Quick Take on Fixed Income (August, 2015)

Q: What Is the Federal Reserve System?

A: The Federal Reserve is the central bank for the United States. It is composed of 12 regional Federal Reserve Banks located around the country as well as the Board of Governors, the independent government agency, in Washington D.C. A 12 member board is selected from these entities to create the Federal Open Market Committee (FOMC). The Federal Reserve controls the country’s monetary policy with the dual mandate of stable prices and full employment with the goal of sustainable economic growth. Monetary policy is concerned with the amount of money and credit in the economy. The Federal Reserve is also in charge of regulating banks and other economically important institutions to protect depositors and ensure the safety of the financial system.

Q: What Is the FOMC?

A: The Federal Open Market Committee consists of 12 members, the seven-member Board of Governors, the Federal Reserve Bank of New York president and four of the remaining Reserve Bank presidents, which serve one year terms on a rotating basis. The Federal Reserve uses three primary tools to conduct monetary policy: open market operations, reserve requirements and the discount rate. These tools are implemented with the intention of influencing the federal funds rate which is the overnight rate that banks pay to borrow reserves from another bank. The FOMC sets the federal funds target and will decrease the rate to make borrowing more attractive and increase the amount of money in the federal reserve system and vice versa. The FOMC will lower the rate to try and spur economic activity when the economy starts to stall, and raise it to slow the economy when it is growing at an unsustainable pace. Many people falsely believe that the federal funds rate impacts all parts of the yield curve, but in actuality, when the Federal Reserve increases (decreases) the target rate, it will only directly impact short-term lending rates. A study by the Federal Reserve Bank of New York found monetary policy contributes to the increase in interest rates but is not responsible for persistent high rates.

The graph above displays the historical correlations between the effective Fed Funds rate, 2 year, and 30 year treasury. Historically, the 2 year treasury has more closely tracked the changes in Fed Funds rates than the 30 year treasury.

Below is a graph of the three rates. The 30 year treasury rate (green line) has a more gradual slope compared to the Fed Funds rate (white) and 2 year treasury (purple). The 2 year treasury tracks federal funds rate very closely.

Q: What Are Open Market Operations (OMOs)?

A: Open market operations (OMOs) consist of buying or selling government securities to increase or decrease the money supply in the banking system. This is the primary tool used to influence the Federal Funds Rate and is typically done with short-term repurchase agreements. The Federal Reserve Bank puts upward pressure on short-term interest rates by increasing or decreasing OMOs. The recent rounds of quantitative easing, the large scale purchase of U.S. government securities by the Federal Reserve, is an example of unconventional monetary policy. The Fed used quantitative easing to drive down interest rates to encourage more borrowing and therefore spur more economic growth.

Q: What Is the Reserve Requirement?

A: The reserve requirement is the least known and used tool in the Fed’s arsenal. The reserve requirement is the amount of funds banks must hold at the Federal Reserve against their deposit liabilities. By increasing reserve requirements, the Federal Reserve can decrease the money supply available and potentially increase interest rates, slowing the economy.

Q: What Is the Discount Rate?

A: The discount rate is the rate at which Federal Reserve District Banks directly lend to depository institutions through the lending facility known as the discount window. The discount window is known as the lender of last resort, these loans are typically short term and the obligor is often facing liquidity or funding issues. Banks are hesitant to use the discount window because of the negative connotation of securing a loan from the lender of last resort. In theory, The Federal Reserve Bank may decrease the discount rate to make borrowing more attractive in times of crisis.

Sources: Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York Quarterly Review: Winter 91-92

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