How the Fed Works – A Screenplay

Greetings, caps and cappettes!

There’s been a deal of noise in the financial media of late regarding the question of whether the U.S. Federal Reserve will drive on with its plan to gradually raise rates, bucking the easing trend of the rest of the globe, or if they’ll reverse course in the face of recessionary signs and cries of pain from Wall Street.

Last week, I said that I’d make a case for raising rates, and it looks like I’ll have to spread that over at least a couple of posts. In this week’s post, let’s lay some groundwork for the argument by describing exactly what the Fed does in order to adjust short-term rates.

Ok, maybe “exactly” isn’t quite the right word. If you’re looking for the kind of extreme detail that can only be found by wading deep into the weeds, then you might try someplace like ZeroHedge or the Fed site itself. No no, the screenplay that follows is an uber-dramatized and slightly whimsical version of what happens, but I think the main points will be clear.

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FADE IN

INTERIOR – A POSH BOARD ROOM – MORNING

Along both sides of the massive table sit the twelve members of the Federal Open Market Committee.

JANET, the Chair of the Fed occupies the seat of power at the head of the table.

JANET: So we’re all agreed? Most indicators are flashing red, and we’re looking at an economic slowdown unless we drop interest rates by at least another quarter of a percent. Now, the seven of us on the Board of Governors have the authority to drop the discount rate, since that’s the rate we charge for loans to member banks, but that’s really mainly a symbolic rate.

STAN, the distinguished looking VP of the Fed, looks up.

STAN: Right, we really need to drop the fed funds rate, the market rate at which banks make overnight loans to each other. That should affect rates throughout the entire banking system.

JANET: Then that means buying assets to inject more money into the system. A larger supply of money means lower prices for money, i.e. lower interest rates. I assume we’re looking at T-bills here, since that’s the largest and most liquid market?

DAN, another distingu…ok, look. They’re all very distinguished, so let’s just move on.

DAN: Right, mainly T-bills. The quants recommend starting off with half a billion over the course of this week.

JANET: Let’s get the traders on it then. Thank you Stan, Dan, and everyone.

DISSOLVE

INTERIOR – A CLUTTERED OFFICE – LATE MORNING

FRANKIE, a rumpled looking Fed trader is flipping through a Rolodex.

FRANKIE: (dialing the phone) Let’s see, how about we start with UBS.

SPLIT SCREEN

BERNIE, a harried bond trader picks up the phone.

BERNIE: Yeah, UBS. Bernie at bonds-r-us here.

FRANKIE: Hey Bernie, Frankie at the Fed. How’s the kids? What’s the offer on 50 million July 31 bills?

BERNIE: What’s up Frankie! They’re great. 99 and a quarter firm.

FRANKIE: Done. What account do we use for payment?

BERNIE: The Wells Fargo account you have on file. The bonds settle in your account tomorrow.

FRANKIE: Always a pleasure, buddy. See you at the bar.

SINGLE SCREEN
FRANKIE’S OFFICE

Frankie flips through the Rolodex one more time, and then turns to his computer to look up the account number. He picks up the phone and dials.

SPLIT SCREEN

WILSON, a prim and proper bank executive answers.

WILSON: Welcome to Wells Fargo! Wilson William Willingham, ahem, the third speaking. How may I assist you, keeping in mind that I have a tee time of 12:15 sharp of course?

FRANKIE: Hi there Willie, Frankie at the Fed. Don’t think I’ve had the pleasure.

WILSON: Frankie? Fed? The Federal Reserve? Oh my! I mean yes, of course! Ahem, this wouldn’t be an audit…surely…

FRANKIE: Relax pal, it’s not an audit. I just need you to credit the account of one of our primary dealers. UBS Securities, account 12345, credit with $49,625,000.00.

WILSON: Well, ahem, yes but you see…now look here. Customer demand deposits are liabilities to a bank. By increasing this customer’s account balance by almost 50 million dollars, our bank’s net worth would drop by that amount! Are you mad bro, ahem I mean sir?

FRANKIE: Ok, ok, you sound new, so I’ll explain how this works. Under Fed reserve requirements, banks have to set aside a certain percentage of their deposits, but can loan out the rest right? So if the reserve requirement is say, 20% and someone deposits $100, you could lend up to $80 of that out to the public. The other $20 is your reserve requirement.

WILSON: Yes, of course! Basic fractional banking. I wasn’t born yesterday you know.

FRANKIE: Glad to hear it. Now, explain how your books balance when you get that $100 deposit and loan $80 of it out.

WILSON: Easy! The depositor has $100 in their account, which is a liability to us as I’ve said. But we have the actual $100 in our vault, which is an asset. So that balances. When we loan out $80, those loans are carried on our books as assets, and the remaining $20 in reserves is still in our vault as an asset. So the customer’s $100 account liability is still balanced by a total of $100 in assets.

FRANKIE: Awesome. But you don’t really keep all your reserves at your bank do you?

WILSON: Well no. As a member bank, we have an account with you, at one of the 12 regional Fed banks. Most of our reserves are on deposit there.

FRANKIE: Exactly. And guess what? I just credited your account at the Fed for $49,625,000.00.

WILSON: Oh, I see. Oh! I see!

FRANKIE: Yeah, you see. You see that first of all, you can credit that UBS account without bringing your books out of balance. Also, I just did more than balance your books, didn’t I?

WILSON: You certainly did! It’s as if UBS just deposited the money directly with us, thus increasing our reserves by almost 50 million dollars. Which means…

FRANKIE: Which means you now have the ability to loan out almost 40 million dollars more than you could have 5 minutes ago. If I were you, I’d give your commercial sales manager a call.

WILSON: Yes, you’re right. We can’t leave all that excess money just sitting around not earning a good return. The shareholders would be up in arms. But to move all that money out into loans…the sales people are going to want to drop the prime rate to make loans more attractive. And in the meantime, we can loan the excess reserves out to other banks that are short on reserves, but again, we’ll have to lower our overnight fed funds rate to attract those banks…

FRANKIE: That’s the whole idea, pal. Now you’re catching on!

WILSON: But wait. I understand that my books are balanced now, but what about yours at the Fed? Isn’t our reserve deposit a liability on your books? What’s going to balance that?

FRANKIE: Well, think about it. Why do you think we’re crediting that UBS account? Think we may be paying for something?

WILSON: Ahh, I see. You bought bonds from them. Now you’re holding the bonds as an asset on your books, and you’re balanced too. So I’m balanced here at the bank, you’re balanced at the Fed, and the bond dealer is balanced because they’re out the bonds but they have almost 50 million more in their bank account now. So everyone’s square.

FRANKIE: Especially you, Willie. But anyway, you’ve got it. everybody’s books balance, but there’s now an additional 50 million dollars out in the economy that wasn’t there a few minutes ago.

WILSON: I get it now! Ok, I’ve gone ahead and credited that bond dealer’s account. Anything else?

FRANKIE: That’s it for now. I’ve got about 10 more deals to do today. See ya!

FADE OUT

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So there you have it. That’s essentially how the Fed moves money into the economy and thus attempts to lower short term interest rates and stimulate lending, investment, and growth. When the Fed wants to put on the brakes, they just sell securities out of their portfolio, thus pulling money back out of the economy.

Notice that there’s no actual “printing” of money going on here. The idea that the Fed prints off green dollar bills and injects them into the economy is a simplistic and inaccurate description of what actually happens. In fact, money is printed by the Bureau of Printing and Engraving, a part of the U.S. Treasury. Those paper bills are nothing more than a convenient physical form of the money sitting in demand deposits. People convert their bank balances into paper form and then back again as it suits them, such as during the holidays and such.

Also, for those wondering why the amount being moved around in this scenario is just under 50 million dollars, that’s because treasury bills are original discount securities. That means you buy them at an amount below their face value, receiving the full face value back only when they mature. In the scenario, the bond dealer quoted the Fed 99-1/4 for the bonds, so the actual purchase price is only 0.9925 of the total 50 million dollar face value. Just a bit of geeky realism there.

Anyway, hopefully this little dramatization of how the Fed uses open market operations to adjust the money supply has been enlightenting. Next week, we’ll use this knowledge to discuss recent Fed policy.

Until then…keep pipping up!

 

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