Podcast: How the Fed influences credit market liquidity

As the stock market continues to shake following the crash of the subprime market, all eyes are on the Federal Reserve. Now more than ever it's important to understand how the Fed works. For example, what is the federal funds rate and how does it differ from the discount rate? Here with a primer on how the Federal Reserve operates is Herbert Kaufman, professor of finance at the W. P. Carey School of Business.

As the stock market continues to shake following the crash of the subprime market, all eyes are on the Federal Reserve. Now more than ever it's important to understand how the Fed works. For example, what is the federal funds rate and how does it differ from the discount rate? Here with a primer on how the Federal Reserve operates is Herbert Kaufman, professor of finance at the W. P. Carey School of Business.

Transcript:

Knowledge: As the stock market continues to shake from the crash of the subprime lending market, all eyes are on the Federal Reserve. Here with a primer on how the Federal Reserve operates is Herbert Kaufman, Professor of Finance at the W. P. Carey School of Business. The fed funds rate and the discount rate, what are they? And how do they differ?

Herbert Kaufman: The fed funds rate is the rate that banks pay to borrow from each other. So they pay and receive to borrow from each other overnight. It's the overnight rates on bank reserves, basically between individual commercial banks. And by setting to the federal funds rate, or by keeping the federal funds rate as a target, the Federal Reserve is able to determine the reserve position of the banks, which converts into their liquidity that they have available.

And so, when they set a federal funds rate, for example, which they currently have at 5.25 percent, the intention is that that 5.25 percent will provide the amount of reserves that the banks need to make the kind of credit available that the Fed thinks is consistent with non-inflationary growth. With regard to the discount rate, that's the rate that banks are charged to borrow directly from the Fed itself.

And until this last move the discount rate was fairly irrelevant at this present time. The reason being it is kept at a rate above the federal funds rate to be a penalty rate. The Fed had previously discouraged banks from borrowing except under extreme circumstances. And as a result of that, that discount rate, which had long been regarded as a peripheral part of monetary policy, really ceased to have much of an impact whatsoever.

Knowledge: What are the mechanics of what the Fed actually does to achieve the funds target rate?

Kaufman: The Fed buys and sells primarily U.S. Government securities, although they can expand that, but primarily U.S. Government securities. The actual implementation of what are called open market operations — buying and selling of U.S. Government securities in the open market — is handled through the Federal Reserve Bank of New York.

And there is a manager of the Open Market Trading Desk at the New York Fed that actually looks at the federal funds rate in real time and determines if he has to add or remove reserves from the banking system depending on where the rate is relative to the target rate.

And his goal is to achieve a 5.25 percent currently, because that's the current target — 5.25 percent federal funds rate by buying and selling securities in the open market. That in turn impacts the reserves of the banking system by either injecting reserves when he buys securities, or removing reserves when he sells securities. So that's the mechanics of how it's done. And it's done in real time.

Knowledge: Why is the funds rate more important?

Kaufman: That's an interesting question. But the funds rate is generally the target that the Fed uses to control the reserves in the banking system. That in turn influences the money supply, other interest rates in the economy, as well as the liquidity position of the credit markets and the banks themselves.

All those conspire to affect the availability of credit and the interest rates on that credit available, particularly in the short maturity area of the marketplace.

Knowledge: What does it mean exactly for the Fed to increase the money supply, or raise or lower liquidity?

Kaufman: The Fed doesn't actually control the money supply directly, but by influencing and impacting the reserves of the banking system that induces or reduces the incentive of banks to make more or less loans. And when those loans are made or reduced — the rate of increase is reduced — the money supply will change.

And so, it's an indirect impact on the money supply, but an important one. Another way of thinking about it is the reserves are really the raw material from which the money supply expands or contracts. The process itself is somewhat complicated to explain briefly, but it's a fair approximation to say the reserves are the base on which the money supply changes.

Knowledge: Where does that money come from and where does it go?

Kaufman: The reserves come from the Fed. So when they buy securities the credit bank deposit accounts at the Fed for those funds, and the reserves of the banking system increase. When they sell securities, reserves are removed from those accounts and the amount of reserves in the banking system are reduced accordingly.

The reason for that is when they buy securities, they buy securities in the open market. Those checks from the Fed, although they're electronic transfers, are actually credited to the sellers of those securities in the marketplace. The banks credit that to the sellers of the securities bank accounts and present the Fed with the clearing of those checks, of those obligations.

And the Fed pays those in the case of a purchase by actually crediting reserve accounts at the Fed. Depository institutions maintain accounts at the Fed just like you and I maintain accounts at our banks. And those are the accounts that change, but when they change that changes the reserve position of the banking system.

Knowledge: What are these changes intended to achieve?

Kaufman: Well, they are intended to achieve either making funds more readily available in the economy, or making funds less readily available, and also influencing the terms on which those funds are available — namely interest rates.

When we think about liquidity in the economy, which is kind of a catchall for everything that is available for lending purposes, or the purchase of securities and so forth, we tend to think of liquidity as being either readily available or under some stress and therefore not being readily available. And that changes the terms of credit. And it may also change the ability to obtain credit.

And we're going through something like that right now. What the Fed did with its change in the discount rate, which we didn't really cover in this last time, it reduced the discount rate penalty from one percentage point to half of one percentage point, which we call "50 basis point."

And at the same time it did two other things. It encouraged banks to actually borrow from the Fed, which is an unusual occurrence. And it gave them 30 days to repay. Normally these discount rate loans are overnight. So, it made it available more easily, more cheaply for the banks. The Fed wanted to guarantee that there was enough liquidity in the economy.

And they didn't want to do it by reducing the federal funds rate target, at least yet. I suspect they will do that. At least yet because they weren't sure how much was required in the economy, and they felt that the federal funds rate had been the appropriate rate three weeks ago. They wanted to wait and see. But they have a meeting coming up in September.

And they're going to certainly reassess that, if not before, and see whether they have to reduce the federal funds rate. And that would be another way of injecting additional reserves into the banking system. And again, in terms of a popular way of thinking about it — making liquidity more available, making the markets more liquid and therefore credit more available at better terms.