US Fed stands for the “United States Federal Reserve”.The 12 Federal Reserve banks in the different regions of the United States of America are collectively called as US Federal Reserve.
During the times of Covid-19 whole new breed of investors came into stock markets.
The trading and investing activity increased exponentially. Every share you purchased rocketed toward the sky. Nobody was caring about the fundamentals.
Suddenly at the beginning of 2022, the story of the war started between Russia and Ukraine; the stock markets also started to show tantrums.
This was the time when the United States Federal Reserve (The US Fed) came into the limelight in India Suddenly.
Every Stock market enthusiast started to look at the US Fed, A buzzword started in the media (Including social media) and still it is continuing.
We would try to give you all the possible answers to these questions like;
What are Money supplies in the US? How are the money supplies created? How does the US banking system work? How do the fed control money supplies in the US?
Let us start with understanding “The Fed” and its working.
US Fed
US Fed stands for the “United States Federal Reserve”.
The 12 Federal Reserve banks in the different regions of the United States of America are collectively called as US Federal Reserve.
This means Fed is not a single bank, but a combination of 12 regional reserve banks is called the US Federal Reserve.
The 12 regional reserve banks are located in:
New York, San Francisco, Chicago, Richmond, Philadelphia, Boston, Cleveland, Atlanta, Saint Louis, Kansan City, Minneapolis, and Dallas.
Organisational structure of US Fed and Regional Reserve Banks
Organisational Structure of Fed
US Fed has 7 members, known as the “Board of Governors”.
The Board of governors is appointed by the US president from among the Presidents of regional reserve banks and the appointment has to be confirmed by the Senate.
Senate is the Upper House of the US Parliament like the Rajya Sabha in India.US Parliament is called “US Congress”.
Tenure of the board of governors is 14 years,
The US Fed Chairman is appointed by the US president from among the board of governors.
The tenure of the chairman is 4 years.
The Fed chairman reports periodically to both houses of Congress (Senate and House of Representatives).
The House of Representatives is like Lok Sabha in India.
US Federal Reserve is considered the most independent body in the US after the Supreme Court.
Organisational Structure of Regional Banks
Each regional reserve bank has 9 directors.
6 directors out of 9 are elected by the commercial banks in that specific region.
3 directors are elected by the “Board of Governors”.
The President of the regional reserve bank is appointed by the directors of the regional reserve bank.
Functions of the US Federal reserve
US Federal Reserve has the power to issue money as RBI has in India.
It is the Government’s bank (.i.e. bank of government) and a banker’s bank (.i.e. bank of banks).
Fed is called Government’s Bank; Meaning thereby, it maintains the bank account of the US treasury. i.e. Fed manages the deposits (the taxes which are paid by the citizens are deposited in the US treasury account maintained with the US Fed) and borrowings (.i.e. when the US treasury issues bonds or redeems US bonds) of the US government.
Fed is called the Banker’s Bank; Meaning Thereby, Private sector banks, and large financial institutions also maintain their account with US Fed.
Fed is the regulator of banks and the lender to US banks.
Fed manages the US payment system.
What is FOMC of US Fed?
FOMC stands for Federal open market committee.
This committee consists of 7 members of the board of governors and 5 presidents of regional reserve banks.
The monetary policy stance of the US Fed is determined on the basis of the Federal Open Market Committee meeting.
So next time when you hear about the FOMC meeting it means the meeting of these 12 members, who would take the monetary policy decision.
Money Supplies in the US (Money in circulation in the US)
Supplies of money in the US do not only mean physical currency but there are three components of money used for payments in the United States:
>The physical (Paper) currency and coins
>Reserves maintained by banks with US Federal Reserve.
>Various deposits like saving accounts, FD accounts, etc. To understand the impact of the monetary policy of the US Fed let us first understand the method of working of banks in the United States.
How do banks operate in the United States?
You know that banks provide the facility of depositing money and giving loans to customers.
But it does not mean that banks give the entire deposits as loans to other customers.
Banks usually keep a certain amount of deposits in the reserves and give the remaining amount as a loan.
In India, banks are required to maintain CRR, SLR, etc. More about CRR and SLR here.
Similar is the case with the workings of US banks. Let us understand the technical terms in the US banking system.
Fractional Reserve Banking
When a customer in the US opens an account with a bank and deposits money, the bank used to keep a fraction of the money deposited by the customer in reserves. This method is known as fractional reserve banking.
The purpose of the fractional reserve banking system is to meet the withdrawals of the customers. i.e. if the bank would give the entire deposit as loans and subsequently a customer comes to withdraw his money or issued a cheque for payment.
The bank would not be able to honour the cheque or give the withdrawals, therefore to meet the demand of depositors for currency or payment service the fractional reserve banking system is followed.
The question is how much do the banks keep in reserves?
This is decided by the “Reserve Ratio”.
Reserve ratio
Reserve Ratio is the ratio of reserves to deposits.
.i.e. Reserve Ratio = Reserves/Deposits
Reserve Ratio represents the portion of deposits that banks want to keep with them.
It is decided by the banks themselves.
When banks are of the view that depositors might withdraw their funds or when it seems to banks that giving loans might not be profitable then they keep the reserve ratio on the higher side.
When banks have a view that the withdrawals might be less or giving more loans would be profitable they keep the reserve ratio on the lower side.
Money Multiplier
The money Multiplier is the reverse of the Reserve Ratio
.i.e. Money Multiplier = Deposits/Reserves or
Money Multiplier = 1/Reserve Ratio
But what does “Money Multiplier” reflects?
The money multiplier is an important concept that tells us about the increase in deposits. i.e. money flow in the economy with an increase in reserve.
Every time money is created by Federal Reserve, it has a multiplier effect on the flow of money in the economy.
Let us understand by an example.
When the Fed wants to pump up the economy it creates money. i.e. it credits the money in the account of banks held at the Fed ( as we have said earlier the Fed is the bank of banks . i.e. banks also have an account with Fed).
Let’s say the Fed has credited $ 1000 in the account of “X” bank, if the “X” bank maintains a reserve ratio of 10% .i.e. 0.1 then “X” bank would keep 10% of $1000. i.e. $ 100 in its reserves and give the remaining $ 900 as loans.
Suppose this $ 900 has been given as a loan to you. i.e. $900 has been credited by “X” bank to your account in “Y” bank.
Now “Y” bank has $ 900, it would keep 10% as reserves (assume that “Y” bank also maintains a reserve ratio of 10%) and give the remaining amount as a loan. i.e. $ 810.
This process goes on and on……….
If you apply simple mathematics, you would get the following infinite series:
$1000 + ($1000 x 0.9) + ($1000 x (0.9)2) + ($1000 x (0.9)3) +…………+∞
If we add on this geometric progression series it would come out to $ 10,000.
The formula to add a geometric progression series is S∞ = (a/1-r)
Here “a” is 1000 and “r” is 0.9 (This is a mathematical formula of adding an infinite geometric progression series)
So, a $1000 created initially by Fed becomes $10,000 in the economy, if the Reserve Ratio is set at 10%.
Since, Money Multiplier = 1/Reserve Ratio
Therefore for the Reserve Ratio of 1/10, the money multiplier will be 10.
So we can say that every penny created by Fed has a ripple effect or multiplier effect on the economy.
Now the question arises,
How the US Fed does control the supply of money?
To control the money supply the US Fed has four tools:
- Open Market Operations
- Lending through discount rates
- Term Auction Facility
- Payment of interest on reserves held by banks at Fed.
Open Market Operations of US Fed
Open Market Operations is the system wherein the US Fed buys and sells government bonds.
When the Fed wants to increase the money supply in the economy it buys government bonds and credits the money in the reserves of the institutions selling the bonds. (Remember that Fed is the bank of banks therefore banks maintain their accounts with the Fed).
When the money is credited to the reserves of institutions, every dollar created has a ripple effect on the economy (as we discussed above in the money multiplier).
The increased flow of money in the system leads to more loans by banks and financial institutions, more loans by banks mean more money is available for expenditure, consumption, mortgages, etc.
When the banks are eager to lend, they keep the reserve ratio on the lower side. i.e. less money is kept by banks in reserves and therefore the banks give more loans.
When the US Fed wants to reduce the money supply in the economy it sells government bonds and debits the money from the reserves of the institutions buying the bonds.
Debiting the money from the reserves also has a multiplier effect on the economy as we discussed in the money multiplier.
Impact of open market operations on interest rates
When the Fed buys government bonds to increase money flow in the economy
The purchasing of government bonds by the Fed increases the prices of government bonds and you know that increase in bond prices leads to a reduction in interest rates.
When Fed sells the government bonds to decrease the flow of money in the economy
The selling of government bonds by the Fed decreases the price of Government bonds, which in turn leads to an increase in interest rates.
Refer here for the entire discussion on the “relation between bond prices and interest rates”
Fed Funds Rate
Every time when a buzz is created in the media regarding the FOMC meeting; every person having an interest in the stock markets tries to speculate about the change in interest rates.
But which interest rate is affected by the Fed FOMC meeting?
It is the Fed funds rate that is increased or reduced by Fed.
Fed funds rate is the short-term lending rate at which the banks give loans to each other.
Fed has the control over the Fed funds rate.
Banks not only give loans to customers and businesses but also to other banks, and the rate of interest which is charged by the lending bank from the receiving bank is the Fed funds rate.
On the basis of this Fed funds rate the interest rates in the entire banking system are decided.
So next time when you watch business channels and see the anchors talking about interest rate change be clear that they are discussing the “Fed funds rate”.
Quantitative easing and Quantitative tightening
As we discussed in open market operation the fed buys and sells government bonds to increase or decrease the money supply.
This practice to reduce or increase the money supply is done by purchasing or selling short-term bonds. i.e. to affect the liquidity in the short term.
But when the same exercise of buying bonds is done in long-term bonds let’s say in bonds with a tenure of more than 10 years it is called quantitative easing.
And when the exercise of selling long-term bonds is done by US Fed it is called quantitative tightening.
Lending through discount rates
Another method to increase the supply of money in the economy used by the Fed is lending through discount rates.
Now you are aware that Fed is the bank of banks. i.e. it gives loan to banks as well as keep their money in the form of reserves.
Fed gives loans to banks and charges an interest rate on the amount of the loan.
The rate at which the interest is charged is called the discount rate.
This lending by Fed to banks is for the short-term, when the banks are not getting the funds from anywhere.
When the banks do not get funds from anywhere they approach the US Fed to obtain the money therefore the Fed is also called the lender of last resort.
Borrowing from Fed through discount rates is sentimentally considered negative for banks.
It is considered if the bank is approaching the US Fed for raising a loan through a discount rate facility the bank is financially weak.
In normal times banks usually approach other banks or financial institutions to raise loans but when they approach the US Fed, it is thought that the bank is not in good health; it is not able to raise funds from anywhere and therefore it has approached Fed for funding.
So banks generally avoid getting funds through discount rate facilities.
Term Auction Facility
Under the discount rate facility banks approach Fed for taking loans but as we said earlier borrowing through the discounted facility is sentimentally negative and creates questions about the health of the bank.
Banks generally avoid raising money through discount rate facility, so US Fed came up with a term auction facility during the 2008 sub-prime crisis.
In the discount rate facility, banks approach the US Fed that “we need a dollar 1 million as a loan”. The rate of interest is as per the Fed discount rate window.
But in the case of the Term auction facility, US Fed gives an announcement that “we want to inject US dollar 10 million those banks who want to borrow may give the bids for the amount needed and the rate of interest”.
Confused………
Let’s clarify again, in the discounted facility the amount of loan which the banks want to receive is decided by the bank that is willing to take the loan and the rate of interest is fixed as per the discounted facility of the Fed.
In the Term auction facility, the amount of loan to be taken by banks and interest rates are decided on the basis of bids or auctions. US Fed just decides the upper limit of the amount which it can give as loans.
Payment of interest on reserves
You are aware that banks maintain their account with Fed in the form of reserves.
Before the 2008 crisis Fed did not give any interest to banks for the amount of money in reserves, due to this the banks wanted to minimise their reserves as they are not earning anything.
But after 2008 Fed started to give interest on reserves to banks, this amount increases the flow of money with banks and in turn in the economy.
The Fed varies the rate of interest on such loans as per the policy objectives.
Problems of banking business
There are mainly two types of problems that arise in the banking business.
Liquidity crisis:
When the banks are not able to meet up the withdrawals by customers for a short period of time or we can say when there is the possibility of withdrawals surpassing the income, the banks are said to be facing a liquidity crisis.
There may be the possibility that the banks have given good long-term loans but the loans are not getting the income at a pace more than the withdrawals.
This creates a short-term liquidity crisis.
Solvency crisis:
A solvency crisis arises when the banks face a liquidity crisis in the long term.
In such a situation the value of the assets of the banks gets eroded to such an extent that it becomes almost impossible for the banks to remain solvent without extra capital.
The same happened with Silicon Valley bank when the price of bonds it was holding got eroded at a faster rate than the withdrawal of funds. (For more on Silicon Valley Bank click here)
It became insolvent and therefore closed.
To protect the banks from a solvency crisis the only way is to infuse capital.
You may have read about the meeting of CEOs of various regional US banks with Warren Buffett for investments. (Read Here), this may be for requesting him to infuse capital investment in banks to save them from the crisis.
Now you are aware of the Fed, its organisational structure, and the ways by which the money supplies are controlled by Fed. Next time when you read about the Fed FOMC meeting in the newspaper, try to analyse it on the basis of the above concepts.