Federal Reserve Operations and Market Impact

What tools are used by the Federal Reserve to implement monetary policy?
Monetary policy refers to the actions undertaken by the Federal Reserve, which is the central bank, to control credit and its flow within the United States economy. Significantly, what occurs with money and credit influences interest rates and also the performance of the nation’s economy as a whole (Federal Reserve Education, n.d).
The Federal Reserve presently utilizes numerous tools in the implementation of monetary policy about its statutory obligation to nurture maximum employment and stability in prices. The following are the tools:
1. Open market operations (OMO)
The Fed carries out OMO in domestic markets. The terminology open market implies that the Federal Reserve does not decide on its own concerning the kind of securities dealers it will carry out business with on a certain day. Instead, this choice emanates from an open market whereby the different securities dealers that the central bank conducts business with, have competition based on price.
Open market operations can, on the one hand, be permanent and encompass the downright buying and selling of Treasury securities or government-sponsored enterprise debt securities. On the other hand, they can be temporary and encompass the buying of these securities under covenants to resell and the selling of these securities under covenants to repurchase. Significantly, OMOs have been employed in the past to make adjustments in the supply of reserve balances to maintain the federal funds rate close to the target federal funds rate (Federal Reserve, 2017).
2. Reserve Requirement
The reserve requirement alludes to the money that banks have to maintain overnight. Banks can maintain their reserves either within their respective vaults or with the Fed. On the one hand, a low reserve requirement enables banks to carry out greater lending of bank deposits and, in the long run, generates credit.
On the other hand, a high reserve requirement makes it more challenging for banks to lend out money. Conceivably, the most renowned tool is the feds funds rate. In this case, if a bank is unable to meet the reserve requirement, then it is conceivable to borrow funds from a different bank that currently has excess cash. The rate of interest paid is the feds funds rate Federal Reserve, 2017).
For example, at the culmination of the 2013 fiscal year, the central bank necessitated banking institutions to maintain reserves equivalent to zero percent of the initial $13.3 million in the bank deposits. Secondly, the banks were necessitated by the Fed to maintain reserves equivalent to 3 percent of the bank deposits up until $89 million regarding the checking and savings account. Lastly, there was a requirement of holding 10 percent of any banking deposit amount that surpasses $89 million.
Notably, there are very minimal or negligible changes that are made to the reserve requirements virtually on an annual basis. From a practical perspective, significant changes or alterations in reserve requirements are hardly employed to implement monetary policy. An unexpected or abrupt demand that all of the banks ought to increase their reserves would be exceedingly disruptive and challenging to comply with, whereas relaxing such requirements exceedingly would generate a hazard of banks being incapable of meeting the demand for consumer withdrawals (Lumen Learning, n.d).
3. Discount rate
An additional tool employed by the Federal Reserve in its monetary policy obligation is to either increase or decrease the discount rate. If the Fed increases this rate, it implies that the commercial banks will be impelled to decrease their level of borrowing of reserves from the Fed, and in exchange, call in loans to supplant those reserves.
Taking into consideration that there is the availability of fewer loans, the money supply declines, and the market interest rates increase. Alternatively, if the Fed decreases the discount rate, it implies that the commercial banks will opt to increase their borrowing of reserves. In turn, more loans will be dished out by the banks, thereby increasing the money supply and resulting in a decline in the market interest rates Federal Reserve, 2017).
What is more, Brandl (2020) indicates that akin to several tools, open market operations are not effective at all times. For instance, in the course of the recent economic crisis in the United States, open market operations showed to be comparatively inefficacious. Therefore the Federal Reserve has to employ different tools. Specifically, these novel tools are referred to as quantitative easing and emergency lending.
Why does the Federal Reserve rarely use the discount rate to implement its monetary policy?
As aforementioned, the discount rate is the rate that the Fed charges the member banks in the United States to borrow during its discount window to sustain the cash reserve requirements of the bank. The Federal Reserve hardly employs the discount rate to execute its monetary policy. One of the major reasons is that it is challenging for the Fed to forecast changes in the discount window for banks to borrow when there are changes in the discount rate. There is no assurance that financial institutions will borrow more at the discount window in reaction to a decline in the discount rate, or borrow less at the discount window in reaction to a rise in the discount rate. As a result, the precise impact of a discount rate change on the economy’s money supply is usually ambiguous, which increases the likelihood of missing the target change. A second reason why the Federal Reserve hardly uses the discount rate is that on top of their impact on the money supply, the changes in the discount rate usually have significant influences on the financial markets
Which tool is most often used by the Federal Reserve? Why?
The tool that is most often used by the Federal Reserve is open market operations. It is imperative to note that open market operations are the most flexible monetary tool, and as a result, most often employed by the Fed in its conduct of monetary policy. Open market operations are conducted by the Domestic Trading Desk of the Federal Reserve Bank of New York with such directives being handed out by the Federal Open Market Committee (FOMC). Notably, these transactions are carried out with primary dealers (Federal Reserve Education, n.d). There are numerous ways in which the central bank can carry out OMOs.
Nonetheless, for the most part, OMOs are carried out through the purchasing and selling of government securities to influence the number of bank reserves. Significantly, this takes into account the purchasing and selling of government securities in the secondary market. This implies that the Fed is not directly purchasing government securities from the government itself. Rather, the buying and selling of the securities are done with a private entity (Brandl, 2020).
Moreover, following Federal Reserve Education (n.d), the Fed regularly carries out open market operations numerous times in a week. The huge majority of open market operations are not designed to carry out alterations in monetary policy. In its place, open market operations are carried out on an everyday basis to preclude technical, transitory forces from pushing the effective federal funds rate exceedingly far from the target rate.
References
Brandl, M. (2020). Money, banking, financial markets & institutions. New York: Cengage Learning.
Federal Reserve Education. (n.d). Monetary Policy Basics. Retrieved from: https://www.federalreserveeducation.org/about-the-fed/structure-and-functions/monetary-policy
Federal Reserve. (2017). Monetary Policy Tools. Retrieved from: https://www.federalreserve.gov/monetarypolicy/bsd-monetary-policy-tools-201711.htm
Lumen Learning. (n.d). Macroeconomics: How a Central Bank Executes Monetary Policy. Retrieved from: https://courses.lumenlearning.com/suny-macroeconomics/chapter/tools-of-monetary-policy/