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Alternative Instruments for Open Market and Discount Window Operations Federal Reserve System Alternative Instruments for Open Market and Discount Window Operations Federal Reserve System Study Group on Alternative Instruments for System Operations Federal Reserve System Alternative Instruments for Open Market and Discount Window Operations Federal Reserve System Study Group on Alternative Instruments for System Operations Board of Governors of the Federal Reserve System, Washington, D.C., December 2002 CONTENTS Study Group on Alternative Instruments for System Operations v Foreword vii 1. Principles and illustrations for Federal Reserve portfolio selection and management 1-1 Principles 1-1 Illustrations of the principles 1-9 Appendix 1.A: Legislative history of the Federal Reserve Act as it relates to the discount window and open market operations 1-17 Appendix 1.B: Portfolio risks and accounting treatment 1-24 Appendix 1.C: The practice of central banking in other industrialized countries 1-28 Appendix 1.D: Criteria for assessing discount window collateral 1-36 2. Financial assets available for purchase in the open markets 2-1 Common issues 2-1 Assets available for purchase in the open markets 2-7 Appendix 2.A: Section 14 of the Federal Reserve Act–– Selected passages authorizing purchases in the open markets 2-26 3. Discount window alternatives to open market operations 3-1 Alternative Federal Reserve lending facilities 3-3 Central banking principles and related key policy issues 3-10 Summary 3-27 Appendix 3.A: Current discount window lending arrangements 3-29 Appendix 3.B: Basic framework of the discount window alternatives 3-34 Appendix 3.C: The potential effects on financial markets and institutions of replacing the SOMA's Treasury securities with advances of Federal Reserve credit 3-45 Appendix 3.D: Practical and operational issues associated with expanded use of discount window credit 3-75 Appendix 3.E: Assessment of discount window alternatives in terms of the study's overall principles 3-87 v FEDERAL RESERVE SYSTEM Study Group on Alternative Instruments for System Operations TEAM LEADERS AND TEAM MEMBERS Affiliations are as of the time the papers were written (November 2000). Team leaders are listed alphabetically and are the principal authors of their chapters except as noted in the appendixes. Team members are listed alphabetically within their System affiliations, which are the Board of Governors of the Federal Reserve System (Board) and the Federal Reserve Banks in Federal Reserve District order (1–Boston, 2–New York, 3–Philadelphia, 4–Cleveland, 5–Richmond, 6–Atlanta, 7–Chicago, 8–St. Louis, 9–Minneapolis, 10–Kansas City, 11–Dallas, 12–San Francisco) 1. Principles and Illustrations for Federal Reserve Portfolio Selection and Management TEAM LEADERS: Jack Beebe (San Francisco) and Christine M. Cumming (New York) TEAM MEMBERS: BOARD: Carol C. Bertaut, Seth Carpenter, William R. Nelson, Vincent R. Reinhart BOSTON: Richard W. Kopcke, Jane Sneddon Little, Giovanni P. Olivei, Geoffrey M.B. Tootell NEW YORK: Leonardo Bartolini, Paul Bennett, George Bentley, Joyce M. Hansen, HaeRan Kim CLEVELAND: Mark S. Sniderman, Gregory Stefani RICHMOND: Marvin Goodfriend, Robert Hetzel ATLANTA: Robert A. Eisenbeis CHICAGO: Anne Marie Gonczy, Edward Green ST. LOUIS: Robert H. Rasche MINNEAPOLIS: Arthur Rolnick SAN FRANCISCO: John P. Judd 2. Financial Assets Available for Purchase in the Open Markets TEAM LEADERS: Sandra Krieger (New York) and Brian Madigan (Board) TEAM MEMBERS: BOARD: Marvin Barth, Antulio Bomfim, Seth Carpenter, Alex David, Christopher T. Downing, Eric Engen, Paul Harrison, Kathleen Johnson, Linda Kole, Joe Lange, Dean Maki, Stephen D. Oliner, Wayne Passmore, Martha Scanlon, Steven A. Sharpe, Jeffrey Slone NEW YORK: Clay Berry, Jason Bonanca, Sophia Drossos, Steven Friedman, R.J. Gallo, Richard Insalaco, Timothy Johnson, Frank Keane, Helen Mucciolo, Michael Nelson, Michael Pedroni, Wayne Pettway, Michael Schetzel, Charles Sims, Teresa Tijerina, Robert B. Toomey, Laura Weir, Patricia Zobel CLEVELAND: Joseph G. Haubrich, James Thomson DALLAS: John Duca 3. Discount Window Alternatives to Open Market Operations TEAM LEADERS: Craig Hakkio (Kansas City) and Rick Lang (Philadelphia) TEAM MEMBERS: BOARD: James A. Clouse, William R. Nelson NEW YORK: Spence Hilton PHILADELPHIA: Stephen Meyer ATLANTA: Lois Berthaume CHICAGO: Carl Vander Wilt KANSAS CITY: Gordon Sellon vii FOREWORD During its meeting on January 30-31, 2001, the Federal Open Market Committee discussed the management of the Federal Reserve System's asset portfolio in light of the rapid declines at that time in the amount of Treasury debt outstanding. The FOMC's historical reliance on purchases and sales of Treasury securities to implement monetary policy would be difficult to maintain if large budget surpluses and the associated steep reductions in Treasury debt were to continue. To prepare for such a contingency, the Committee needed to identify alternative instruments for the conduct of monetary policy and to explore the implications of their use. Staff members of the Federal Reserve System prepared a variety of materials for the Committee's January 2001 meeting. During the meeting, Committee members indicated that an edited version of the staff's background work should be released to make the public aware of the System’s efforts and to spur examination of the topic in the academic and financial communities. Since then, the prospects for large reductions in Treasury debt appear to have been significantly reduced, at least in the near term. In addition, the Federal Reserve System has revised some of its operating procedures, procedures that in some cases were the subject of close attention in these papers. Especially important among these initiatives has been the redesign of the Federal Reserve's lending facility, to be implemented in early January 2003. The studies in this volume represent conditions as they appeared in late 2000, and they have not been revised to reflect subsequent changes in circumstances. They have been edited for the sake of clarity, to update some citations to the literature, and to remove confidential information. The analyses and conclusions set forth are those of the authors and do not necessarily indicate concurrence by the Board of Governors, by the Federal Open Market Committee, by the Federal Reserve Banks, or by members of their staffs. VINCENT R. REINHART Secretary, Federal Open Market Committee 1-1 1. PRINCIPLES AND ILLUSTRATIONS FOR FEDERAL RESERVE PORTFOLIO SELECTION AND MANAGEMENT If the Federal Reserve wishes to widen the types of assets it acquires for the System Open Market Account, it should be guided by a prior set of principles for managing the composition and operations of the account. This chapter offers four such principles for managing the Federal Reserve's portfolio and provides several illustrations of putting them into practice. In discussing the four principles, we cast the presentation largely in terms of open market operations because they currently are the principal method for effecting the growth and cyclical flexibility of the Federal Reserve's balance sheet. The same principles apply, however, to any discount window credit that would substitute for, or complement, direct purchases and repurchase agreements in the open market. PRINCIPLES The starting point for developing a set of principles is the Federal Reserve Act, which gives the central bank its goals of achieving price stability and fostering sustainable economic growth.1 To accomplish its long-run objectives, the Federal Reserve should adhere to the following principles: 1. Exercise effective control over the stock of high-powered money and the size of the System's balance sheet, both in a technical sense and in the broader sense that the Federal Open Market Committee alone is able to choose and achieve its monetary policy stance in furtherance of its pursuit of the overall goals given by the legislation ("instrument independence") 2. Structure its portfolio and undertake its activities so as to minimize their effect on relative asset values and credit allocation within the private sector 3. Manage its portfolio to be adequately compensated for risks and to maintain sufficient liquidity in its portfolio to conduct potentially large actions on short notice NOTE. For helpful comments, the authors thank Peter Fisher, Donald L. Kohn, David E. Lindsey, Brian Madigan, Glenn D. Rudebusch, Thomas D. Simpson, and Bharat Trehan. 1. The Federal Open Market Committee has used these terms to describe the Federal Reserve's goals. Section 2A of the Federal Reserve Act gives the goals as maximum employment, stable prices, and moderate long-term interest rates (12 U.S.C. §225a). 1-2 Federal Reserve System 4. Place a high priority on transparency and accountability in its monetary policy operations. The principles as stated are not immutable, and in other periods of the Federal Reserve's history, they undoubtedly would have been stated differently. But each principle is related to the goals of price stability and sustainable economic growth. The principle of instrument independence is of fundamental importance. Its importance to achieving the Federal Reserve's goals is supported by a very broad theoretical and empirical literature in monetary economics. In the 1990s, instrument independence figured prominently in central bank reforms in several major foreign economies. These developments reflect a greater social and political consensus globally on the importance of price stability in enhancing economic growth over time and on the
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