Here we would try to understand the different components of the Fed’s balance, for the further study of policy impacts on the economy and the cash in advance model.
The fed’s balance sheet (H.4.1 report) is weekly updated every Thursday, and it presents the assets and liabilities of Federal Reserve Banks.
Assets
Fed’s assets are how the Fed uses money. Most of the money is spent on securities, unamortized premiums and discounts, repurchase agreements, and loans. For example, if the fed buys assets (MBS) or bonds (T-securities) by printing money, then those purchased investments are the assets of the Fed. The followings are some typical assets of the Fed that occupy a significant proportion.
- Treasury Securities: Treasury Securities account for the highest proportion of the fed’s assets. They are consisted of the T-bills, T-notes, and T-bonds by maturity. Treasutry secuirities account for 64% of total assets, (5,533,219 million dollors).
- Mortgage-backed Securities: MBS are securitisations of a basket of home loans. They occupy about 29% of total assets (2,527,824 million dollars).
- Loans: Those are money borrowed by other commerical banks through repo or discount window. The discount window is simplised as that Fed lends money to those borrowers and chages for an interest rate, federal discount rate. Loans have 48,317 million dollars balance.
(Total assets are 8,574,871 million dollars.)
Liabilities
The liabilities of the fed represents how the money comes from, consisting of Federal Reserve Notes, Reverse repurchase agreements, and deposits.
- Federal Reserve Notes: Paper currency (Federal Reserve notes) outstanding net of the quantities held by Reserve Banks. In short, they are net of money oustanding. The balance of it is 2,158,089 million dollars, which is about 25% of total liabilities of the Fed. From historial data, we can find that the money growth at relatively constant rate except during Aprial, 2020. The growth rate jumps.
- Reverse repurchase agreements: Fed sells securities to a counterparty subject to an agreement to purchase back the securities at a later date. The Fed uses Repo or Reserve Repo to conduct open market operations. By Repo, the Fed can release liquidity into the financial amrket. In contrary, the Fed tightens liquidity by revsere repo.
- The deposits, which is also call reserves, are amount of money deposided by commercial banks. The reserve ratio is proportion required in order to keep financial banks operating less risky, and it is also an important tool of the monetary policy. When reserve ratio decrese, then the money supply woul increase. The Board was reduced to zero on 26 March 2020.
Fed’s Tools
- Securities held outright: Treasury security and MBS together consist of the Securities held outright. The increase in those is due to the QE by Federal Reserve. Since the financial crisis of 2008, the Fed started to use QE to boost the economy, through which it purchased a huge number of financial assets (especially long-term assets). That account increased dramatically as well during the pandemic.
- Repos and Reverse Repos: Those transactions are between cash and Treasury securities (mostly short term ones). These open market operations support effective monetary policy implementation and smooth market functioning by helping maintain the federal funds rate within target ranges. Repo: the desk purchases securities from the counterparty subject to an agreement to resell the securities at a later date. Each repo is similar to a loan collateralised by securities, and temporarily increase the supply of reserve banlances in the banking system. Reverse repo is the opposite. The desk sells securities and reduce supply of money.
- Reserve rate as I have discussed before.
Federal Fund Rate
The following content is directly copied from the FRED. Links would be attached in the reference.
The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate. The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.
The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. As previously stated, this rate influences the effective federal funds rate through open market operations or by buying and selling of government bonds (government debt). More specifically, the Federal Reserve decreases liquidity by selling government bonds, thereby raising the federal funds rate because banks have less liquidity to trade with other banks. Similarly, the Federal Reserve can increase liquidity by buying government bonds, decreasing the federal funds rate because banks have excess liquidity for trade. Whether the Federal Reserve wants to buy or sell bonds depends on the state of the economy. If the FOMC believes the economy is growing too fast and inflation pressures are inconsistent with the dual mandate of the Federal Reserve, the Committee may set a higher federal funds rate target to temper economic activity. In the opposing scenario, the FOMC may set a lower federal funds rate target to spur greater economic activity. Therefore, the FOMC must observe the current state of the economy to determine the best course of monetary policy that will maximize economic growth while adhering to the dual mandate set forth by Congress. In making its monetary policy decisions, the FOMC considers a wealth of economic data, such as: trends in prices and wages, employment, consumer spending and income, business investments, and foreign exchange markets.
The federal funds rate is the central interest rate in the U.S. financial market. It influences other interest rates such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Additionally, the federal funds rate indirectly influences longer-term interest rates such as mortgages, loans, and savings, all of which are very important to consumer wealth and confidence.
Key Takeaway: The Fed can adjust the effective federal fund rate by Open Market Operation, QE, etc.
Reference
Fed’s statement until 10 Nov 202`1: https://fred.stlouisfed.org/release/tables?rid=20&eid=1194154#snid=1194156
A good explanation of Repo: https://www.bankrate.com/banking/federal-reserve/why-the-fed-pumps-billions-into-repo-market/
https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation/repo-reverse-repo-agreements