Overview of fed

Group 9 & 10 Federal Reserve System

OVERVIEW OF FEDERAL RESERVE SYSTEM

1. BACKGROUND
The Federal Reserve System (FED or is the central banking system of
the United States. It was establish in 1913, with the enactment of the
Federal Reserve Act. By creating the Federal Reserve System, Congress
intended to eliminate the severe financial crisis that had periodically
swept the nation, especially the sort of financial panic that occurred in
1907. According to this Act, FED evolved over time into an independent
entity to attend to the nation’s credit and monetary needs without undue
influence from political pressure or situation. In keeping its
independence within the government, the system works without
appropriations from Congress.
The current structure of the system has three major components
established by the original act. The system consists of a Board of
Governors, twelve regional Federal Reserve Banks throughout the
nation and the member banks.
2. CHARACTERISTICS
The U.S Federal Reserve System has several features that distinguish it:
- Setting apart centralized authority into many divisions.
- Ownership and control by member banks
- Optional membership in the Fed of some banks
Federal Reserve System is a decentralized central bank. Its authority is
vested in the Board of Governors and the presidents of twelve
Regional Reserve banks (district banks).
FED is also considered to be an independent entity from government
because its decisions do not have to be ratified by the President or
anyone else in the executive branch of government. The System is,
however, subject to oversight by the U.S. Congress. It must work

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within the framework of the overall objectives of economic and
financial policy established by the government; therefore, the
description of the System as ―independent within the government‖ is
more accurate. It is independent, moreover, because it finances its own
operation.
FED does not have right to solely approve or disapprove the monetary
policy or relevant legal issues. It must rely on the FOMC and district
banks to carry out the banking policies developed at the national level.
Especially, stocks are owned by the bank members, not the
Government. In the U.S only chartered banks, which only satisfy
required conditions, are accepted to join the Fed’s member banks.
3. FUNCTIONS

 Serving Government
Federal Government’s Banker
The Fed maintains a checking account for the Treasury Department and
processes payments such as social security checks and IRS refunds.
Government Securities Auctions
The Fed serves as a financial agent for the Treasury Department and
other government agencies. The Fed sells, transfers, and redeems
government securities. Also, the Fed handles funds raised from selling
T-bills, T-notes, and Treasury bonds.
Issuing Currency
The district Federal Reserve Banks are responsible for issuing paper
currency, while the Department of the Treasury issues coins.
 Serving Bank
Check Clearings
Check clearings is the process by which banks record whose account
gives up money, and whose account receives money when a customer
writes a check.
Supervising Lending Practices

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To ensure stability in the banking system, the Fed monitors bank
reserves throughout the system.
Lender of Last Resort
In case of economic emergency, commercial banks can borrow funds
from the Federal Reserve. The interest rate at which banks can borrow
money from the Fed is called the discount rate
 Regulating the Banking System
The Fed generally coordinates all banking regulatory activities.
Reserves
Each financial institution that holds deposits for its customers must
report daily to the Fed about its reserves and activities.
The Fed uses these reserves to control how much money is in circulation
at any one time.
Bank Examinations
The Federal Reserve examines banks periodically to ensure that each
institution is obeying laws and regulations.
Examiners may also force banks to sell risky investments if their net
worth, or total assets minus total liabilities, falls too
 Regulating the Money Supply
The Federal Reserve is best known for its role in regulating the money
supply. The Fed monitors the levels of M1 and M2 and compares these
measures of the money supply with the current demand for money.
Stabilizing the Economy
The Fed monitors the supply of and the demand for money in an effort
to keep inflation rates stable

4. THE STRUCTURE OF FEDERAL RESERVE SYSTEM

The Federal Reserve System was established by the Federal Reserve Act
in 1913 and began operating in 1914. It is an unusual mixture of public
and private elements.

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The structure of the Federal Reserve System is based on five
components: the Board of Governors of the Federal Reserve System, the
Federal Open Market Committee, the Federal Reserve Banks, member
banks, and advisory committees.
Figure 1 illustrates the organizational relationship of these components.

Federal Open
BOARD OF GOVERNORS Market
(CHAIRMAN & VICE CHAIRMAN) Committee
(FOMC)

Federal Consumer Thrift
Advisory Institutions
Advisory Advisory
Committees Advisory
Council Council
Council

FEDERAL RESERVE BANKS (12)

FEDERAL RESERVE BRANCHES

(25)
Member Banks

Figure 1: Federal Reserve Structure
4.1. BOARD OF GOVERNORS
The Board of Governors, frequently called the Federal Reserve Board,
represents the ultimate authority of the Federal Reserve System. Located
in Washington, D.C., the board consists of seven members, mostly
professional economists, appointed by the President of the United States
and confirmed by the Senate. Governors serve 14-year, staggered terms
to ensure stability and continuity over time. The chairman and vice-

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chairman are appointed to four-year terms and may be reappointed
subject to term limitations.
 Responsibilities:
- Providing centralized authority.
- Establishing regulations.
- Supervising activities of the Federal Reserve Banks.
- Overseeing and approves merger applications.
- Controlling effectively the discount rate.
- Calculating Margin Requirements.
- Setting Reserve Requirements

4.2. FEDERAL OPEN MARKET COMMITTEE (FOMC)

The Federal Open Market Committee (FOMC) is the Fed's monetary
policy making body. The voting members of the FOMC are the Board of
Governors, the president of the Federal Reserve Bank of New York and
presidents of four other Reserve Banks, who serve on a rotating basis.
All Reserve Bank presidents participate in FOMC policy discussions.
The chairman of the Board of Governors chairs the FOMC. Hence,
FOMC is considered as an example of the interdependence built into the
Fed's structure. It combines the expertise of the Board of Governors and
the 12 Reserve Banks. Regional input from Reserve Bank directors and
advisory groups brings the private sector perspective to the FOMC and
provides grassroots input for monetary policy decisions.
- Monitor District Economy.
- Convey regional economic perspectives to the Board of
Governors (Beige Book).
- Examine and Supervise banks.
- Lend to banks (Discount Window).
- Provide financial services to banks and the U.S. Treasury in the
region.

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- Recommend Discount Rate changes.
- Nine Board of Directors representing banks, business, and the
public
4.3. FEDERAL RESERVE BANKS (DISTRICT BANKS)
The Reserve Banks, also known as district banks, are nongovernmental
organizations, set up similarly to private corporations, but operated in
the public interest. The districts are headquartered in Boston, New York,
Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis,
Minneapolis, Kansas City, Dallas, and San Francisco. So far, there are
totally 25 Reserve bank branches.
- Clear checks
- Issue new currency
- Withdraw damaged currency from circulation
- Administer and make discount loans to banks in their districts
- Evaluate proposed mergers and applications for banks to expand
their activities
- Act as liaisons between the business community and the Federal
Reserve System amine bank holding companies and state-
chartered member banks
- Collect data on local business conditions
- Use their staffs of professional economists to research topics
related to the con-duct of monetary policy

4.4. MEMBER BANKS:
Member banks can be divided into three types according to which
governmental charters and whether or not they are members of FED:
(1) A state-chartered bank is a financial institution that receives its
charter from a state authority such as the Arkansas State Bank
Department. These banks are supervised jointly by their state

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chartering authority and either the Federal Deposit Insurance
Corporation (FDIC) or the Fed.
(2) A national bank is chartered issued by the Office of the
Comptroller of the Currency. This choice of state or national
charter for commercial banks is referred to as the "dual banking
system."
(3) A state nonmember banks is not chosen by FED because some of
mismatch with the standard requirements.
- As a member, each bank is required to hold stock in its respective
Reserve bank.
- Member banks also have to hold 3 percent of their capital as
stock in their Reserve Banks.

4.5. ADVISORY COUNCILS

(1) Federal Advisory Council (FAC), which is composed of twelve
representatives of the banking industry, consults with and advises the
Board on all matters within the Board's jurisdiction. The council
ordinarily meets four times a year, the minimum number of meetings
required by the Federal Reserve Act.
(2) Consumer Advisory Council also meets with the Board of Governors
at least four times each year. Composed of 30 members, the group
represents the interests of consumers and creditors. Its function is to
advise the Board of Governors on such matters related to the Fed's
authority in the areas of consumer and creditor laws.
(3) Advisory committees (one for each Reserve Bank) take a
responsibility for advising banks on matters of agriculture, small
business and labor. Every two years, the Board solicits the advice
and views of these committees by emails.
(4) Thrift Institutions Advisory Council, established in 1980 with the
Monetary Control Act, provides information related to issues and

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concerns of thrift institutions. The council is composed of
representatives from savings banks, savings and loan associations,
and credit unions. It meets at least four times every year.

 Assessing the Federal Reserve System’s Structure
 Independence from Political Influence
- The Fed controls its own budget, which is an important criterion for
central bank independence.
- It does occasionally come under political attack, especially when it
believes it must raise interest rates.
 Decision Making by Committee
- The Fed meets this criterion for independence because the FOMC is
a committee.
- The chair may dominate policy decisions, but the fact that there are
12 voting members provides an important safeguard against arbitrary
action by a single individual.
 Accountability and Transparency
- The FOMC releases huge amounts of information to the public.
- However, there is no regular press conference or real questioning of
the chair on the FOMC’s current policy stance.
- Moreover, some information is released well after the fact of the
meeting.
- Also, the Committee’s refusal to state its objectives clearly and
concisely hampers communication.
 Policy Framework
- The Congress of the United States has set the Fed’s objectives, but
the statement is vague enough that the Fed can essentially set its own
goals.
- Many people have argued that the system should be replaced by one
in which the FOMC’s objectives are made clear and the Committee

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announce a specific numerical objective for consumer price inflation
over some horizon.

FEDERAL RESERVE SYSTEM (FED)
VS. EUROPEAN CENTRAL BANK (ECB)
In world economy, nowadays, the Fed and the ECB are the most influential and
powerful central banks. Their decisions or issues can change the whole global
economy in different directions, maybe they lead to better or worse cases. Our
group thinks it is interesting to make a comparison of two important banks.
Although FED and ECB have not established in the same legal issue or
methodology, and history, they still have some similarities as same as some
major differences. In this part, we focus on the organizational structure, role in
the economy, and the monetary policy framework. Besides, the purpose of this
comparison is to give a brief overview of the history, structure, objectives, and
monetary policy strategies of The European Central Bank (ECB) and The
Federal Reserve System (Fed). Table 1 below is the brief description from
comparing two central banks.
FED (FEDERAL OF RESERVE ECB (EUROPEAN SYSTEM OF
SYSTEM) CENTRAL BANK)

ESTABLISHED YEAR 1914 1998

SUPERVISOR Board of Governors in control NCBs Governors in charge
FED decentralizes its authority Governing Council, comprising 22
DECENTRALIZATION

into 12 Federal Reserve Banks, members: the ECB Executive
each serving a specific region of Board (6 members) and the
the country. The Board of Governors of the 16 NCBs
Governors (7 members), based in (National Central Banks) of the
Washington, DC, set up to Euro system
oversee the Fed System.

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- Governors (14 year terms) - All president and governing
- Chairman (4 year terms) council (8 year terms) y
- Appointed by the US President - Appointed b National
LEGAL TERM
- Approved by the Congress governments
- Approved by the European
Parliament

INDEPENDENCE - Still report regularly to the - More independent than FED
FROM Congress - Lay under the Maastricht Treaty
POLITICAL - Under the Federal Reserve Act
INFLUENCE (1913)
Multiple objectives: to promote Price stability is the primary
maximum employment, price objective as set in the Maastricht
stability, and moderate long-term Treaty. The ECB has quantified
MONETARY
interest rates. Price stability not this as medium-term inflation
POLICY
defined, but widely viewed as 1- goal of ―below but close to 2%‖.
OBJECTIVES
2% comfort zone (skewed
toward upper portion) for core
PCE inflation
Focus on economic forecasts;
Two pillar strategy:
rates adjusted to optimize
- First pillar focuses on longer- on
expected outcomes and minimize
shorter-term economic and price
MONETARY risks of deviating from those
developments (―economic
POLICY outcomes (factoring in costs of
pillar‖);
STRATEGY those deviations).
- Second pillar term inflation
Preference for gradualism unless
outlook based on monetary
risks dictate more aggressive
analysis
action
DECISION The decision-making authority is The main decision-making body is
MAKING hold by the FOMC. But it needs Governing Council, which
BODY to be ratified by the Chairman. formulate monetary policy.

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The 12 Reserve Banks The Executive Board is in charge
implement it. of implementing it.

OPEN MARKET OPERATION
Repurchase Agreements Reserve transaction at weekly
(Repos) on daily basis with auctions with maturities of two
MAIN
very short-term weeks
maturity(sometime can
range from 1->90days)
Outright purchases or sales Transaction with 3 months
MONETARY
of Government securities maturities, conducted on monthly
POLICY TOOLS
(once a week) basis
SUB

(OPERATIONAL
Non standard fine tuning
POLICY)
operations used various
Both use
instruments
similar tools
STANDING FACILITIES
to implement
OVERNIGHT LIQUIDITY
the monetary
Discount Window Lending Marginal Lending Facility
policy
The provision of overnight Overnight facility at an interest
adjustment credit at an interest rate _ marginal lending
rate _ discount rate, which stay rate(usually 100 basis points
at least 25-50 basis points below above target refinancing rate)
the target for the federal funds
rate.

DEPOSIT FACILITY
Required reserve balance and Banks with excess reserve can
excess balance have been paid deposit them overnight at an
by the interest rate on required interest rate 100 basis points
reserve since 2008. below the target refinancing rate.
This rate ranges from 0 to ¼ This rate has been used since
percent. 1999

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RESERVE REQUIREMENT
Reserve requirement is not used
- Called minimum reserve, which
to influence the inflation, but
based on the level of liabilities in
used to stabilize the demand of
hand over a month.
reserve. Based on two weeks
- Remunerations, be at the average
average balance on accounts
of refinancing rate over the
with unlimited checking
period.
privileges.

Table 1: Differences between FED and ECB

FEDERAL RESERVE SYSTEM:
MONETARY POLICY BASICS
Monetary policy includes all the Federal Reserve actions that change the
money supply in order to influence the economy. Its purpose is to curb
inflation or to reduce economic stagnation or recession. Hence, it would
encompass various activities of the U.S. Treasury for those relating to
foreign exchange operations and the receipt and disposition of public
funds can affect the supply of money.
Thus, a more realistic definition of monetary policy is that it consists of
the directives, policies, pronouncements, and actions of the Federal
Reserve System that affect aggregate demand or national spending.
Among these, the dominant action consists of open market operations.
These involve the buying and selling of seasoned Treasury securities by
the Federal Reserve. When Treasury securities are purchased, the
Federal Reserve does so with newly created money. This money can
serve as reserves for the financial system and allows commercial banks
and other depository institutions to make new loans and investments,

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thereby expanding the money supply and aggregate demand. The
opposite happens when the Federal Reserve sells government securities

1. GOALS OF MONETARY POLICY
The goals of monetary policy are amended in the dual mandate in the
Federal Reserve Act, and other legislation indicates goals of policy:
(1) Price stability (by maximum purchasing power)
(2) Employment stability ( by maximum employment)
There are two factors to achieve the employment goal. First, low and
stable inflation rate retention maximizes the economy growth rate in
order to maximize the sustainable employment. Secondly, FED can
enhance this goal by timely adjustments in its policy stance to adapt the
economic changes.
By implementing effective monetary policy, the Fed can maintain stable
prices, thereby supporting conditions for long-term economic growth
and maximum employment.

2. LIMITATIONS OF THE FED MONETARY POLICY
Monetary policy is not the only force that influences on national output,
unemployment, and prices. There are many forces go along with
aggregate demand and supply and the whole economy, such as:
Fiscal policy, which is undertaken by the Government, has an impact on
both demand and supply side. Although price stability is FED’s goal, it
is easy or affected by the changes of both fiscal policy and monetary
policy. Fiscal policy usually affects the economy through changes in
taxes, governmental spending and economic decisions or also political
mattes..
Many factors can be quietly unpredictable and influence the economy in
unforeseen point. On the demand side, for instance, the changes in
consumer and business confidence would lead to the changes in the
lending posture lending by the commercial bank or creditors. On the

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supply side, natural disasters, disruptions in the oil market… would
restraint the productivity growth.
Useful information is limited not only by lags in the construction and
availability of key data but also by later revisions, which can alter the
picture considerably.
The stat utor y goals of maximum employment and stable price
are easier to achieve if the public understands those goals and believes
that the FED will take effective measures to achieve them. Hence,
resident confidence for FED should maintain to achieve the better
results in implementing monetary policy.

3. GUIDES OF THE FED MONETARY POLICY RULE
The FED monetary policy rule has been calculated by a number of
elements and methods. In this part, discussion will focus on some
important of these:
3.1. THE TAYLOR RULE
The ―Taylor rule,‖ named after the prominent economist John Taylor, is
another guide to assessing the proper stance of monetary policy. It
relates the setting of the federal funds rate to the primary objectives of
monetary policy—the extent to which inflation may be departing from
something approximating price stability and the extent to which output
and employment may be departing from their maximum sustainable
levels.
John Taylor noted that these characteristics of FOMC policy actions
could be summarized in a simple expression (original equation):

.5 p − p
* *
i p .5y r

1.5 p − p
* * *
.5y r p

Where;
_ i is the nominal federal funds rate,
_ p is the inflation rate,

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_ p* is the target inflation rate,
_ y is the percentage deviation of real gross domestic product
(GDP) from a target,
_ r* is an estimate of the ―equilibrium‖ real federal funds rate.
Under this characterization:
- The funds rate is raised (lowered) when actual inflation exceeds
(falls short of),
- The long-run inflation objective and is raised (lowered) when
output exceeds (falls short of) a target level.
- In subsequent analyses this target has been interpreted as a measure
of ―potential GDP.‖ When inflation and real GDP are on target,
then the policy setting of the real funds rate is the estimated
equilibrium value of the real rate.
To make this rule effective, however, data on the inflation rate and GDP
must be known to the FOMC. In practice, the equation can be specified
with lagged data on inflation and GDP. More generally the equation can
be written as follows:

a pt − 1 − p
* P * *
it 100bln y t −1 / y t−1 r p

Where;
pt–1 is the previous quarter’s PCE inflation rate measured on a year-over-
year basis,
yt –1 is the log of the previous quarter’s level of real GDP,
ytP–1 is the log of potential real GDP as estimated by the Congressional
Budget Office.
Drawbacks of the Taylor Rule:
The level of short-term interest rates associated with achieving longer-
term goals, a key element in the formula, can vary over time in
unpredictable ways.
Moreover, the current rate of inflation and position of the economy in
relation to full employment are not known because of data lags and

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difficulties in estimating the full-employment level of output, adding
another layer of uncertainty about the appropriate setting of policy.

3.2. FOREIGN EXCHANGE RATES
Exchange rate movements are an important channel through which
monetary policy affects the economy, and exchange rates tend to
respond promptly to a change in the federal funds rate. Moreover,
information on exchange rates, like information on interest rates, is
available continuously throughout the day.
Interpreting the meaning of movements in exchange rates, however, can
be difficult. A decline in the foreign exchange value of the dollar
monetary policy has become. But exchange rates respond to other
influences as well, notably developments abroad; so a weaker dollar on
foreign exchange markets could instead reflect higher interest rates
abroad, which make other currencies more attractive and have fewer
implications for the stance of U.S. monetary policy and the performance
of the U.S. economy. Conversely, a strengthening of the dollar on
foreign exchange markets could reflect a move to a more restrictive
monetary policy in the United States. But it also could reflect
expectations of a lower path for interest rates elsewhere or a heightened
perception of risk in foreign financial as-sets relative to U.S. assets.
Some have advocated taking the exchange rate guide a step further and
using monetary policy to stabilize the dollar’s value in terms of a
particular currency or in terms of a basket of currencies. However, there
is a great deal of uncertainty about which level of the exchange rate is
most consistent with the basic goals of monetary policy, and selecting
the wrong rate could lead to a protracted period of deflation and
economic slack or to an overheated economy. Also, attempting to
stabilize the ex-change rate in the face of a disturbance from abroad
would short-circuit the cushioning effect that the associated movement
in the exchange rate would have on the U.S. economy.

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3.3. POLICY ASYMMETRY

Policy bias exists because turning points in economic activity—peaks
and troughs of business cycles—are infrequent. Changes in economic
activity as measured by output and employment are highly persistent.
Given such persistence, once it becomes apparent that a cyclic peak
likely has occurred, the issue is never whether the Fed will raise the
target funds rate but whether and how much the Fed will cut the target
rate. Similarly, once it is apparent that an expansion is underway, the
solution is not whether the Fed will cut the target rate, but the extent and
timing of increases. Transitory and anomalous shocks to the data are
ordinarily rather easy to identify. Both Fed and market economists
develop estimates of these aberrations in the data shortly after they
occur. The principle of looking through aberrations is easy to state but
probably impossible to formalize with any precision.
Policymakers piece together a picture of the economy from a variety of
data, including anecdotal observations. When the various observations
fit together to provide a coherent picture, the Fed can adjust the intended
rate with some confidence. The market generally understands this
process, as it draws similar conclusions from the same data.

3.4. CRISIS MANAGEMENT
These rules are suspended when necessary to respond to a financial
crisis.
 For examples of the Greenspan era are the stock market of 1987, the
combination of financial market events in late summer and early fall
1998 that culminated in the near failure of Long Term Capital
Management, crisis avoidance coming up to the century date change
at the end of 1999. In this case, the response was tailored to
circumstances unique event. Because markets had confidence in the
Federal Reserve, including confidence that extra provision of

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liquidity would be withdrawn before risking an inflation problem. In
the absence of such confidence, the Fed’s ability to respond would
be severely curtailed.

4. TRADITIONAL INSTRUMENTS (TOOLS) OF FEDERAL MONETARY
POLICY
 Why does FED need tools to control or implement its policy?
Because the function of the central bank has grown and today, the Fed
primarily manages the growth of bank reserves and money supply in
order to allow a stable expansion of the economy.
To implement its primary task of controlling money supply, there are
three main tools the Fed uses to change bank reserves:
(1) The target federal funds rate (FFR)
(2) The discount window lending (the primary credit rate)
(3) The Reserve Requirements
(1) THE TARGET FEDERAL FUNDS RATE AND THE OPEN MARKET
OPERATIONS
 The target funds rate is the Federal Open Market Committee’s
primary policy instrument. On the other word, it is the interest
rate at which banks make overnight loans to each other. It is
sensitive to changes in the demand for and supply of reserves in
the banking system, thus provides a good indication of the
availability of credit in the economy.
 The Open Market Operations (OMO) plays a role of buying and
selling U.S. government securities to raise or lower the interest
rate. It means OMO change the amount money supply or money
base.
- This tool consists of Federal Reserve purchases and sales of
financial instruments, securities issued by the U.S.
Treasury, Federal agencies and government-sponsored
enterprises. Open market operations are carried out by the

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Domestic Trading Desk of the Federal Reserve Bank of
New York. The transactions are undertaken with primary
dealers.
- When the Fed wants to increase reserves, it buys securities
and pays for them by making a deposit to the account
maintained at the Fed by the primary dealer’s bank.
- When the Fed wants to reduce reserves, it sells securities
and collects from those accounts. Trading securities, the
Fed influences the amount of bank reserves, which affects
the federal funds rate, or the overnight lending rate at
which banks borrow reserves from each other.

(2) THE DISCOUNT WINDOW LENDING

 The discount window lending is the Fed’s primary tool for
ensuring short-term financial stability, eliminating bank panics,
and preventing the sudden collapse of financial institutions in
financial difficulties.
 The lending rate which the Fed charges banks for these loans is
the discount rate (officially the primary credit rate).
- Through its discount and credit operations, Reserve Banks
provide liquidity to banks to meet short-term needs stemming
from seasonal fluctuations in deposits or unexpected
withdrawals. Longer term liquidity may also be provided in
exceptional circumstances. In making these loans, the Fed
serves as a buffer against unexpected day-today fluctuations
in reserve demand and supply. This contributes to the
effective functioning of the banking system, alleviates
pressure in the reserves market and reduces the extent of
unexpected movements in the interest rates.

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- The Fed rarely uses the discount rate as a policy tool. As its
changes are strong signals of the Federal Reserves’ intentions
and no guarantee that banks will borrow.
- However, at times of market disruption, for instance, the
September 11, 2001, terrorist attacks, loans extended through
the discount window can supply a considerable volume of
Federal Reserve balances.  This tool is also considered as
an important safeguard against bank runs. To sum up, it is the
lender of last resort, means making loans to banks when no
one else can or will.

(3) THE RESERVE REQUIREMENTS
Reserve requirements are the reserve assets depository institutions must
keep to ―backing‖ transaction deposits. Reserve assets include vault cash
and deposits at Federal Reserve Banks. In short, the reserve requirement
is the percentage of deposits in demand deposit accounts that financial
institutions must set aside and hold in reserves.
The original purpose of this tool was to ensure banks were sound and to
reassure depositors that they could withdraw currency on demand. It is
lightly different from the current purpose. Today, the reserve
requirement is primarily to stabilize the demand for reserves and keep
the target federal funds rate close to the market rate.
Hence, in practice, if the Fed raises the reserve requirement, banks have
less money to lend, which restrains the growth of the money supply. On
the other hand, if the Fed lowers the reserve requirement, banks have
more money to lend and the money supply increases. The Fed rarely
changes the reserve requirement. In fact, it is the least-used monetary
policy tool because changes in the reserve requirement significantly
affect financial institution operations. Reserve requirement changes are
seen as a sign that monetary policy has swung strongly in a new
direction.

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 T HE CORRELATION OF MONETARY P OLICY AND INFLATION
STABILIZATION

EASE (LOOSE)
TIGHT MONEY SUPPLY
MONEY SUPPLY
Buy government securities Sell government securities
Lower interest rate Higher interest rate
METHOD
Lower reserve requirements rate Increase reserve requirements
(RRR) rate (RRR)
More Money Supply in
MACRO- Less Money Supply in circulation
circulation
ECONOMY (Money back to Federal reserve)
(Money creation is set)
Stimulate economy Fight Inflation
More borrowing and lending Less borrowing and lending
EFFECTS
E NCOURAGE INVESTMENT D ECLINE INVESTMENT
SPENDING SPENDING

RESULT B OOSTING ECONOMIC D ELAY THE WHOLE
GROWTH ECONOMY

CASE STUDY: FEDERAL RESERVE RESPONSES
TOWARD THE FINANCIAL CRISIS (2007-2009)

THE FINANCIAL CRISIS (2007): REVIEWING THE DISASTER

In near the end of 2007, the great financial crisis exploded in US, and
rapidly affected most of the global economy. In an interconnected
world, a seeming liquidity crisis can very quickly turn into a solvency

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crisis for financial institutions, a balance of payment crisis for sovereign
countries and a full-blown crisis of confidence for the entire world
Indeed, this explosion related to the Housing Market Bubbles Pop,
which has not been subject to pricing ―bubbles‖ as the other assets
market. Most of people, investing in real estate, have not ever thought
about price declining of their house as the enormous amount of money
they have to pay to the transaction cost of purchasing, legal fees of
owning and maintaining costs for house blurred their analytical and
assessing vision. However, theoretically, the price of housing, like the
price of any good or service in a free market, is driven by supply and
demand. When demand increases and/or supply decreases, prices go up.
So, if there is a sudden or prolonged increase in demand, prices are sure
to rise.
The policy to keep away from the recession in 2001 was a wrong
decision. According to this, the federal funds rate was lowered 11 times
_ from 6.5% in 5/2001 to 1.75% in 12/2001. This action which created
the flood of liquidity in the economy made money cheaper. As result, it
was easy to become an attractive pitfall, which caused damage the
restless bankers and borrowers. This environment of easy credit and the
upward spiral of home prices made investments in higher yielding
subprime mortgages look like a new rush for gold. In 6/ 2003, interest
rates continued downing 1%, the lowest rate in 45 years. The whole
financial market resembled this rate.
But, every good item has a bad side, and several of these factors
started to emerge alongside one another. The trouble started when the
interest rates started rising and home ownership reached a saturation
point.6/ 2004, onward, the Fed raised rates so much that by 6/2006, the
Federal funds rate had reached5.25%.
Declines Begin: There were early signs of distress: by 2004, U.S.
homeownership had peaked at 70%; no one was interested in buying
houses. Then, during the last quarter of 2005, home prices started to fall,

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which led to a 40% decline in the U.S. Home Construction Index during
2006. This caused 2007 to start with bad news from multiple sources.
Every month, one subprime lender or another was filing for bankruptcy.
During February and March 2007, more than 25 subprime lenders filed
for bankruptcy, which was enough to start the tide. In April, well-known
New Century Financial also filed for bankruptcy.
Investments and the Public: Problems in the subprime market began
hitting the news, raising more people's curiosity. Horror stories started to
leak out. According to 2007 news reports, financial firms and hedge
funds owned more than $1 trillion in securities backed by these now-
failing subprime mortgages - enough to start a global financial tsunami
if more subprime borrowers started defaulting. By June, Bear Stearns
stopped redemptions in two of its hedge funds and Merrill Lynch seized
$800 million in assets from two Bear Stearns hedge funds. But even this
large move was only a small affair in comparison to what was to happen
in the months ahead.
August 2007: The Landslide Begins
The financial market could not solve the subprime crisis on its own and
the problems spread beyond the United States borders. The interbank
market froze completely, largely due to prevailing fear of the unknown
amidst banks. By that time, central banks and governments around the
world had started coming together to prevent further financial
catastrophe. It became apparent in August 2007 that the financial market
could not solve the subprime crisis on its own and the problems spread
beyond the United State's borders.

THE FEDERAL RESERVE’S RESPONSES
TO THE CRISIS

In the national financial corruption, from 2007 to 2009, the Fed
announced many plans/ strategies to try to push long-term interest rates

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down. By reducing the supply of long-term interest rate Treasuries, the
Fed intends to force investors to accept lower rates of return on the
ultra-safe securities, or to move their money into a wide range of riskier
investments that could do more to promote growth. In this part, we will
pay attention to the Quantitative Easing (QE), the unconventional
monetary policy, is the Fed’s major policy to escape from the crisis.

The chart below will direct the changes in money supply from the very
beginning of the financial crisis (2007) to the points after applying the
QE policy in economy.

Figure 2: M2 vs. True money supply (2000-2010)
The figure 2 compares the year-over-year (YOY) growth rates of True
Money Supply (TMS - the blue line) and M2 (the red line). As at the end
of January the TMS yearly rate of change was down a few percent from
its high, but was still well into double digits and in the top quartile of its
10-year range. The M2 rate of change, however, was at a 10-year low.
As explained in previous commentaries, the large divergence over the
past year between these two monetary aggregates is primarily due to
declines in the nonmonetary components of M2 (the main non-monetary
components of M2 being money-market funds and time deposits). From
the chart, the money aggregates (2000-2001) rate was low. But, after the

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24


Fed enforced the ―cheap money‖ rules, this rate soared rapidly. It was
the point that led to the greater crisis in 8/ than small-recession in 2001.

 SUBSEQUENT BAILOUT IN 2008 (FOR FINANCIAL INSTITUTION S)

The Treasury and the Federal Reserve began working on a $700 billion
bailout plan. Most of amounts was used to repurchase and invest to keep
some important financial institutions from bankruptcy.
- On Sept. 8, 2008, the U.S. Treasury seized control of mortgage
giants Fannie Mae and Freddie Mac and pledged a $200 billion cash
injection to help the companies cope with mortgage default losses.
- About a week later the government bailed out American
International Group Inc., or AIG, with $85 billion.
- The Fed refused to save Lehman Brothers and the company was
forced to file for bankruptcy. Some of the largest financial
institutions were on the verge of collapse as the mortgage market
melted down. As the crisis hit the global market, the credit freeze
spread.
- President George W. Bush signed the bailout plan into law October
3, 2008.
- October 29, 2008, the Fed cut the key interest rate to 1 percent.
 Expectation
The Fed’s chairman claimed the bailout was necessary to provide
stability in the economy and prevent disruption in the financial
system. The interest rate cut aimed to revive the economy, help
free up credit and make loans cheaper to consumers and
businesses.
 Result:

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The financial markets remained in turmoil for several months.
Credit remains tight to this day; although it loosened significantly
compared to when lending nearly came to a halt during the
collapse period. Mortgage rates in figure 4 fell significantly after
the interest rate cut and amid expectations that the Fed would
start buying mortgage-backed securities.

Figure 4: Mortgage rates during the collapse and government bailout

 REASONS FOR IMPLEMENTING UNCONVENTIONAL TOOLS

The size of the monetary policy funds rate shortfall has also caused
the Fed to expand its use of unconventional policy tools that change
the size and composition of its balance sheet.
- The Fed started to employ these balance sheet tools in late 2007
as unusual strains and dislocations in financial markets clogged
the flow of credit.
- Typically, changes in the funds rate affect other interest rates and
asset prices quite quickly.
- However, the economic stimulus from the Fed's cuts in the funds
rate was blunted by credit market dysfunction and illiquidity and
higher risk spreads. Accordingly, the Fed started to lend directly
to a broader range of counterparties and against a broader set of

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collateral in order to enhance liquidity in critical financial
markets, improve the flow of credit to the economy, and restore
the full effect of the monetary policy interest rate easing.
Toward the end of 2008, the recession deepened with the prospect of a
substantial monetary policy funds rate shortfall.
- In response, the Fed expanded its balance sheet policies in order
to lower the cost and improve the availability of credit to
households and businesses.
- One key element of this expansion involves buying long-term
securities in the open market. The idea is that the funds rate and
other short-term interest rates fall to the zero lower bound; there
may be considerable scope to lower long-term interest rates. The
FOMC has approved the purchase of longer-term Treasury
securities and the debt and mortgage-backed securities issued by
government-sponsored enterprises.
- These initiatives have helped reduce the cost of long-term
borrowing for households and businesses, especially by lowering
mortgage rates for home purchases and refinancing.
In terms of overall size, the Fed's balance sheet(B.S) has more than
doubled to just over $2 trillion.
- The increase in B.S. has likely only partially offset the funds rate
shortfall, and the FOMC has committed to further balance sheet
expansion by the end of this year.
- Looking ahead even further over the next few years, the size and
persistence of the monetary policy shortfall suggest that the Fed's
balance sheet will only slowly return to its pre-crisis level. This
gradual transition should be fairly straightforward, as most new
assets acquired by the Fed are either marketable securities or
loans with maturities of 90 days or less.

THE QUANTITATIVE EASING (QE) POLICY

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(UNCONVENTIONAL TOOLS)

The original definition of Quantitative easing (QE) is an
unconventional monetary policy used by central banks to stimulate the
national economy when conventional monetary policy has become
ineffective. A central bank buys financial assets to inject a pre-
determined quantity of money into the economy. This is distinguished
from the more usual policy of buying or selling government bonds to
keep market interest rates at a specified target value.
 HOW THE FED APPLIED QE POLICY IN U.S.?
 It’s the electronic equivalent of starting up the Fed’s printing
presses to create money for buying financial assets in the market –
in this case long-term U.S. Treasury bonds. Buying bonds pushes
down their yields and the interest rates across the debt markets that
are closely tied to U.S. Treasury rates.
The chart in Figure 3 following is the timeline chart of from the money
infusion in the Fed’s monetary policy to rescue the national economy.

END OF QE-1 END OF QE-2
2007-2008 FINANCIAL CRISIS (March 31, 2010) (June 30, 2011)

QE-2
QE-1 (Nov. 3, 2010)
(Nov. 25, 2008)

Figure 3: Timeline of FED implementing the money infusion

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THE FIRST QUANTITATIVE EASING (QE-1) (NOV. 25, 2008 – MAR. 31, 2010)
The Fed initiated purchases of $500 billion in mortgage-backed
securities.
- It announced purchases of up to $100 billion in debt obligations of
mortgage giants Fannie Mae, Freddie Mac, Ginnie Mae and
Federal Home Loan Banks.
- The Fed cut the key interest rate to near zero, Dec. 16, 2008.
- In March 2009, the Fed expanded the mortgage buying program
and said it would purchase $750 billion more in mortgage-backed
securities.
- The Fed also announced it would invest another $100 billion in
Fannie and Freddie debt and purchase up to $300 billion of longer-
term Treasury securities over a period of six months.
- The quantitative easing program, or QE1, concluded in the first
quarter of 2010, with a total of $1.25 trillion in purchases of
mortgage-backed securities and $175 billion of agency debt
purchases.
- After completing the purchase of $1.25 trillion in mortgage-backed
securities, $300 billion in Treasury bonds and $175 billion in
federal agency debt, the Fed ended QE1.
 QE1 was initially open-ended. The Fed did not set an end date
for the program until about six months out, as it slowed the
buying pace.
 Expectation:
- The Fed wanted to lower mortgage interest rates and increase the
availability of credit for homebuyers to help support the housing
market and improve financial market conditions.
- Many industry experts expected mortgage rates to rise after QE1
ended.
 Result:

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- Mortgage rates dropped significantly, to as low as 5 percent in
figure 4, about a year after QE1 started.
- Contrary to analysts' expectations, mortgage rates tumbled after the
program ended. See in Figure 5

Figure 4: Mortgage rate reacted during QE-1

Figure 5:
Mortgage rate
reacted after QE-1
ended

THE SECOND QUANTITATIVE EASING (QE-2) (NOV. 3, 2010 – JUN. 30, 2011)

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The Fed continued to reinvest payments with the larger amount than the
first purchase on securities purchased during the QE-1 program.
- In second investment, it began the purchase of $600 billion of
longer-term Treasury securities.
- As the announcement, the Fed pushed the entire second budget into
$600 billion bond purchasing program.
 QE-2 was conducted at an even pace, and the end date was
telegraphed from the start of the program.
 Expectations:
- The Fed said QE-2 would help promote a stronger pace of
economic recovery.
- Industrial observers expected QE-2 to keep mortgage rates low or
push the rates lower.
- Lower borrowing costs should help some homeowners refinance,
even if many others don’t qualify because of weak credit scores
or diminished home equity. It also should help businesses that
can qualify for loans through cheaper credit, though larger
corporations already can access money at cheap rates.
- The Fed figures that buying up government debt, in theory,
should push investors into riskier assets — such as stocks and
corporate bonds — and raise their value.
- It also will tend to weaken the dollar, helping U.S. exporters be
more competitive in overseas markets.
 Results:
- Contrary to what was expected, mortgage rates spiked more than
half a percentage point in a little more than a month after QE-2
started. When the program ended, the 30-year fixed-rate
mortgage rate was about 30 basis points higher than it was when
QE-2 started.
- However, after the QE-2 ended, the mortgage rate was
dramatically tumbledown. See in Figure 7

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Figure 6:
Mortgage
rate during
QE-2

Figure 7:
Mortgage
rate after
QE-2 ended

THE RESULTS OF THE QUANTITATIVE EASING POLICIES

Through two rounds of pumping money into the U.S. economy, instead,
stabilizing the price and promoting employment rate should have been
paid more concern; the Fed was going too far from these two main
functions as a central bank. Pumping money into the market could not
help the every homeowners refinancing. By this way, the gap between
the poor and the rich is more severe and bigger than ever.
Although, the Fed’s starting points are based on the economic situations
and the household’s needs. But, its predictions might be no precisely
true as it should be.
UNEMPLOYMENT RATE (HIGH THAN PREDICTED )
As shown in Figure 8, over the past two decades, the Fed has set the
federal funds rate, a key gauge of the stance of monetary policy, in a

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fairly consistent relative to various economic indicators such as
unemployment and inflation. (Figure 8 shows the quarterly average
funds rate and unemployment rate, and the four-quarter inflation rate for
prices of core personal consumption expenditures.) During the current
and two previous recessions—around 1991, 2001, and 2008—the Fed
responded to large jumps in unemployment with aggressive cuts in the
funds rate. In addition, episodes of lower inflation also were generally
associated with a lower funds rate.

Figure 8: Federal Funds rates, Unemployment rates, Inflations rates

The unemployment rate is important as a gauge of joblessness. For this
reason, it's also a gauge of the economy's growth rate.
However, the unemployment rate is a lagging indicator. This means it
measures the effect of economic events, such as a recession, and so
occurs after one has already started. It also means the unemployment
rate will continue to rise even after the economy has started to recover.
The unemployment rate is another indicator used by the Federal Reserve
to determine the health of the economy when setting monetary policy.
Investors also use unemployment statistics to look at which sectors are
losing jobs faster. They can then determine which sector-specific mutual
funds to sell.
The year-over-year unemployment rate will tell you if unemployment is
worsening. If more people are looking for work, less people will be

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buying, and the retail sector will decline. Also, if you are unemployed
yourself, it will tell you how much competition you have, and how much
leverage you might have in negotiating for a new position. As the
unemployment rate reaches 6-7%, the government gets concerned, and
tries to create jobs through stimulating the economy. It may also extend
or add benefits to help the unemployed.
 After implementing the QE-1, Unemployment peaked at
10.2% in October 2009. It rose steadily from its low of 4.4% in
March 2007. It did not really become a concern until a year later
when it broke above 5% in March 2008. By then, the economy
had contracted., the unemployment rate rose rapidly, breaking
6.2% in August 2008, 7.2% by November 2008, 8.1% by
February 2009, and 9.4% three months later, finally reaching
10.2% in October, 2009.
 After the QE-2 enacted, although unemployment is projected
to range between 8.7-9.1% through 2011, according to the
Federal Reserve's June 2011 forecast. But, it will decline slowly,
falling to 7.5-8.7% in 2012, 6.5 - 8.3% in 2013. These forecasts
seem a little optimistic, since unemployment was still 9.1% as of
August 2011. (See in Figure 9)

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Figure 9: Unemployment rate historical data from 1948 to 2012
Source: US Bureau Labor Statistics

Figure 10: Unemployment rate vs. Jobs hard to get (1978-9/2011)
Source: US Department of Labor and The Confidence Board

In its monthly survey of consumer confidence, the Conference Board asks their
respondents whether jobs are available, plentiful, or hard to get. The percentage
saying that ―jobs are hard to get‖ (JHTG) is highly correlated with the
unemployment rate. In August, (Figure 10) it increased to 50% from 44.8% in
July. Its most recent low was 42.4% during April 2011. So the labor market has
actually been deteriorating every month for the past three months, according to
this measure. It gets worse: The latest reading is the highest since May 1983.
And that’s after the White House spent $880 billion aimed at creating 3.7
million jobs over the past two and a half years.
 The main reason for this issue was an ineffective method ―money
infusion‖ too much. It makes commodity price soar highly, reaches out
of consumers’ hands. Declining in retail sales, supply, CPI… gave an
impulse to downsize or dismiss workers. In addition, most businesses
slashed their payrolls in 2008 and 2009 and didn’t turn around and

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rehire everyone they let go. Still, the high correlation between JHTG
and the jobless rate is unnerving given that the former is the highest in
almost three decades.
Commodity price (crucial part)

Figure 11: Real Retail Sales
Source: Federal Reserve Board

The rise in commodity prices has directly increased the rate of inflation
while also adversely affecting consumer confidence and consumer
spending. It is shown clear in Figure 11, which indicated that the CPI
(consumer price index) was one of elements affecting the change in
retail sales. In figure 11, the retail sales had some good news from
economic recovery, commodity price still so high for consumer.

The basic facts are familiar. Oil prices have risen significantly, with the
spot price of West Texas Intermediate crude oil near $100 per barrel as
of the end of last week, up nearly 40 percent from a year ago.
Proportionally, prices of corn and wheat have risen even more, roughly
doubling over the past year. And prices of industrial metals have
increased notably as well, with aluminum and copper prices up about
one-third over the past 12 months. When the price of any product moves

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sharply, the economist's first instinct is to look for changes in the supply
of or demand for that product. And indeed, the recent increase in
commodity prices appears largely to be the result of the same factors
that drove commodity prices higher throughout much of the past decade:
strong gains in global demand that have not been met with
commensurate increases in supply.

From 2002 to 2008, a period of sustained increases in commodity prices,
world economic activity registered its fastest pace of expansion in
decades, rising at an average rate of about 4-1/2 percent per year. This
impressive performance was led by the emerging and developing
economies, where real activity expanded at a remarkable 7 percent per
annum. The emerging market economies have likewise led the way in
the recovery from the global financial crisis: From 2008 to 2010, real
gross domestic product (GDP) rose cumulatively by about 10 percent in
the emerging market economies even as GDP was essentially
unchanged, on net, in the advanced economies.

Naturally, increased economic activity in emerging market economies
has increased global demand for raw materials. Moreover, the heavy
emphasis on industrial development in many emerging market
economies has led their growth to be particularly intensive in the use of
commodities, even as the consumption of commodities in advanced
economies has stabilized or declined. For example, world oil
consumption rose by 14 percent from 2000 to 2010; underlying this
overall trend, however, was a 40 percent increase in oil use in emerging
market economies and an outright decline of 4-1/2 percent in the
advanced economies. In particular, U.S. oil consumption was about 2-
1/2 percent lower in 2010 (Figure 12) than in 2000, with net imports of
oil down nearly 10 percent, even though U.S. real GDP rose by nearly
20 percent over that period.

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Figure 12: Crude oil chart (May, 2010- May, 2011)
Source: Finviz.com

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Figure 13: US dollar chart (5/2010 – 5/2011)
Source: Finviz.com

Figure 14: CRB Index (Commodity Price Index) (5/2010 – 5/2011)
Source: Finviz.com

The value of the US Dollar and the price of Crude Oil are DIRECTLY
RELATED (as comparing two charts in Figure 12 and Figure 13) and anyone
that would deny that is either Liar, a Cheat, a Buffoon, an Idiot or a shill for the
Federal Reserve and Wall Street which makes a fortune when there is a lot of
volatility in the currency markets and thus they hate more than anything in the
world a stable US Dollar.

- Let’s have a close look in two charts in Figure 13 and Figure 14.
Notice in the above two charts of the US Dollar and the CRB Index
that when Bernanke, the Fed’s chairman, started talking about
cranking up the printing presses in June 2010 that the value of the
Dollar began falling and the prices of commodities started rising.

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- Also, note that in Nov., 2010 that the value of the US Dollar rallied
for a few weeks and the CRB Index that tracks the prices for
commodities went down over the same timeframe.
- Next note at the beginning of 2011 that the value of the US Dollar
started to fall again the prices of commodities started to go up.
 Finally, note that since early May that the value of the US Dollar has
stabilized in the 74 to 76 range that comm0odity prices have
stabilized as well and even started to come down as traders and
investors around the world .
 So, as we know, he value of the US Dollar falls due to the out-of-
control “money printing” at the Fed, of course commodity
prices that are priced in Dollars would go up. Something that
most everyone at the Federal Reserve forgot long ago, but then the
Fed and US Treasury were after something else when it comes to all
this money printing and devaluation of the US Dollar and that was
goosing the stock market in hopes that companies and the American
People would think that everything is now ―fine and dandy,‖ the
economy is back on track and all of the unwashed masses will be
solved by the Fed.

THE FED’S BALANCE SHEET AFTER TWO QE

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Figure 15: The Fed’s liabilities
Source: Board of Governors of the FED

The dollar might soar again. That is good as same as bad news. It led to a
flight away from counterparty risk and a flight to quality. The US Dollar Index
soared from a low of 71.99 during the summer of 2008 to a peak of 89.54 on
March 4, 2009.

In figure 15, the Fed’s liabilities blew very high in the financial crisis
period (2007- 2009). And after ending the QE-2 (2011) again soar
quickly and higher than ever. Because the Fed’s monetary policy in
crisis basically injects money into market to avoid the financial
institution collapses, encourage risky investments, stimulus
manufacturing and consuming. To do these things, the first action is to
help borrowers lending money by easing credit (other name of QE). or
put money in the consumers’ hands to push them run the consuming
cycle. Purchasing Treasury securities and other long term securities are
to lower down the short-term rate and also Federal funds rate to make
money ―flood‖ in market.
But with the huge amount of debts, it may be a signal for new recession:
(1) Foreign official and international accounts deposited $102.8
billion at the Fed, up sharply from $57.6 billion at the start of the
year, and well above the previous high of $88.9 billion during the
week of January 7, 2009.
(2) The flight to quality is most apparent in the plunge in 10-year
government bond yields around the world to record lows. This
morning these yields are at 0.92% in Switzerland, 1.00% in Japan,
1.66% in Sweden, 1.71% in Germany, 1.89% in the US, 2.11% in

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Canada, 2.19% in the UK, and 2.47% in France. On the other hand,
yields are much higher among the credit-challenged governments of
Spain (5.19%), Italy (5.44%), and Greece (18.56%).
(3) At the end of last week, the high yield spread in the US widened
to 651bps from 416bps at the beginning of the year. It is the widest
since November 30, 2009. This spread is an excellent leading
economic indicator and suggests that the outlook is deteriorating.

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