Reaction Report - 3
1. Between 1990 and 2010, while the monetary base soared, the money supply did not rise in a similar proportion. Concurrently, there was a decline in the money multiplier, which dropped sharply by 50% during the financial crisis in 2007-08. The reason the monetary base rose beyond the money supply could be attributed to the trends displayed by the Currency to Deposit Ratio (C/D) and the Excess Reserves to Deposit Ratio (ER/D) in the same timeframe. The currency to deposit ratio, while rising in the 90s, fell during the financial crisis of 2007-8 as households preferred to hold checkable accounts over other riskier assets in the market. A decrease in the currency-to-deposit ratio causes the money multiplier to increase, causing the money supply to also increase. However, in the period under discussion, the money multiplier actually decreased. This was because the Excess Reserves to Deposit Ratio (ER/D exponentially soared from nearly zero. This was because banks were holding more excess reserves than checkable deposits. As the increase in excess reserves outstripped the increase in checkable deposits, the money multiplier declined. As a result, the increase in monetary base resulted in a much smaller rise in money supply. The reason banks opted to increase their excess reserves dramatically was due to three reasons. The excess earned an interest rate of 0.25% paid by the Fed- an amount that compared favorably to all other market instruments in free fall during the financial meltdown. Banks also wanted to remain liquid after having suffered heavy losses. They became stricter in lending due to increased doubts about creditworthiness of customers. Thus, the drag on the money multiplier due to increased amounts of excess reserves by banks was more than the boost due to increased checking accounts, resulting in a reduction in the money multiplier. The reduction in the money multiplier counteracted the rise in the monetary base that had occurred due to the Fed buying mortgage backed securities and other assets, stymying the growth in the money supply (Hubbard and O’Brien).
2. The Fed sets a target for the federal funds rate because it does not directly control it; rather, the federal funds rate is determined by the demand and supply of reserves in the federal funds market. The trading desk at the New York Fed uses open market operations to attempt to align the actual federal funds rate to the target rate as much as possible. The graph at Page 456 shows that the actual federal funds rate has been quite closely aligned to the target federal funds rate over the period 1998 to 2010. The federal funds rate was below 0.25% while the target was 0% in October 2010. While it would make no sense for banks to lend in the federal funds market at rates below 0.25% as they would earn 0.25% on excess reserves left with the Fed, the lending in the federal funds market at this level is by government-sponsored enterprises such as Freddie Mac and Fannie Mae, which are ineligible to receive interests of deposits with the Fed. Thus, the successful alignment of the actual federal funds rate to the target rate is a function of open market operations, combined with financial interactions with banks as well as government sponsored financial institutions in the federal funds market (Hubbard and O’Brien).
3. Traditionally, the Fed has resorted to buying and selling short term Treasury Securities in its open market operations with the intention of controlling the market for bank reserves and the equilibrium federal funds rate. However, the Fed reached a quandary in December 2008, when the target for the federal funds rate had reached nearly zero. Concurrently, the financial crisis had heightened. The Fed had to restore confidence in the housing market. Without the Fed’s intervention, the housing market would have collapsed, leading to a contagion effect and imploding the entire banking system. Therefore, the Fed decided to move away from its traditional approach of buying and selling short-term securities, and instead taking the step to buy more than $1.7 trillion in mortgage-backed securities and longer-term Treasury securities. This approach to buying long-term securities is called quantitative easing. The Fed’s objective in quantitative easing was to reduce interest rates on mortgages and on 10-year Treasury notes. While the former would propel people to return to the housing market, the latter would result in lower rates in corporate bonds, resulting in increased investment spending. As a result, the process of quantitative easing helped in increasing money supply in the economy and restoring confidence in the housing market. Having gone through one round of quantitative easing in 2008, the Fed intended to reverse the process and reduce money supply at a later date. However, unemployment figures did not reduce enough to allow the Fed to take this step. Instead, the Fed had to go through another round of quantitative easing in November 2010, when it bought an additional $600 billion in long term Treasury Securities. The bond purchases would result in increase in the monetary base and result in increased money supply. As a result, there is concern amongst economists that it could ultimately lead to increased levels of inflation. This concern arises out of the fact that the process of quantitative increasing involved the Fed to buy securities with bank reserves. As a result of the quantitative easing process, banks become flush with funds. During the first round of quantitative easing, banks may have attempted to increase their capital and borrowers may have attempted to pay their debts, resulting in a situation where inflation did not rise dramatically and the Fed was rightfully seen as a banker of the last resort. However, economists might worry that in QE2, the second round of quantitative easing, the situation is not the same as in 2008. Banks may have gotten over their imperative to retain capital, and may resort to lending the reserves to industry and households. If the industry and households take up the excess capital into the system, the situation might trigger inflation (Hubbard and O’Brien).
Work Cited
Hubbard, R. Glenn, and O’Brien, Anthony Patrick. Money, Banking and the Financial System. New Jersey: Prentice Hall, 2012. Print.
