F(un)AQs about the Fed

What can the Fed do to change the Federal Funds rate?

• Open-market operations
• Discount rate
• Reserve requirements
• Etc.

What are “open-market operations?”
When the trading desk at the Federal Reserve (“the Desk”) buys or sells government securities from Primary Dealers in the open market in order to alter the Federal Funds rate.

How do open-market operations affect the rate charged to banks to borrow funds from another bank?
The Fed does NOT directly transact in the Federal Funds market. Here is an example of the chain of events that occurs when the Fed reduces the amount of liquidity in the market and increases the Federal Funds rate:

1) Pretend the US economy is booming and the Fed decides to increase their target for the Federal Funds rate

2) The trading desk at the Federal Reserve contacts their Primary Dealers and asks them for their bids on an unspecified amount of treasury securities. Primary dealers participate in this auction for two reasons:

a. They are required to participate

b. They have accounts at clearing banks, which are depository institutions that hold reserves at the Fed. When the primary dealers buy Treasury securities from the Fed, the depository institutions’ supply of reserves decreases as primary dealers use the cash they have deposited to pay for the Treasuries. This decreases the amount of available reserves in the Federal Funds market, increases the demand for reserves, and increases the Federal Funds rate.

3) Once all the bids are submitted, the auction price is set by the Desk, securities are sold to primary dealers and liquidity evaporates causing the Federal Funds rate to increase

This process works in the reverse fashion when the Fed is seeking to increase liquidity. This time, the Fed is buying securities from Primary Dealers and giving them cash in exchange for government securities. This cash is deposited at their respective depository institutions, increasing the amount of reserves in the banking system.

Types of Open Market Operations
The Fed can structure their open market operations as repos or outright sales/purchases

Repos: These are the most common types of open market operations conducted by the Fed. They are preferred because they give the Desk much more flexibility in offsetting temporary swings in the level of reserves, which can be very volatile.

Here is an example of why flexibility is so important for the Fed when trying to control the Fed Funds rate:

Every 3^rd day of the month the government pays out social security benefits. This causes reserves to shift from the government’s depository account to the bank accounts of private sector banks (note that the government’s reserves are not part of the Federal Funds market until they are given to Social Security beneficiaries and deposited in their accounts at depository institutions). This results in a huge increase in the supply of reserves, but the Federal Funds rate does not change! This is because traders at the Desk conduct defensive operations in the form of repos in order to control the supply of reserves.

Outright sales/purchases: Similar to repos, but result in a more permanent creation/elimination of liquidity, as the transactions are not reversed after a few days, like with repos.

Discount rate: Since the discount rate is above the Federal Funds rate, borrowing from the Discount Window is rare. A relatively high discount rate puts a ceiling on the Federal Funds rate and deters banks from borrowing from the Fed before they have exhausted less expensive alternatives. The stigma of borrowing from the Discount Window is largely a result of this implication.

Reserve requirements: By increasing the reserve requirement ratio, the amount of tradable reserves in the Federal Funds market decreases. Supply goes down so prices go up, i.e. the Federal Funds rate increases.