The financial crisis that has crippled the housing and credit markets since the fall of 2007 has reached such proportions that traditional methods for correcting these problems are inadequate. Like David looking for a bigger stone to sling at Goliath, the Federal Reserve has devised an array of monetary policy tools in an ongoing attempt to buffer the staggering economy and provide stimulus for recovery and growth.
If you're not well-versed in the credit markets, the laundry list of so-called facilities may seem like nothing more than alphabet soup. Using material from the Federal Reserve and the Federal Reserve Banks of New York, San Francisco and St. Louis, we're going to try to make these tools easier to understand.
In a recent speech at the London School of Economics, Fed Chairman Ben Bernanke spoke at length about these tools. Excerpts from that speech will be interspersed throughout this report in italics.
Bernanke breaks the policy tools into three distinct sets -- lending to financial institutions, providing liquidity directly to key credit markets, and buying long-term securities. He notes that they have a common feature in that each tool represents a use of the asset side of the Fed's balance sheet; in other words, they all involve the lending or purchasing of securities.
"The virtue of these policies is that they allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound."
Toolbox 1: Lending to financial institutions These first three tools -- open market operations, reserve requirements and the discount window -- have long been used by the Fed to influence monetary policy.
Open market operations: Monetary policy refers to the actions taken by the Federal Reserve to influence the availability and cost of money and credit to help promote the nation's economic goal of noninflationary growth.
The Fed began using open market operations in the 1920s. These operations are the most important and active tool of monetary policy that the Fed uses. They consist of the Fed buying and selling U.S. government securities, or IOUs from the federal government.
The Fed adds extra credit to the banking system when it buys Treasury securities from the dealers, and drains credit when it sells to the dealers. Primary dealers are broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York.
The Fed's open market operations are conducted in the following manner:
Open market operations
|Fed buys government securities from a firm that deals in them.||Fed sells government securities to a firm that deals in them.|
|It pays by crediting the account that the dealer's bank has at the Fed.||It pays by debiting the account that the dealer's bank has at the Fed.|
|The bank in turn credits the dealer's account.||The bank in turn debits the dealer's bank.|
|The banking system has more funds to lend.||The banking system has fewer funds to lend.|
|Downward pressure on the federal funds rate -- the interest rate banks charge each other for overnight loans.||Upward pressure on the federal funds rate.|
|Influences other interest rates in the economy -- which also go down.||Other interest rates in the economy also rise as a result.|
|Gives the economy a boost.||Slows the economy and curbs inflation.|