 0.22 0.11 Bernanke takes office
3/1/2006 -0.14 -0.03 Sell Stocks
4/1/2006 -0.19 -0.07
5/1/2006 -0.22 -0.07
6/1/2006 -0.3 -0.02
7/1/2006 -0.13 -0.02
8/1/2006 -0.43 -0.18
9/1/2006 -0.4 -0.06
10/1/2006 -0.85 -0.18
11/1/2006 -0.29 -0.17
12/1/2006 0.12 -0.08
1/1/2007 0.34 0
2/1/2007 -0.14 -0.11
3/1/2007 -0.36 -0.17
4/1/2007 -0.27 -0.09
5/1/2007 -0.12 -0.15
6/1/2007 -0.04 -0.07
7/1/2007 0.16 -0.08
8/1/2007 0.15 -0.13
9/1/2007 -0.19 -0.09
10/1/2007 -0.48 -0.22
11/1/2007 0.14 -0.18
12/1/2007 0.44 -0.23
1/1/2008 0.64 0.08
2/1/2008 0.22 0
3/1/2008 -0.46 -0.18
4/1/2008 -0.09 -0.03
5/1/2008 -0.14 -0.06
6/1/2008 0.00 -0.03
7/1/2008 0.13 0.01
8/1/2008 -0.10 -0.08
9/1/2008 -0.1 0.08
10/1/2008 -0.34 0.06
11/1/2008 0.13 0
12/1/2008 0.32 0.02
1/1/2009 0.73 0.33

2008 Jul 24 01:33 PM

[flow5:]

www.newyorkfed.org/cha... Funds Rate Charts1/3/2001 eased from 6.5 to 6
1/31/2001 5.5
3/20/2001 5
4/18/2001 4.5
5/15/2001 4
6/27/2001 3.75
8/21/2001 3.5
9/17/2001 3
10/2/2001 2.5
11/6/2001 2
12/11/2001 1.75
11/6/2002 1.25
6/25/2003 1
6/30/2005 1.25
8/10/2004 1.5
9/21/2004 1.75
11/10/2004 2
12/14/2004 2.25
2/2/2005 2.5
3/22/2005 2.75
5/3/2005 3
6/30/2005 3.25
8/9/2005 3.5
9/20/2005 3.75
11/1/2005 4
12/13/2005 4.25
1/31/2006 4.5
3/28/2006 4.75
5/10/2006 5
6/29/2006 5.25
9/18/2007 4.75
10/31/2007 4.5
12/11/2007 4.25
1/22/2008 3.5
1/30/2008 3
3/18/2008 2.25
4/30/2008 2

Fed Funds Rates. From the time Greenspan changed to an "easy" money policy (1/31/01), until the time it ended (9/18/2007), the expansion coefficient (money multiplier) changed from 49 to 94 (an increase of 92%). I.e, legal reserves are no longer binding. Thus, regardless of the policy formula used, the math projected a much "tighter" monetary policy than what actually took place.

2008 Jul 25 02:06 PM

[paulsjj:]

KISS! The Fed & Treasury record is clear: a 2008 dollar buys less than 5 cents of 1913 dollar. The rest is BS.

2008 Jul 31 09:19 AM