Economics of Global Money Markets
When money became a commodity, money market became part of the financial markets for the reasons that assets that are involved in short-term buying, borrowing, selling and lending with the original maturities of about one year or less. The trade in money markets is carried out over the counter and as such it is wholesale. There are various instruments that exist and they include deposits, treasury bills, bankers’ acceptances, certificates of deposit, bills of exchange, commercial paper, federal funds, repurchase agreements and asset backed securities. This provides a funding that is liquid for the global financial system. Capital markets and money markets are also part of the financial markets. These instruments have differing currencies, credit risks, maturities and structure and therefore they can be used in the distribution of exposure.
Money markets constitute of dealers in credit or money and financial institutions who wish to either lend or borrow. Participants lend and borrow for short durations of time, usually up to thirteen months. Often, the money market does trade in the short-term financial instruments usually referred to as “paper”. It contrasts with capital market for the longer-term funding that is supplied by equity and bonds. The heart of money markets is made up of interbank lending where banks lend and borrow each other through repurchase agreements, commercial paper and other similar instruments. The finance companies usually fund themselves by issuing huge amounts of commercial paper that is asset-backed which is then secured by a pledge of assets that are eligible into asset-backed commercial paper conduit.
Some examples of assets that are eligible include credit card receivable, auto loans, commercial/residential mortgage loans and other similar financial assets. In the United States, local, federal and state governments issue paper in order to meet their funding needs. Local and state governments issue the municipal paper whereas US Treasury issues the treasury bills in order to finance the US public debt. The main functions of the markets include:
- Transfer of large amounts of money
- Allowing the government to raise funds
- Transfer of funds from parties with surplus to those with deficit.
- Helping in the implementation of monetary policy
- Determining the short-term interest rates.
The Federal Reserve in the United States was created the U.S. Congress in the year 1913. Initially, the U.S. did not have any organization that was formal for implementation and study of monetary policy. As a result markets were usually unstable and as such the public did not have faith in the system of banking. The Federal Reserve is an entity that is independent but it is subject to supervision by the Congress. Essentially, this means that the decisions they make do not have to be approved by the President or any other person in the government even though the Congress has to periodically review the activities of the FED. The Federal Reserve is headed by Board of Governors in Washington which is a government agency.
The board of governors is made up of seven appointees of the president, each of whom has to serve for terms of 14 years. All the members have to be confirmed by the Senate and they can also be reappointed for their positions. The board of governors is headed by a chairman and a vice chairman who are also appointed by the president and confirmed by the Senate and the duration of their terms is four years. Currently, the chairman is Ben Bernanke who took over from Alan Greenspan on 1st February 2006. Alan Greenspan had been the chairman of the Federal Reserve since 1987.
There are a total of 12 Federal Reserve Banks which located in the major cities all over the country and they all operate under the oversight of the Board of Governors. These Reserve Banks do act as the operating arms of central bank and as such, they do carry out most of the tasks of the Federal Reserve. The banks acquire their income from the following four main sources:
- The interest that is earned on government securities which are acquired in carrying out the work of the Federal Reserve.
- The services that are provided to banks.
- Interest on loans to the depository institutions.
- The income from foreign currency held.
The income that is collected from the above activities is used in the financing of the day to day operations which include economic research and gathering of information. The other excess income is channeled back to the U.S. Treasury.
The Federal Reserve also includes the policy making branch referred to as the Federal Open Market Committee and is better known as FOMC. This committee makes the crucial decisions on the interest rates and also on other monetary policies and this is the reason they get more attention in the media. The FOMC of the Federal Reserve System meets almost every six weeks so as to determine the monetary policy goals of the nation and also to set a target for the rates of the federal funds. The rates of the Fed funds is the interest rate at which the banks do lend balances to other banks which is usually done overnight. The Federal Open Market Committee has maintained the current rate of federal funds at a range of 0-0.25% since the meeting on 16th December 2008.
The rates of Federal Reserve funds have been kept at a historically low level because of the long durations of low and negative gross domestic growth, high rates of losses in the non-farm employment and also the high rates of unemployment. Due to these low rates, it has provided additional stimulus and stabilization through a range of programs that have the intention of improving the banks’ balance sheet and liquidity in the credit markets. Fed has bought securities that are worth hundreds of billions of dollars through programs of qualitative easing which are called “QE”. An operation called “operation twist” was started in September 2011. Through sale of shorter-term bonds and purchase of longer-term bonds, Federal Reserve hopes to drive down interest rates on the 10-year bonds.
Under the program of Operation Twist, Fed bought $400 billion in the long-term treasury securities which it later sold at an equivalent price of short-term treasury securities from its own portfolio. This program was at the beginning estimated to end by June of 2012 but on nearing its date of termination, Federal Reserve extended it to the end of 2012 which will as result lead to the purchase and sale of more $267 b treasury securities. Federal Reserve argues that the program of maturity extension will stimulate the economy through reduction of long-term rates of borrowing throughout the economy. Dissimilar from the qualitative easing, maturity extension does not have any effect on the size of Federal Reserve balance sheet, monetary base or the bank reserves. Due to this reason, the program of maturity extension program is expected have little effects on the growth of the economy, inflation and interest rates than if the same amount of treasury securities were purchase through the program of qualitative easing. It is for this reason that the effects of Maturity Extension Program on the economy are likely to be modest.
The FOMC seeks to create maximum price stability and high rates of employments. It however remains concerned that with little policy accommodation, the growth of the economy may not be not be strong enough so as to generate improvements that are sustainable in the conditions of labor markets. Moreover, the strains in the global financial market have gone ahead to pose a great downside risk to the outlook of the economy. The Federal Open Market Committee also anticipates that the inflation over medium terms would most probably run at or even below its objective of 2%. Just as always, the Federal Open Market Committee had made it clear that it was very ready to counter any pressures of inflation. It later on recognized the recent high food and energy prices where it indicated to having no expectations of serious and long-term impact in the shorter term.
The primary mission of the Fed is ensuring that there is enough money and credit so as to sustain the growth of the economy without the problems of inflation. If it is seen that inflation will threaten the purchasing power, Federal Reserve may be required to slow down the growth of money supply. The Fed does this by use of three tools which include reserve requirements, discount rates and the most crucial is the open market operations. The responsibility of the open market operations is dependent on the Federal Open Market Committee. This committee which is a Board of Governors which consists of seven members and 12 presidents of the Reserve Banks meet eight times every year. The president and the governors of the Fed in New York are considered to be permanent voting members.
The other presidents of the Reserve Bank fill in the other remaining four voting positions in rotation even though the nonvoting members also fully participate in deliberations. The Reserve Bank research departments, regional business leaders and the board of directors contribute to the grassroots insight and information that is used in the formulation of monetary policy. The board of Reserve Bank recommends some changes in discount rates to the board of governors and for this reason, the board of governors have the jurisdiction over the reserve requirements. In such ways, both the private and the public sectors have a contribution to these decisions.
Open Market operations
The most frequent used tool of the monetary policy by the Fed is the open market operations. Open market operations is the selling and buying of government securities in the open market so as to influence the short term rates of interest and growth of credit and money aggregates. When there is a rise in the growth rate of credit and money supply is needed and also when a drop in the pressure on the short-term rates of interest is required, Federal Reserve purchases securities from the dealers or the brokers and every transaction is carried out electronically.
The dealers send the securities to Federal Reserve on a network that is electronic and the Federal Reserve sends money to reserve bank accounts of the dealers or brokers. In turn, the banks credit the dealers and brokers accounts and this increases the amount of credit and money that is available in the market. When it is necessary to reduce the growth of credit and money, the process is then reversed. The Federal Reserve sends securities to dealers and brokers and they debit the bank accounts that they use in doing their businesses. The reserves then leave the banking system and as such there is reduction in the supply of money and hence the curtailed expansion of credit.
The Discount Rate
Discount rate can be described as the interest rate that the Federal Reserve Banks charge the financial institutions on the short term loans of reserve. Changes in the discount rate will encourage or inhibit the lending of financial institutions and their activities of investment through sending of signals about the goals of the Fed and also by influencing the rates on interests that the banks pay to their depositors and the rate at which the banks offer their loans. Discount rates are infrequently changed.
The Reserve Requirement
Reserve requirement can be described as the proportion of deposits that are in demand deposit accounts which the financial institutions have to set aside and also hold in reserve. In case the Federal Reserve increases the reserve requirements, then the banks end up having less money to lend to its customers and this will restrain the growth in supply of money. On the other side, when the Federal Reserve lowers its reserve requirements, the banks will have more many available to lend and this results to increase in the supply of money. The Federal Reserve does not use reserve requirement more often. Actually, it is the tool of money monetary that is least used because any changes in the reserve requirements greatly affect the operations of the financial institutions. In situations where this tool is used, it is a sign that there is a strong swing of monetary policy in a new direction.
When the vice chairman of Federal Reserve in 1994 said that the central bank has a mandate in the reduction of unemployment, his colleagues were very dismissive. The word “employment” had not appeared in the policy statement until the year 2008. The officials insisted that the Fed should be focused on inflation. That era is now gone. The signs are now present for some time and now they are even unmistakable. The Fed chairman Ben S. Bernanke said it clearly that creation of jobs is now its major concern for the future. This remarkable transformation in the priorities of Federal Reserve is part of a response to the reality that above 20 million of Americans are not able to find jobs. This is made easier putting in mind that the Federal Reserve has been very successful in the stabilization of inflation to about 2 % annually which has been considered to be the healthiest.
The idea of the central bank having a priority in the reduction of unemployment is a very good idea because it will be another way of stabilizing the economy. In the future, the Fed should also be committed having a clear public communication on the current conditions of the economy, its framework of making policy and the outlook of the economy. The Fed should improve its discussions on the economy through publication of monetary reports that are more comprehensive. The Fed should also define its reaction function so that the public is able to anticipate and understand future policy actions. In order to improve the effectiveness of the monetary policy, the Fed should also have an increased transparency in its operations and also work to preserve its independence. It is good governance to maintain a healthy separation between the institutions responsible for spending and tax policies and those that are responsible for creation of monetary.
Work cited
Broz, J. Lawrence. The International Origins of the Federal Reserve System. Cornell University Press, 2007.
Marrs, Jim. "Secrets of Money and the Federal Reserve System. HarperCollins, 2000.
Michael D. Reagan. "The Structure of the Federal Reserve System." Money and Banking (2011): 153-161.
Wicker, Elmus. Federal Reserve Monetary Policy. New York, 2010.
Wood, John H. A history of the Central Banking in the United States. 2005.
