Monetary Policy Normalization: The Tools of the Fed

Stephen Williamson, a vice president and economist with the St. Louis Fed, explained some of the tools the Fed has at its disposal to influence the economy, such as discount window lending and open market operations, or the buying and selling of securities such as Treasuries. He also discussed the use of these tools around the Great Depression.

Presentation (PDF)

• Part 1: Introduction
• Part 2: The Bank of England
• Part 3: Why the Fed Was Founded
• Part 4: The Tools of the Fed
• Part 5: Monetary Policy around the Great Recession
• Part 6: Normalization of Monetary Policy
• Part 7: Audience Q and A

Transcript:

Stephen Williamson: Okay, so the initial plan for the Fed was that it would work in a particular way, that you get this currency elasticity through a particular mechanism. And the mechanism was supposed to be discount window lending. Lending to banks. Currently, there's not an actual physical window where people, banks borrow, but the idea is the Fed lends to banks through what was formerly called the discount window, but it's, of course, done electronically now. But early on, when the Fed was designed, so that injecting money would work through lending by the central banks. So the Fed's balance sheet, you know, an early Fed balance sheet would kind of look like this. Where the assets would be loans through private banks. Discount window loans. I'd put gold in here, because we were still under the gold standard at the time. And then the liabilities would be one currency, circulating notes. And then the other liability is bank reserves.

Bank reserves are effectively, just like a checking deposit for a commercial bank. There's a whole lot of transactions get made among banks during the day. In fact, the equivalent of an annual GDP in financial transactions is done using bank reserves every day. Just like checking accounts for commercial banks, but they show up as a liability of the Fed. Just like, for Bank of America, your checking deposit is the Bank of America's liability.

Okay, so then the basic idea was that making the currency elastic through discount window lending would act to smooth interest rates over time. So the way we understand that now, smoothing interest rates over time is a good thing to do. And that helps to prevent panics. Okay. So the way—people had this vision about how the Fed would work when they wrote the Federal Reserve Act, but it didn't exactly turn out that way. The Fed discovered something along the way, which was open market operations. So that kind of comes out of 1920's experience. That's when financial markets get highly developed in the U.S. You have kind of a well-developed market for Treasury Securities. Fed discovers that if it buys and sells Treasury Securities, that it can move market interest rates. Key discovery, you know. Changes the governance of the Fed, because it makes the New York Fed become very important, because that's where the open market operations are done. So now the Fed balance sheet starts looking like this, you've got discount window loans and Treasury Securities on the asset side of the balance sheet. And maybe some gold in there. We still have some of that, but it's not so important anymore. And then the liabilities are currency and bank reserves. So there's—you know, it's a bank.

It's a central bank; we call it a central bank for a reason. The thing's a bank. There's assets and liabilities. Nothing actually so mysterious about it. It basically works in the same way. In some ways, it's kind of simpler. The assets aren't so complicated, because, you know, especially the Treasury Securities, these are marketable liquid assets. Here's roughly how an open market operation works. It's an asset swap. So what's the Fed doing? It's trading—it's issuing liabilities in exchange for some assets. No more mysterious than General Motors issuing corporate bonds to finance a new plant. It's issuing a liability to buy an asset. That's exactly what the Fed is doing. So effectively, what the Fed does, is it's—when it actually does the open market operation, the mechanical thing that actually happens, you know, it's an exchange of reserves for Treasury Securities. But ultimately, and this may not take long, it's going to show up in both currency and reserves. Because the, you know, reserves, as I said, it's like a checking account for commercial bank. And the commercial bank can withdraw currency from the Fed. So the reserves are convertible, one for one into currency. And so somehow, the Fed—all the Fed can do is determine the total. The total of currency, plus reserves. Its total liabilities, and then the banks, and people who use currency are going to determine the mix of the stuff. So effectively, what's happening is it's like a swap of currency in reserves for treasuries, and this is how it shows up in the balance sheet. This and that. That's going to increase the size of the balance sheet. Assets and liabilities increase by an equal amount, and it's going to show up as an increase in Treasury securities, and increase in liabilities of an equal amount on the other side of the balance sheet.

Okay, so now in the ‘30s, the Fed's got some serious tools. So they got a discount window lending. It's got that mechanism. And discount window lending is done through the regional Feds. The idea is going to be that you have this centralized system, you know, where the discount window lending is done through institutions like the St. Louis Fed and then the open market purchases are done in New York, where the financial center is. Okay? Now the question is, once you get to the Great Depression, what happens? Well, did the Fed use its tools? Well, you know, the conclusion seems to be not so much. They did a pretty crappy job of it. Not us. I wasn't alive at the time. I'm not responsible. Not that anybody thinks the Fed caused the Great Depression, but the idea is once you get into the thick of it, especially off in here. One year is like 1929. So this is real GDP in the Great Depression, scaled to 100. One hundred is 1929, and so here's 1933. 1933 is where you get the big collapse of the financial system. That's where a third of the banking system fails. And this is highly disruptive. It's highly disruptive at the level of—like retail transactions. Banks are suspending withdrawal. You know, you can't make payments. Even though some of the banks—the bank may not have failed, but you can't make payments using your deposit with banks, et cetera. Things froze up badly, and the Fed didn't do much about it. That was a problem. So this puts it—so what I did here was compare that to the Great Recession. For the Great Recession, this is 2007. This is annual data, so you can see the dip in real GDP and then it kind of comes back. So relative to the Great Depression, it doesn't look so bad. Of course, you know in terms of—if you look in terms of Post-World War II recessions, the Great Recession was severe. That's why we call it that.