The Federal Reserve

Introduction

The Federal Reserve (Fed) was established by Congress back in 1913. The Federal Reserve Act provided “for the the establishment of Federal Reserve Banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”1 The Fed has a dual mandate to enact policies that promote price stability and maximum sustainable employment. Though not an explicit mandate, since the global financial crisis (GFC) of 2008-2009 the Fed has been concerned with financial stability and this has led to the creation of many novel programs, such as the Troubled Assets Relief Program (TARP) and the Large-Scale Asset Purchases (commonly called quantitative easing).

The size of the Fed in the economy has increased dramatically since the GFC. In this chapter we take a closer look at the balance sheet of the Fed, its assets and liabilities, and the impact of changes to the Fed’s preferred interest rate. In the first part of this chapter, we will focus on just the Assets side of the Fed’s balance sheet, how it adds or subtracts liquidity from the financial system and how it ultimately leads to easing or tightening financial conditions. Then, we will look at the Liabilities side of the balance sheet and the Fed is using a novel instrument, reverse repurchase agreements, to fine tune its policy. Finally, we will take another look at the Federal Reserve’s main tool for fine-tuning monetary policy, the Federal Funds rate.

How does monetary policy affect the economy? Traditional macroeconomic models posit that monetary policy works primarily through three neo-classical channels:

  • cost-of-capital effects,
  • wealth effects, and
  • exchange-rate

Consider a situation where the central bank raises interest rates in order to prevent the economy from overheating. Consequently, the following may happen

  • First, increase in the cost of capital nay dissuade capital investments by firms and purchases of houses and durables by consumers.
  • Second, higher rates will reduce the present value of various assets and the resulting wealth effects will lower aggregate spending.
  • Third, higher rates may strengthen the domestic currency, depressing net exports.

In addition, a more modern view recognizes the importance of frictions in financial markets, so that monetary policy may also affect economic activity via so-called credit channel. There may be frictions in raising capital. For example, a tighter policy reduces both the net worth and the cash flow of firms, and these balance-sheet effects make it more expensive for them to obtain external financing, thereby depressing firm investment.

Readers interested in the intricacies of central banking would do well to read The Fed Guy Blog by former Fed trader Joseph Wang or his book Central Banking 101 where he explains how the Fed transforms words into actions. This chapter is an attempt to visualize and make concrete changes in the the Fed balance sheet, so we can track the end result of Fed actions.

Fed Balance Sheet: Asset Side

In addition to interest rate targeting via the Federal Funds Rate, the Fed can affect overall financial liquidity through it’s balance sheet. The Fed can expand its balance sheet almost without limit because it buys securities from primary dealers and pays them with excess reserves, which is just a number in the Fed’s ledger. Fortunately, the Fed publishes a weekly update about its balance sheet every Thursday, in Factors Affecting Reserve Balances Table H.4.1 and FRED also publishes the time series of that data. For starters, let’s pull the weekly level of total assets (in millions of dollars) in the Fed’s balance sheet.

fed_at = ( 
    pdr.get_data_fred('WALCL',
                     start='2000-01-01')
       .reset_index()
       .rename(columns={'DATE': 'Date',
                      'WALCL': 'Assets'})
)

Let’s visualize the growth in Fed total assets and add vertical lines that mark the start of each round of quantitative easing (QE), just as we did in Interest Rates. We will scale assets to trillions of dollars, but notice we do it differently than before; instead of reassigning the column in the dataframe, we change the labels in the y-axis by dividing the original value by one million (this is the labelExpr argument in the chart). This is just an alternative way to achieve the same outcome (namely, plot trillion of dollars) but with an important difference: the plot is in trillions while the dataframe remains in millions. Any change we make in the labelExpr only affects the chart and leaves the dataframe unaltered.

at_plot = (
    alt.Chart(fed_at,
         title = alt.Title(
            'Total Assets of Federal Reserve; trillions of dollars',
            subtitle='source: FRED'))
        .mark_line(color='slateblue')
        .encode(alt.X('Date:T')
                    .title(None),
                alt.Y('Assets:Q')
                    .title(None)
                    .axis(labelExpr='"$" + datum.value/1000000 + "T"')
            )
)

# vertical dashed lines
xrule = (
    alt.Chart(pd.DataFrame({
            'Date': ['2008-11-01', '2010-11-01', '2012-09-01', '2020-03-01'],
            'label': ['QE1 GFC', 'QE2 Treasury Only',
                    'QE3 Treasury and MBS', 'QE4 Covid']
        }))
        .mark_rule(color="brown",  strokeWidth=2, strokeDash=[5,3])
        .encode(alt.X('Date:T'))
)

# text to acompany vertical lines
xtext = (
    xrule.mark_text(angle=270,
                    dy=-10,
                    align='left',
                    fontSize=14)
        .encode(alt.X('Date:T'),
                alt.Text('label') )
)

alt.layer(at_plot, xrule, xtext)

Fed Balance Sheet: the Liabilities Side

Fed Liquidity and Markets

Fed Funds Announcements

Impact on Ten-Year Treasury Yields

Impact on Market Returns

Unexpected Fed Funds Announcements

Conclusion

Footnotes

  1. A brief history of the creation of the Fed can be found at https://www.newyorkfed.org/aboutthefed/history_article.html↩︎