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. Sterilization
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
infhttp://henryckliu.com/page240.htmllation 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 otherdomestic 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.
