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Understanding Open Market Operations Foreword The Federal Reserve Bank of New York is responsible for Michael Akbar Akhtar, vice president of the day-to-day implementation of the nation’s monetary pol- Federal Reserve Bank of New York, leads the reader— icy. It is primarily through open market operations—pur- whether a student, market professional or an interested chases or sales of U.S. Government securities in the member of the public—through various facets of mone- open market in order to add or drain reserves from the tary policy decision-making, and offers a general per- banking system—that the Federal Reserve influences spective on the transmission of policy effects throughout money and financial market conditions that, in turn, the economy. affect output, jobs and prices. Understanding Open Market Operations pro- This edition of Understanding Open Market vides a nontechnical review of how monetary policy is Operations seeks to explain the challenges in formulat- formulated and executed. Ideally, it will stimulate read- ing and implementing U.S. monetary policy in today’s ers to learn more about the subject as well as enhance highly competitive financial environment. The book high- appreciation of the challenges and uncertainties con- lights the broad and complex set of considerations that fronting monetary policymakers. are involved in daily decisions for open market opera- William J. McDonough tions and details the steps taken to implement policy. President Understanding Open Market Operations / i Acknowledgment Much has changed in U.S. financial markets and institu- Partlan for extensive comments on drafts; and to all of tions since 1985, when the last edition of Open Market the Desk staff for graciously and patiently answering my Operations, written by Paul Meek, was published. The questions. formulation and implementation of monetary policy also Many other colleagues at the New York Fed also have undergone some noteworthy changes over the made significant contributions to this book’s publication, years. Consequently, the current edition is a substantial- including Peter Bakstansky, Robin Bensignor, Scott Klass, ly new book rather than simply an update of the earlier Steve Malin, Carol Perlmutter, Ed Steinberg, Charles work. Even so, I have made considerable use of materi- Steindel and Betsy White, as well as Martina Heyd and als from Paul Meek’s book and have followed its struc- Eileen Spinner, who provided much of the data assis- ture where possible. tance, and Elisa Ambroselli, who typed numerous ver- I owe a special debt of gratitude to the Open sions of the manuscript; David Lindsey and Vincent Market Desk staff at the Federal Reserve Bank of New Reinhart of the Board of Governors also made many use- York: to Peter Fisher for allowing me to observe the daily ful suggestions. I am greatly indebted to them all. operations over an extended period of time; to Spence Hilton, Sandy Krieger, Ann-Marie Meulendyke and John M. A. Akhtar Understanding Open Market Operations / i ONE Introduction As the nation’s central bank, the Federal Reserve System plans must be based on a much broader array of indica- is responsible for formulating and implementing mone- tors. Today, the monetary aggregates still play a useful tary policy. The formulation of monetary policy involves role in judging the appropriateness of financial conditions developing a plan aimed at pursuing the goals of stable and in making monetary policy plans, but their role is prices, full employment and, more generally, a stable quite similar to that of many other financial and nonfinan- financial environment for the economy. In implementing cial indicators of the economy. that plan, the Federal Reserve uses the tools of monetary To a considerable extent, changes in policy for- policy to induce changes in interest rates, and the mulation have been accompanied by corresponding amount of money and credit in the economy. Through changes in the implementation approach. In the early these financial variables, monetary policy actions influ- 1980s, monetary policy was implemented by targeting a ence, albeit with considerable time lags, the levels of quantity of bank reserves that was based on numerical spending, output, employment and prices. objectives for the monetary aggregates. As the Federal The formulation of monetary policy has under- Reserve reduced its reliance on the monetary aggre- gone significant shifts over the years. In the early 1980s, gates and conditioned its policy decisions on a wide for example, the Federal Reserve placed special empha- range of indicators, the implementation strategy shifted sis on objectives for the monetary aggregates as policy toward a focus on reserve and money market conditions guides for indicating the state of the economy and for consistent with broader policy goals, rather than on stabilizing the price level. Since that time, however, achieving a particular quantity of reserves. ongoing and far-reaching changes in the financial system No one approach to implementing monetary have reduced the usefulness of the monetary aggregates policy can be expected to prove satisfactory under all as policy guides. As a consequence, monetary policy economic and financial circumstances. The actual Understanding Open Market Operations / 1 approach has been adapted from time to time in light of ations, which add or drain reserves through purchases or different considerations, such as the need to combat sales of securities in the open market. Indeed, open mar- inflation and the desire to deal with uncertainties stem- ket operations are, by far, the most powerful and flexible ming from structural changes in the financial system. tool of monetary policy. Thus, it is fair to say that the current implementation Focusing on open market operations, this book approach is likely to continue to evolve in response to offers a detailed description of how monetary policy is changing circumstances. implemented. By tracing the economic and financial con- Regardless of the particular approach, imple- ditions that influence the actual decision-making menting monetary policy involves adjustments in the process, it attempts to provide a sense of the uncertain- supply of bank reserves, relative to the reserve demand, ties and challenges involved in conducting day-to-day in order to achieve and maintain desired money and operations. The book also reviews the monetary policy financial market conditions. Among the policy instru- formulation process, and offers a broad perspective on ments used by the Federal Reserve, none is more impor- the linkages between monetary policy and the economy. tant for adjusting bank reserves than open market oper- 2 / Understanding Open Market Operations TWO Monetary Policy and the Economy Policy Formulation sets reserve requirements, under which depository insti- The basic link between monetary policy and the econo- tutions must hold a fraction of their deposits as reserves. my is through the market for bank reserves, more com- At present, as described in the next chapter, these monly known as the federal funds market. In that market, reserve requirements apply only to checkable or transac- banks and other depository institutions trade their non- tions deposits, which include demand deposits and interest-bearing reserve balances held at the Federal interest-bearing accounts that offer unlimited checking Reserve with each other, usually on an overnight basis. privileges. Directors of the Reserve Banks set the dis- On any given day, depository institutions that are below count rate and initiate changes in it, subject to review their desired reserve positions borrow from others that and determination by the Board of Governors. The are above their desired reserve positions. The bench- Reserve Banks administer discount window lending to mark interest rate charged for the short-term use of depository institutions, making short-term loans. these funds is called the federal funds rate. The Federal The Federal Open Market Committee (FOMC) Reserve’s monetary policy actions have an immediate directs the primary and, by far, the most flexible and effect on the supply of or demand for reserves and the actively used instrument of monetary policy—open mar- federal funds rate, initiating a chain of reactions that ket operations—to effect changes in reserves. The transmit the policy effects to the rest of the economy. Chairman of the Board of Governors presides over The Federal Reserve can change reserves mar- FOMC meetings, currently eight per year, in which the ket conditions by using three main instruments: reserve Chairman, the six other governors, and the 12 Reserve requirements, the discount rate and open market opera- Bank presidents assess the economic outlook and plan tions. The Board of Governors of the Federal Reserve monetary policy actions. The voting members of the System (hereafter frequently referred to as the Board) FOMC include the seven members of the Board of Understanding Open Market Operations / 3 Governors, the president of the Federal Reserve Bank of the relationship of money and credit to the economy. In New York—designated, by tradition, as the vice chair- particular, monetary velocities—ratios of nominal GDP man of the FOMC—and four other Reserve Bank presi- (gross domestic product) to various monetary aggre- dents who serve in annual rotation. There is sometimes gates—have shown frequent and marked departures discussion as well at the FOMC meetings of reserve from their historical patterns, making the monetary requirements and the discount rate, although
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