Development Through Wage-Led Growth
Henry C.K. Liu
Part I:    Stagnant Worker Income Leads to Overcapacity
Part II:  Gold Keeps Rising as Other Commodities Fall
Part III: Labor Markets de-linked from the Gold Market

Part IV: Central Banks and Gold

This article appeared in AToL on January 6, 2011

The official central bank gold holdings (listed by amount of gold) as of December 2010 are as follows:
United States: 8,133.5 tonnes, about 73.9% of national forex reserve;
Germany: 3,401.8 tonnes, about 70.3% of national forex reserve;
IMF: 2,846.7 tonnes, percentage of forex reserve not known;
Italy: 2,451.8 tones, about 68.6% of national forex reserve;
France: 2,435.4 tonnes, about 67.2% of national forex reserve;
China: 1,054.1 tonnes, about 1.7% of national forex reserve;
Switzerland: 1,040.1 tonnes, about 16.4% of national forex reserve.
Portugal, with only 382.5 tonnes, has the highest percentage of national forex reserve of 81.1%;
Greece, with only 111.7 tonnes, has the next highest percentage of national forex reserve at 78.7%.
The low percentage of national forex reserve in gold for China is due to its large forex reserve holding.
The high percentages for Portugal and Greece are due to the small size their forex reserves.
The gold listed above for each of the countries may not be physically stored inside the country as central banks generally have not allowed independent audits of their reserves.
Gold Holdings Corp., a publicly listed gold company, estimates that the amount of in-ground verified gold resources currently controlled by publicly traded gold mining companies is roughly 50,000 tonnes.
In 2008, central banks held about 18% of the world’s gold, jewelry took up 52%, private investment held 16%, industry uses 12%, 2% unaccounted for. As of October 2009, gold exchange-traded funds held 1,750 tonnes of gold for private and institutional investors.
Gold Holding not a Central Bank Prime Function
Among the prime functions of a central bank are to issue the nation’s currency that is legal tender for all debts, public and private, and to formulate monetary policy setting short-term interest rate (the cost of money) to maintain optimum economic growth without inflation, and by managing the money supply (the quantity of money) through setting the discount rate to sustain a robust economy.
The Federal Reserve, the US central bank, describes its role in setting the nation’s monetary policy as “to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates. The challenge for policy makers is that tensions among the goals can arise in the short run and that information about the economy becomes available only with a lag and may be imperfect.” The role of gold is not mentioned.
It describes the goals of monetary policy as spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Mar­ket Committee should seek “to promote effectively the goals of maxi­mum employment, stable prices, and moderate long-term interest rates.”
The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve Banks. Depository institutions have accounts at their respective regional Reserve Banks, and they actively trade balances held in these accounts in the federal funds market at an interest rate known as the federal funds rate. The Federal Reserve exercises considerable control over the federal funds rate through its influence over the supply of and demand for balances at the Reserve Banks.
In the federal funds market, depository institutions actively trade balances held at the Federal Reserve with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds rate—the interest rate at which these transactions occur—is an important benchmark in financial markets. Daily fluctuations in the federal funds rate reflect demand and supply conditions in the market for Federal Reserve balances.
The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments. A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect other short-term interest rates, longer-term interest rates, the foreign exchange value of the dollar, and stock prices. In turn, changes in these variables will affect households’ and businesses’ spending decisions, thereby affecting growth in aggregate demand and the economy.
Short-term interest rates, such as those on Treasury bills and commercial paper, are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Federal Reserve surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Federal Reserve was going to be holding the federal funds rate lower than had been anticipated.
Similarly, short-term interest rates would increase if the Federal Reserve surprised market participants by announcing an increase in the federal funds rate, or if some event prompted market participants to believe that the Federal Reserve was going to be holding the federal funds rate at higher levels than had been anticipated.
Thus the Fed funds rate has come to be regarded by the market as an indicator of the Central banks view on the current and future conditions of the economy and commensurate monetary policy responses.
Monetary aggregates have at times been advocated as guides to monetary policy on the grounds that they may have a fairly stable relationship with the economy and can be controlled to a reasonable extent by the central bank, either through control over the supply of balances at the Federal Reserve or the federal funds rate. An increase in the federal funds rate (and other short-term interest rates), for example, will reduce the attractiveness of holding money balances relative to now higher-yielding money market instruments and thereby reduce the amount of money demanded and slow growth of the money stock. There are a few measures of the money stock—ranging from the transactions-dominated M1 to the broader M2 and M3 measures, which include other liquid balances—and these aggregates have different behaviors.

On March 23, 2006, the Fed under Bernanke stopped tracking M3, the broadest measure of US money supply, arguing it had not been used in interest rate decisions for some time, as if that was a rational justification rather than an operational neglect that needed to be corrected. The term ‘credit easing’ reflects the Fed’s focus on bank balance sheets, rather than ‘quantitative easing’ which describes the boosting of the money supply.  (Please see my September 11, 2009 AToL article: Federal Reserve Power Unsupported by Credibility)

Traditionally, the rate of money growth sought over time would be equal to the rate of nominal GDP growth implied by the objective for inflation and the objective for growth in real GDP. For example, if the objective for inflation is 1 percent in a given year and the rate of growth in real GDP associated with achieving maximum employment is 3 percent, then the guideline for growth in the money stock would be 4 percent.
However, the relation between the growth in money and the growth in nominal GDP, known as “velocity,” can vary, often unpredictably, and this uncertainty can add to difficulties in using monetary aggregates as a guide to policy. The narrow and broader aggregates often give very different signals about the need to adjust policy. Accordingly, monetary aggregates have taken on less importance in policy making over time
Letting interest rates play a primary role in guiding monetary policy is problematic because of the uncertainty about exactly what level or path of interest rates is consistent with the basic goals of monetary policy. The appropriate level of interest rates will vary with the stance of fiscal policy, changes in the pattern of household and business spending, productivity growth, and economic developments abroad. It can be difficult to gauge the relative strength of these forces and to translate them into a path for interest rates.
The slope of the yield curve (that is, the difference between the interest rate on longer-term and shorter-term instruments) has also been suggested as a guide to monetary policy. Whereas short-term interest rates are strongly influenced by the current setting of the policy instrument, longer-term interest rates are influenced by expectations of future short-term interest rates and thus by the longer-term effects of monetary policy on inflation and output.
For example, a yield curve with a steeply positive slope (that is, longer-term interest rates far above short-term rates) may be a signal that participants in the bond market believe that monetary policy has become too expansive and thus, without a monetary policy correc­tion, more inflationary. Conversely, a yield curve with a downward slope (short-term rates above longer rates) may be an indication that policy is too restrictive, perhaps risking an unwanted loss of output and employment. However, the yield curve is also influenced by other factors, including prospective fiscal policy, developments in foreign exchange markets, and expectations about the future path of monetary policy. Thus, signals from the yield curve must be interpreted carefully.
The Taylor Rule
The “Taylor rule,” named after economist John Taylor, relates the setting of the federal funds rate to the primary objectives of monetary policy—that is, 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. For example, one version of the rule calls for the federal funds rate to be set equal to the rate thought to be consistent in the long run with the achievement of full employment and price stability plus a component based on the gap between current inflation and the inflation objective less a component based on the shortfall of actual output from the full-employment level. If inflation is picking up, the Taylor rule prescribes the amount by which the federal funds rate would need to be raised or, if output and employment are weakening, the amount by which it would need to be lowered. The specific parameters of the formula are set to describe actual monetary policy behavior over a period when policy is thought to have been fairly successful in achieving its basic goals.
Although this guide has appeal, it too has shortcomings. 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 difficulties in estimating the full-employment level of output, adding another layer of uncertainty about the appropriate setting of policy.
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, for example, could indicate that monetary policy has become, or is expected to become, more accommodative, resulting in inflation risks. 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—or expectations of such a move. But it also could reflect expectations of a lower path for interest rates elsewhere or a heightened perception of risk in foreign financial as­sets 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 def lation and economic slack or to an overheated economy. Also, attempting to stabilize the exchange 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 US economy.

The Fed has a long tradition in supporting the lead of the Treasury in intervening on the exchange value of the dollar, albeit not always to keep the dollar strong. (Please see my June 17, 2008 AToL article: The Fed and the Strong Dollar Policy)

The Reagan administration by its second term discovered an escape valve from Volcker's independent domestic policy of stable-valued money. In an era of growing international trade among Western allies, with the mini-globalization to include the developing countries before the final collapse of the Soviet Bloc, a booming market for foreign exchange had been developing since Nixon's abandonment of the gold standard and the Bretton Woods regime of fixed exchange rates in 1971. The exchange value of the dollar thus became a matter of national security and as such fell within the authority of the president that required the Fed's patriotic support. (Please see my series: Critique of Central Banking)
Foreign Currency Operations
The Federal Reserve conducts foreign currency operations—the buying and selling of dollars in exchange for foreign currency—under the direction of the FOMC, acting in close and continuous consultation and cooperation with the US Treasury, which has overall responsibility for US international financial policy. The manager of the System Open Market Account at the Federal Reserve Bank of New York acts as the agent for both the FOMC and the Treasury in carrying out foreign currency operations. Since the late 1970s, the US Treasury and the Federal Reserve have conducted almost all foreign currency operations jointly and equally.
The purpose of Federal Reserve foreign currency operations has evolved in response to changes in the international monetary system. The most important of these changes was the transition in the 1970s from a system of fixed exchange rates—established in 1944 at an international monetary conference held in Bretton Woods, New Hampshire—to a system of flexible (or floating) exchange rates for the dollar in terms of other countries’ currencies.
Under the Bretton Woods Agreements, which created the IMF and the International Bank for Reconstruction and Development (known informally as the World Bank), foreign authorities were responsible for intervening in exchange markets to maintain their countries’ exchange rates within 1 percent of their currencies’ parities with the US dollar; direct exchange market intervention by US authorities was extremely limited. Instead, US authorities were obliged to buy and sell dollars against gold to maintain the dollar price of gold near $35 per ounce.
After the United States suspended the gold convertibility of the dollar in 1971, a regime of f lexible exchange rates emerged; in 1973, un­der that regime, the United States began to intervene in exchange markets on a more significant scale. In 1978, the regime of flexible exchange rates was codified in an amendment to the IMF’s Articles of Agreement.
Under flexible exchange rates, the main aim of Federal Reserve foreign currency operations has been to counter disorderly conditions in exchange markets through the purchase or sale of foreign currencies (called foreign exchange intervention operations), primarily in the New York market. During some episodes of downward pressure on the foreign exchange value of the dollar, the Federal Reserve has purchased dollars (sold foreign currency) and has thereby absorbed some of the selling pressure on the dollar.
Similarly, the Federal Reserve may sell dollars (purchase foreign currency) to counter upward pressure on the dollar’s foreign exchange value. The Federal Reserve Bank of New York also executes transactions in the US foreign exchange market for foreign monetary authorities, us­ing their funds.
In the early 1980s, the United States curtailed its official exchange market operations, although it remained ready to enter the market when necessary to counter disorderly conditions.
In 1985, particularly after September, when representatives of the five major industrial countries reached the so-called Plaza Agreement on exchange rates, the United States began to use exchange market intervention as a policy instrument more frequently. Between 1985 and 1995, the Federal Reserve—sometimes in coordination with other central banks—intervened to counter dollar movements that were perceived as excessive. Based on an assessment of past experience with official intervention and a reluctance to let exchange rate issues be seen as a major focus of monetary policy, US authorities have intervened only rarely since 1995.
Intervention operations involving dollars affect the supply of Federal Re­serve balances to US depository institutions, unless the Federal Reserve offsets the effect. A purchase of foreign currency by the Federal Reserve increases the supply of balances when the Federal Reserve credits the account of the seller’s depository institution at the Federal Reserve. Conversely, a sale of foreign currency by the Federal Reserve decreases the supply of balances. The Federal Reserve offsets, or “sterilizes,” the effects of intervention on Federal Reserve balances through open market operations; otherwise, the intervention could cause the federal funds rate to move away from the target set by the FOMC.
Interest Rates Policy
Whereas short-term interest rates are strongly influenced by the current setting of the policy instrument, longer-term interest rates are influenced by expectations of future short-term interest rates and thus by the longer-term effects of monetary policy on inf and output.
By late 1982, it had become clear to central bankers that the combination of interest rate deregulation and financial innovation had weakened the historical link between M1 and the economic objectives of monetary policy. The FOMC began to make more discretionary decisions about money market conditions, using a wider array of economic and financial variables to judge the need for adjustments in short-term interest rates. In the day-to-day implementation of open market operations, this change was manifested in a shift of focus from a nonborrowed-reserve target to a borrowed-reserve target.

The Federal Reserve routinely supplied fewer nonbor­rowed reserves than the estimated demand for total reserves, thus forcing depository institutions to meet their remaining need for reserves by borrowing at the discount window. The total amount borrowed was limited, however, even though the discount rate was generally below the federal funds rate, because access to discount window credit was restricted. In particular, depository institutions were required to pursue all other reasonably available sources of funds, including those available in the federal funds market, before credit was granted. During the time it was targeting borrowed reserves, the Federal Reserve influenced the level of the federal funds rate by controlling the extent to which depository institu­tions had to turn to the discount window. When it wanted to ease monetary policy, it would reduce the borrowed-reserve target and supply more nonborrowed reserves to meet estimated demand. With less pressure to borrow from the discount window, deposi­tory institutions would bid less aggressively for balances at the Federal Reserve and the federal funds rate would fall.

Beginning in the mid-1980s, spreading doubts about the financial health of some depository institutions led to an increasing reluc­tance on the part of many institutions to borrow at the discount window, thus weakening the link between borrowing and the federal funds rate. Consequently, the Federal Reserve increasingly sought to attain a specific level of the federal funds rate rather than a targeted amount of borrowed reserves. In July 1995, the FOMC began to announce its target for the federal funds rate.
Monetary economics is full of ideological myths that are nore supported by actual data. It is therefore not surprising that monetary policy makers routinely face notable uncertainties about the causes of economic problems and the proper policy response to them.
To begin with, the identification of causality of economic phenomena is subject to ideological interpretation and the methodology of data collection is affected by conceptual fixations. Further, the actual condition of the economy and the growth in aggregate demand at any point in time are only partially known, as key information on spending, production, and prices becomes available only with a lag even to central banker who are given advanced reports before such information is released to the public. Therefore, central bank policy makers must rely on estimates of these economic variables when assessing the appropriate course of policy, being aware that they could and often did act on the basis of misleading or misunderstood information.
Second, in economics, as is true in all social sciences, it is difficult if not impossible to predict the effect of policy measures. For example, exactly how a given adjustment in the federal funds rate will affect growth in aggregate demand—in terms of both the overall magnitude and the timing of its impact—is never certain, either in theory or practice. Economic models can provide rules of thumb for how the economy will respond, but these rules of thumb are subject to conceptual faults and statistical error.
Most model builders assume reality to be rational and orderly. In fact, life is full of misinformation, errors of judgment, miscalculations, communication breakdowns, ill will, legalized fraud, unwarranted optimism, prematurely throwing in the towel, etc. One view of the business world is that it is a snake pit. Very few economic models reflect that perspective. (Please see my January 10, 2004 AToL article: Fed’s Pugnacious Policies Hurt Economies)
Third, the growth in aggregate supply, often called the growth in potential output, cannot be measured with certainty.
According to monetarists at the Fed: The key is the growth of the labor force and associated labor input, as well as underlying growth in labor productivity. Growth in labor input typically can be measured with more accuracy than underlying productivity; for some time, growth in labor input has tended to be around the growth in the overall population of one percentage point per year. However, underlying productivity growth has varied considerably over recent decades, from approximately 1% or so per year to somewhere in the neighborhood of 3% or even higher, getting a major boost during the mid- and late 1990s from applications of information technology and advanced management systems.
If, for example, productivity growth is 2% per year, then growth in aggregate supply would be the sum of this amount and labor input growth of 1% — that is, 3% per year. In which case, growth in aggregate demand in excess of 3% per year would result in a pickup in growth in employment in excess of that of the labor force and a reduction in unemployment. In contrast, growth in aggregate demand below 3% would result in a softening of the labor market and, in time, a reduction in inflationary pressures.
By its own admission, Fed monetarists view growth in aggregate demand as ideally not be more that 3% per year lest inflation will neutralize the benefit of growth. Yet growth in aggregate demand in excess of 3% per year is needed to produce growth in employment, in excess of that of the labor force, to reduce unemployment. Therefore a noninflationary monetary policy stance will condemn the US economy to perpetual high unemployment.
Below is a record of US GDP complied by Kimberly Amadeo:
Q3 2010 GDP:
Advance Report - The economy only grew 2%, prompting additional Fed easing.
Second Report - Growth was revised up to 2.5%, due businesses increasing their inventory levels.
Q2 2010 GDP: 2.4%
Advance Report - Businesses buying durable goods drove 2.4% economic growth.
Second Report - Growth was revised down to 1.6%, due to less inventory replenishment than the BEA originally thought.
Final Report - Economy chugs along at a 1.7% growth rate, driven by business spending on equipment and computers.
Q1 2010 GDP: 3.7% (Was 2.7%)
Advance Report - The economy grew 3.2% because Americans are shopping again.
Second Report - Economic growth was revised down to 3% thanks to new data showing higher exports.
Final Report - Turns out the economy grew 2.7% in Q1.
2009 GDP for the Year: -2.6% (Was -2.4%)
Q4 2009 GDP: 5% (Was 5.6%)
Advance Report - The economy grew 5.7%, but half of that growth was based on businesses re-stocking low inventory.
Second Report - Economic growth was revised up to 5.9%, but businesses re-stocking low inventory drove 4 points of that growth.
Third Report - The report said 5.6% growth, but after taking out restocking of low inventory, the real number was 1.8%.
Q3 2009 GDP: 1.6% (Was 2.2%)
Advance Report - The economy grew 3.5%, which meant that technically the recession was over.
Second Report - Growth was revised down to 2.8%.
Third Report - Growth was revised down to 2.2%.
Q2 2009 GDP: -.7% (No revision)
Advance Report - Government spending propped up the economy, which contracted 1%.
Second Report - In a very unusual move, the BEA did not adjust its estimate, which remained at -1%.
Third Report - The economy declined .7% in Q2 2009.
Q1 2009 GDP: -4.9% (Was -6.4%)
Advance Report: - The economy fell 6.1%, partly due to leaner inventories.
Second Report: - The economy contracted 5.7% in Q1 2009, according to revised figures in the preliminary GDP report.
Final Report: - Growth was down 5.5%. The economy contracted more than 5% for two quarters in a row, the first time since the Great Depression.
2008 GDP for the Year: 0% (Was .4%)
Q4 2008 GDP: -6.8% (Was -5.4%)
Advance Report: - Growth was down 3.8%, the worst since the 1982 recession.
Second Report: - GDP was revised down to -6.1%.
Final Report: - GDP was revised further down to -6.3%, the worst since Q1 1982, when GDP fell 6.4%.
Q3 2008 GDP: -4% (Was -2.7%)
Advance Report - Growth was down .3%, the second time in a year.
Second Report - Growth slowed .5%, slightly more than the advance estimate of .3%.
Third Report: - Whether -.3% or -.5%, the economy declined in Q3.
Q2 2008 GDP: .6% (Was 1.5%)
Advance Report: - The economy grew 1.9%. Revisions for 2007 were also released: 2007 GDP grew 2% and Q4 GDP fell .2%.
Second Report - Growth for Q2 2008 was revised up to 3.3%, thanks to new data about increased exports and decreased imports.
Third Report - Released when the economy was in the grips of a credit crunch, the BEA's downward revision only fueled further pessimism.
Q1 2008 GDP: -.7% (No revision)
Advance Report: - Why slow growth at .6%, though painful, meant the economy (could have) avoided a recession.
Second Report - Growth was revised up to .9%. Why it still felt like a recession, even though it technically wasn't.
Third Report - Growth was revised up to 1% thanks to exports.
2007 GDP for the Year: 1.9% (Was 2.1%)
Q4 2007: 2.9% (Was 2.1%)
Advance Report - Why the economy slumped to .6% and the risk of recession.
Second Report - New data confirmed growth was only .6%.
Third Report - No revisions. Growth still at .6%.
In April 2008, the BEA revised Q4 2007 GDP to -.2%, declaring the start of the current recession.
Q3 2007 GDP: 2.3% (Was 3.6%)
Advance Report: - Why GDP was still so healthy at 3.9%, why it might have declined in Q4, and the annual outlook.
Second Report - Discusses the surprising jump in GDP growth to 4.9%, the factors behind the revision, and the outlook for Q4.
Third Report - Why the Final Report remained at a still astounding 4.9%.
In April 2008, the BEA revised Q3 2007 GDP to 4.8% (same as Q2 2007 revision).
Q2 2007 GDP: 3.2% (No revision)
Advance Report: - Why it was unlikely that GDP could go from .6% in Q1 to 3.4% in Q2
Second Report - Why GDP was revised up to an astounding 4%.
Third Report - Why the Final Report was revised down slightly to 3.8%.
In April 2008, the BEA revised Q2 2007 GDP to 4.8%.
Q1 2007 GDP: .9% (Was 1.2%)
Advance Report: - The significance of 1.2% GDP growth to you.
Deja Vu - Dow High, GDP Low - Why the stock market hit a new high when the underlying economy dropped to a new low. How this was like March 2000, the beginning of the last recession.
Second Report - Why GDP was revised down to .5.
Third Report - GDP was revised up .1 point, to .6%, the lowest growth rate in four years.
In April 2008, the BEA revised Q1 2007 GDP to .1%. In July 2010, the BEA revised it again to .9%.
2006 GDP for the Year: 2.7% (Was 2.8%)
Q4 2006 GDP: 3% (Was 1.5%)
Advance Report - Why growth was up 3.5%.
Second Report - Why growth was only 2.2%.
Third Report - Why growth was revised up to 2.5%.
These GDP figures add up to the prospect of a decade of slow growth (less than 3%) with high unemployment for the US economy.
Depository institutions Balances Held at the Reserve Banks
The Federal Reserve exercises considerable control over the demand for and supply of balances that depository institutions hold at the Reserve Banks. In so doing, it influences the federal funds rate and, ultimately, employment, output, and prices.
Beyond influencing the level of prices and the level of output in the near term, the Federal Reserve can contribute to financial stability and better economic performance by acting to contain financial disruptions and pre­venting their spread outside the financial sector.
The Federal Reserve can enhance the financial system’s resilience to such shocks through its regulatory policies toward banking institutions and payment systems. If a threatening disturbance develops, the Federal Reserve can also cushion the impact on financial markets and the economy by aggressively and visibly providing liquidity through open market operations or discount window lending.
The Federal Reserve implements US monetary policy by affecting conditions in the market for balances that depository institutions hold at the Federal Reserve Banks. The operating objectives or targets that it has used to effect desired conditions in this market have varied over the years. At one time, the FOMC sought to achieve a specific quantity of balances, but now it sets a target for the interest rate at which those balances are traded between depository institutions—the federal funds rate.
Demand for Federal Reserve Balances
The demand for Federal Reserve balances has three components: required reserve balances, contractual clearing balances, and excess reserve balances.
Required Reserve Balances
Required reserve balances are balances that a depository institution must hold with the Federal Reserve to satisfy its reserve requirement. Reserve requirements are imposed on all depository institutions—which include commercial banks, savings banks, savings and loan associations, and credit unions—as well as US branches and agencies of foreign banks and other domestic banking entities that engage in international transactions. Since the early 1990s, reserve requirements have been applied only to transaction deposits, which include demand deposits and interest-bearing accounts that offer unlimited checking privileges. An institution’s reserve requirement is a fraction of such deposits; the fraction—the required reserve ratio—is set by the Board of Governors within limits prescribed in the Federal Reserve Act. A depository institution’s reserve requirement expands or contracts with the level of its transaction deposits and with the required reserve ratio set by the Board. In practice, the changes in required reserves reflect movements in transaction deposits because the Federal Reserve adjusts the required reserve ratio only infrequently.
A depository institution satisfies its reserve requirement by its holdings of vault cash (currency in its vault) and, if vault cash is insufficient to meet the requirement, by the balance maintained directly with a Federal Re­serve Bank or indirectly with a pass-through correspondent bank (which in turn holds the balances in its account at the Federal Reserve). The difference between an institution’s reserve requirement and the vault cash used to meet that requirement is called the required reserve balance. If the balance maintained by the depository institution does not satisfy its reserve balance requirement, the deficiency may be subject to a charge.
Contractual Clearing Balances
Depository institutions use their accounts at Federal Reserve Banks not only to satisfy their reserve balance requirements but also to clear many financial transactions. Given the volume and unpredictability of transac­tions that clear through their accounts every day, depository institutions seek to hold an end-of-day balance that is high enough to protect against unexpected debits that could leave their accounts overdrawn at the end of the day and against any resulting charges, which could be quite large. If a depository institution finds that targeting an end-of-day balance equal to its required reserve balance provides insufficient protection against over­drafts, it may establish a contractual clearing balance (sometimes referred to as a required clearing balance).

A contractual clearing balance is an amount that a depository institution agrees to hold at its Reserve Bank in addition to any required reserve balance. In return, the depository institution earns implicit interest, in the form of earnings credits, on the balance held to satisfy its contractual clearing balance. It uses these credits to defray the cost of the Federal Reserve services it uses, such as check clearing and wire transfers of funds and securities. If the depository institution fails to satisfy its contractual requirement, the deficiency is subject to a charge.

Excess Reserve Balances
A depository institution may hold balances at its Federal Reserve Bank in addition to those it must hold to meet its reserve balance requirement and its contractual clearing balance; these balances are called excess reserve balances (or excess reserves). In general, a depository institution attempts to keep excess reserve balances at low levels because balances at the Fed­eral Reserve do not earn interest.
However, a depository institution may aim to hold some positive excess reserve balances at the end of the day as additional protection against an overnight overdraft in its account or the risk of failing to hold enough balances to satisfy its reserve or clearing bal­ance requirement. This desired cushion of balances can vary considerably from day to day, depending in part on the volume and uncertainty about payments f lowing through the institution’s account.
The daily demand for excess reserve balances is the least-predictable component of the de­mand for balances. (See table 3.1 for data on required reserve balances, contractual clearing balances, and excess reserve balances.)
Reverse Repurchase Agreements
When the Federal Reserve needs to absorb Federal Reserve balances tem­porarily, it enters into reverse repurchase agreements with primary dealers. These transactions involve selling a Treasury security to a primary dealer under an agreement to receive the security back on a specified date. As in repurchase agreement transactions, these operations are arranged on an auction basis. When the Federal Reserve transfers the collateral (usually a Treasury bill) to the dealer, the account of the dealer’s clearing bank at the Federal Reserve is debited, and total Federal Reserve balances decline. When the transaction unwinds, the account of the dealer’s clearing bank is credited and total balances increase.
Every business day, the Federal Reserve also arranges reverse repurchase agreements with foreign official and international accounts. These insti­tutions have accounts at the Federal Reserve Bank of New York to help manage their US dollar payments and receipts. The Federal Reserve permits these institutions to invest cash balances overnight through these agreements.
Reserve Requirements
Reserve requirements have long been a part of our nation’s banking his­tory. Depository institutions maintain a fraction of certain liabilities in reserve in specified assets. The Federal Reserve can adjust reserve require­ments by changing required reserve ratios, the liabilities to which the ratios apply, or both. Changes in reserve requirements can have profound effects on the money stock and on the cost to banks of extending credit and are also costly to administer; therefore, reserve requirements are not adjusted frequently. Nonetheless, reserve requirements play a useful role in the con­duct of open market operations by helping to ensure a predictable demand for Federal Reserve balances and thus enhancing the Federal Reserve’s control over the federal funds rate.
Requiring depository institutions to hold a certain fraction of their de­posits in reserve, either as cash in their vaults or as non-interest-bearing balances at the Federal Reserve, does impose a cost on the private sector. The cost is equal to the amount of forgone interest on these funds—or at least on the portion of these funds that depository institutions hold only because of legal requirements and not to meet their customers’ needs.
Reserve requirements play a useful role in the conduct of open market operations by helping to ensure a predictable demand for Federal Reserve balances.
The burden of reserve requirements is structured to bear generally less heavily on smaller institutions. At every depository institution, a certain amount of reservable liabilities is exempt from reserve requirements, and a relatively low required reserve ratio is applied to reservable liabilities up to a specific level. The amounts of reservable liabilities exempt from reserve requirements and subject to the low required reserve ratio are adjusted annually to reflect growth in the banking system.
The Discount Window
The Federal Reserve’s lending at the discount window serves two pri­mary functions. It complements open market operations in achieving the target federal funds rate by mak­ing Federal Reserve balances available to depository institu­tions when the supply of balances falls short of demand. It also serves as a backup source of liquidity for individual depository institutions.
Although the volume of discount window borrowing is rela­tively small, it plays an important role in containing upward pressures on the fed­eral funds rate. If a depository institution faces an unexpectedly low balance in its account at the Federal Reserve, either because the total supply of balances has fallen short of demand or because it failed to receive an expected transfer of funds from a counterparty, it can borrow at the discount window. This extension of credit increases the supply of Federal Reserve balances and helps to limit any upward pressure on the federal funds rate. At times when the normal functioning of financial markets is disrupted—for example after operational problems, a natural disaster, or a terrorist attack—the discount window can become the principal channel for supplying balances to depository institutions.
The discount window can also, at times, serve as a useful tool for promot­ing financial stability by providing temporary funding to depository insti­tutions that are having significant financial difficulties. If the institution’s sudden collapse were likely to have severe adverse effects on the financial system, an extension of central bank credit could be desirable because it would address the liquidity strains and permit the institution to make a transition to sounder footing. Discount window credit can also be used to facilitate an orderly resolution of a failing institution. An institution ob­taining credit in either situation must be monitored appropriately to ensure that it does not take excessive risks in an attempt to return to profitability and that the use of central bank credit would not increase costs to the de­posit insurance fund and ultimately the taxpayer.
Types of Credit
In ordinary circumstances, the Federal Reserve extends discount window credit to depository institutions under the primary, secondary, and seasonal credit programs. The rates charged on loans under each of these programs are established by each Reserve Bank’s board of directors every two weeks, subject to review and determination by the Board of Governors. The rates for each of the three lending programs are the same at all Reserve Banks, except occasionally for very brief periods following the Board’s action to adopt a requested rate change. The Federal Reserve also has the author­ity under the Federal Reserve Act to extend credit to entities that are not depository institutions in “unusual and exigent circumstances”; however, such lending has not occurred since the 1930s.
Primary Credit
Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight. To assess whether a depository institution is in sound financial condition, its Reserve Bank regularly re­views the institution’s condition, using supervisory ratings and data on ad­equacy of the institution’s capital. Depository institutions are not required to seek alternative sources of funds before requesting occasional advances of primary credit, but primary credit is expected to be used as a backup, rather than a regular, source of funding.
The rate on primary credit has typically been set 1 percentage point above the FOMC’s target federal funds rate, but the spread can vary depending on circumstances. Because primary credit is the Federal Reserve’s main dis­count window program, the Federal Reserve at times uses the term discount rate specifically to mean the primary credit rate.
Reserve Banks ordinarily do not require depository institutions to provide reasons for requesting very short-term primary credit. Borrowers are asked to provide only the minimum information necessary to process a loan, usually the requested amount and term of the loan. If a pattern of borrow­ing or the nature of a particular borrowing request strongly indicates that a depository institution is not generally sound or is using primary credit as a regular rather than a backup source of funding, a Reserve Bank may seek additional information before deciding whether to extend the loan.
Primary credit may be extended for longer periods of up to a few weeks if a depository institution is in generally sound financial condition and can­not obtain temporary funds in the market at reasonable terms. Large and medium-sized institutions are unlikely to meet this test.
Secondary Credit
Secondary credit is available to depository institutions that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight. Reflecting the less-sound financial condition of borrowers of secondary credit, the rate on secondary credit has typically been 50 basis points above the primary credit rate, although the spread can vary as circumstances warrant. Secondary credit is available to help a deposi­tory institution meet backup liquidity needs when its use is consistent with the borrowing institution’s timely return to a reliance on market sources of funding or with the orderly resolution of a troubled institution’s difficulties. Secondary credit may not be used to fund an expansion of the borrower’s assets.

Loans extended under the secondary credit program entail a higher level of Reserve Bank administration and oversight than loans under the primary credit program. A Reserve Bank must have sufficient information about a borrower’s financial condition and reasons for borrowing to ensure that an extension of secondary credit would be consistent with the purpose of the facility. Moreover, under the Federal Deposit Insurance Corpora­tion Improvement Act of 1991, extensions of Federal Reserve credit to an FDIC-insured depository institution that has fallen below minimum capital standards are generally limited to 60 days in any 120-day period or, for the most severely undercapitalized, to only five days.
Seasonal Credit
The Federal Reserve’s seasonal credit program is designed to help small depository institutions manage significant seasonal swings in their loans and deposits. Seasonal credit is available to depository institutions that can demonstrate a clear pattern of recurring swings in funding needs through­out the year—usually institutions in agricultural or tourist areas. Borrow­ing longer-term funds from the discount window during periods of sea­sonal need allows institutions to carry fewer liquid assets during the rest of the year and make more funds available for local lending.

The seasonal credit rate is based on market interest rates. It is set on the first business day of each two-week reserve maintenance period as the aver­age of the effective federal funds rate and the interest rate on three-month certificates of deposit over the previous reserve maintenance period.
Eligibility to Borrow
By law, depository institutions that have reservable transaction accounts or nonpersonal time deposits may borrow from the discount window. US branches and agencies of foreign banks that are subject to reserve require­ments are eligible to borrow under the same general terms and conditions that apply to domestic depository institutions. Banker’s banks, corporate credit unions, and certain other banking institutions that are not subject to reserve requirements generally do not have access to the discount window. However, the Board of Governors has determined that those institutions may obtain access to the discount window if they voluntarily maintain required reserve balances.
Discount Window Collateral
By law, all discount window loans must be secured by collateral to the satisfaction of the lending Reserve Bank. Most loans that are not past due and most investment-grade securities held by depository institutions are ac­ceptable as collateral. Reserve Banks must be able to establish a legal right in the event of default to be first in line to take possession of and, if neces­sary, sell all collateral that secures discount window loans.

Reserve Banks assign a lendable value to assets accepted as collateral. The lendable value is the maximum loan amount that can be backed by that asset. It is based on market values, if available, or par values—in both cases reduced by a margin. The margin depends on how accurately the asset can be valued, how much its value tends to vary over time, the liquidity of the asset, and the financial condition of the pledging institution.
Quantitaive Easing and Long Term Interest Rates
Until central banks resorted to quatitaive easing after the financial crisis that had begun in mid 2007, central banks had not been in the position to set long-term interest rates. This is because long term rates are normally set by market forces in response to the ratio of outstanding long-term debt to the aggregagte amount of savings, both public and private, in the economy. The amount of outstanding long-term debt has been so massive that it is beyond the capacity of central banks to manipulate it without abandoning prudent monetary policy.
In the past two decades, although outstanding long-term debt denominated in dollars has been rising at rapid rate due to both persistent US currenct account (trade) deficits and fiscal deficits, dollar hegemony has compelled the persistent growth of US capital account surplus. This capital account surplus has financed both the currenct accout deficit and the fiscal deficit to keep US long-term rates low. Quantitative easing is essentially a central bank exercise to transfer debt in the private sector into the public sector with the central bank buying private debt from financial institutions in distress with newly issued money though the expansion of the cental bank’s balance sheet. Central banks resort to quantitative easing when short term rates have been cut to zero or near zero and cannot go lowered to stimulate a still depressed economy.

December 20, 2010

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