1. 1 SELECTING OPEN MARKET OPERATIONS Spence Hilton, Markets Group January 9, 2001

2. 2 Structure of the Federal Reserve System for Domestic Monetary Policy 12 Reserve Banks Board of Governors Federal Open Market Committee (FOMC) Board of Directors propose changes in the discount rate. Board of Governors sets reserve requirements and approves proposed changes in the discount rate. Committee members (Board of Governors and 5 voting Reserve Bank Presidents) direct the Desk to implement open market operations to achieve objectives. Trading Desk FRBNY Arranges OMOs to implement directives of the FOMC.

3. 3 Internal Directive to the Trading Desk: In the implementation of policy for the immediate future, the Committee seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 6 1/2 percent. FOMC Tightens Monetary Policy at its Meeting of May 2000 Public Announcement: The FOMC voted today to raise its target for the federal funds rate by 50 basis points to 6 1/2 percent. IN a related action, the Board of Governors approved a 50 basis point increase in the discount rate to 6 percent. Increases in demand have remained in excess of even the rapid pace of productivity- driven gains in potential supply, exerting continued pressure on resources. The Committee is concerned that this disparity in the growth of demand and potential supply will continue, which could foster inflationary imbalances that would undermine the economy’s outstanding performance. Against the background of its long-term goals of price stability and sustainable economic growth and of the information already available, The Committee believes the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future.

4. 4 FED BALANCES AND THE FEDERAL FUNDS MARKET Definition “Fed Balances” refers to the balances held by depository institutions in accounts held at the Federal Reserve Bank Fed Balances are sometimes called “reserves,” but these concepts are not identical Uses of Fed Balances Balances at the Fed can be used to meet reserve requirements and clearing balance requirements Balances at the Fed are also used to settle financial transactions. Federal Funds Market Interbank market for lending or borrowing Fed balances. Interest rate banks charge one another is called the Federal Funds Rate. Mostly overnight trading.

5. 5 Controlling the Federal Funds Rate Operating Premise: If the supply of balances equals their demand, then trades in the federal funds market will be arranged at rates around the target. If supply falls short of demand, the rate will be too high, and if supply exceeds demand the rate will drop. Operating Procedure: Estimate the demand for balances, and estimate the supply before any further open market operations. Arrange additional open market operations to adjust supply to meet demand.

6. 6 The Balance between the Reserve Demand and Reserve Supply Reserve Supply B. target Too high Too low Reserve Demand Federal Funds rate target Too high Too low A. Reserve Demand Reserve Supply Reserve Action: ADD Reserve Action: None Reserve Supply target Too high Too low Reserve Demand C. Reserve Action: DRAIN

7. 7 Reserve Requirements of Depository Institutions Type of Deposit Percentage of Deposits Net transaction accounts $0 million - $50 million 3 More than $50 million 10 Example If a bank has $1 billion of transaction deposit liabilities (demand deposits and other transactions accounts held by individuals and businesses), then that bank must hold $96.5 million of reserves $96.5 million =.03x$50 million +.10x$950 million Reserve Maintenance Periods Two week periods, beginning on a Thursday and ending 14 days later on settlement Wednesday. Banks may average their reserve holdings over this 14 day period to satisfy requirements. Reserve requirements are known when a maintenance period begins (Lagged Reserve Accounting).

8. 8 Sources of Supply: The Broad Categories of the FR Balance Sheet Autonomous Factors assets and liabilities whose sizes are largely outside the control of the Trading Desk currency (Federal Reserve notes), the Treasury balance, bank float, etc. Portfolio of Domestic Financial Securities these items are under the control of the Trading Desk open market operations are transactions initiated by the Trading Desk that change the size of the components of the SOMA the purpose of these operations is to adjust the supply of Fed Balances to keep it equal with estimated demand, thereby maintaining the federal funds rate around target Discount Window Borrowing Fed Balances can be created when banks borrow directly from the Federal Reserve Discount window borrowing largely plays a safety valve role, in the event of a large shortfall in the supply of Fed balances relative to demand.

9. 9 Estimation and Operating Horizons We construct demand and supply for each two-week maintenance period. We attempt to ensure that supplies over each two-week period on average equals demand. In addition to period average estimates, we also estimate the supply of balances available each day of a period from autonomous factors. In practice, we also pay close attention to whether reserve supplies are plentiful or scarce on any single day. There are also distinct patterns to daily demands for excess reserves that we also judge, but not formally estimate. Estimates based on history. This daily information is used to help determine the specific structure of OMOs, maturity and size of daily operations.

10. 10 Desk Creates Reserves through a $1 billion RP Operation Trading Desk Primary Dealer: Goldman Sachs Correspondent Bank: Citibank Trading Desk accepts $1 billion of propositions made by Goldman Goldman delivers $1 billion of securities to the Federal Reserve Desk credits the reserve balance at the Fed of Citibank--the correspondent bank designated by Goldman--for $1 billion, creating reserves Citibank credits the transactions deposit balance of Goldman When the RP matures and we return securities, reserves will fall

11. 11 Daily Routine for Arranging Open Market Operations 8:30 am - Receive estimates of reserve demand and supply for each day in the maintenance period All morning - D iscuss fed funds market conditions with participants 9:00 - Staff has formulated plan for operations 9:20 - Conference call with the Board and FOMC member seeking approval for the plan of operations 9:25 - Roll the die and a nnounce open market operation 9:30 to 9:45 - Dealers submit propositions 9:45 - S elect propositions and return results to dealers Afterwards - Dealers deliver securities and Fed creates reserves

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13. 13 Example: Desk Arranges a 1-day RP Goldman submits a proposition worth $1 billion, with an overnight interest rate of 5.53%, and the Desk accepts the proposition Day 1 Goldman delivers $1 billion of securities to the Fed, and instructs the Fed to credit the reserve account of its correspondent bank, Citi The Fed delivers a claim for $1 billion of reserves at the Fed to Citi Citi delivers a claim on a deposit account to Goldman worth $1 billion There are now $1 billion more of reserves, that Citi can use to meet its reserve requirements; or which Citi can lend in the federal funds market to another bank that needs the reserves to meet requirments. The interest rate Citi would charge another bank for the use of the reserves is called the federal funds rate.

14. 14 Example: Desk Arranges a 1-day RP The RP automatically unwinds on its maturity date Day 2 The Desk returns the $1 billion of securities to Goldman Citi returns the claim of $1 billion on reserves at the Fed back to the Fed Goldman returns the $1 billion deposit claim back to Citi The flow of payments this day is complicated by the payment of interest on the use of funds for one day, including $153,611.11 (=$1 billion x.0553/360) that Goldman now owes the Fed The Desk’s objective in this operation was to increase the supply of reserves so that the total supply would be enough for all banks to meet their reserve requirements, a necessary condition for keeping the federal funds rate close to its target. What is Goldman’s interest in participating in this operation?

15. 15 Rules for the Open Market Operations Game Background The maintenance period is 5 days long The level of reserve requirements is $15,000 Excess reserves is calculated is the level of supply minus reserve requirements. Excess reserves may be calculated for each day, and as an average level for the period when the period ends On day 1, you have a set of estimates of reserve supply for each day of the period On days 2 through 5, in the morning you receive revisions to yesterday’s estimates of reserve supply for that day and perhaps all remaining days in the period. The average absolute daily revision to reserve supply in this problem is about $750 Each morning, you decide on open market operations based on estimates and other restrictions. Keep on the tab for the current day; don’t cheat and look at the tabs for the future days of the period, which show the upcoming revisions to estimates of reserve supply

16. 16 Operations Only 1 RP operation (or none) can be arranged on any given day An operation may be of any maturity out as far as the end of the maintenance period (I.e. up to 5 days on day 1; 4 days on day 2, etc.) Operations can either add (+) or drain (-) reserves Maximum absolute size of any operation on any day (regardless of term) is $5000. Minimum is $1000. Enter your selected open ;market operation in the appropriate cell(s) corresponding to today’s date in the column market “Today’s OMOs.” If it is a term operation, be sure to carry out the same value for all future days covered by the term of the operation

17. 17 Objectives and Scoring The target federal funds rate is 6 percent On days 1 through 4, the daily level of excess reserves must be within +/- $1000 of $0. For each $500 in absolute value outside of this range, the funds rate that day will be 1/4 point below/above target On the last day, average excess reserves at the end of a period must be within +/- $100 of $0. For every $100 in absolute value outside of this range, the federal funds rate on day 5 will be 1/4 point below/above the target Each morning, you will learn what the federal funds rate turned out to be on the previous day, when you learn about the revisions to the estimates of reserve supply for that day At the end of the period we add up the absolute deviations of the daily rates from 5 1/2 to see how well you did A drain operation (add) arranged when an add (drain) operation is counted against you

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