The Fed's new tools (I)

By popular demand, I improved and expanded the notes I published a couple of weeks ago about the new tools of the Federal Reserve. I have added instruments that are not in place yet but the Fed considers using. I have ended up with a very long post, so I have broken it down into two parts. The second part will come out next week.

(I thought somebody would like to use these posts as a refresher, a summary, or even class notes. Jim Hamilton has a few great posts on the subject: September 23, December 14, December 16, March 15. The New York Federal Reserve made its own pocket version. And Greg Ip wrote a rather educational piece. Enjoy.)

UPDATE (4/13/2008): The link to the New York Fed's pocket version does not work any more. But you can find that document here now. Sorry about that.

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The central bank has a balance sheet, as any other bank. As assets, it holds primarily securities issued by the government and loans to banks. As liabilities, it has currency (the cash in your pockets) and reserve balances. Reserves are deposits that regular banks keep at the central bank. When a bank needs currency it withdraws from its deposit, effectively turning it into notes and coins that you and I can use. As you will see in a minute, reserves are a key element in monetary policy.

This was the balance sheet of the Federal Reserve on August 15, 2007:

Federal Reserve's balance sheet, $ millions (Aug. 15, 2007)
Assets	US government securities	789,601
	Repurchase agreements	24,000
	Reverse repurchase agreements	-31,941
	Direct loans	264
	Other assets	37,058
Liabilities	Currency in circulation	813,085
	Reserve balances	5,897

Source: Federal Reserve, H.4.1 release.

(For the moment, regard “repurchase agreements” as loans to banks.)

The sum of currency in circulation and reserve balances is the monetary base (M0). The Federal Reserve’s target, however, is not M0 but the federal funds rate.

Banks keep deposits at the Fed to meet reserve minimums required by the Fed and to clear financial transactions. Institutions with balances in excess of reserve requirements lend reserves to institutions that don't have enough. The interest rate on those loans, typically overnight, is called the federal funds rate. That’s a market rate, determined by the supply and demand of such funds. The more reserves, the lower the fed funds rate, and vice versa.

Source: Federal Reserve Bank of New York