After the Federal Open Market Committee met Tuesday, it issued this statement: “The Federal Open Market Committee decided today to keep its target for the federal funds rate at 1 percent.”
That is a matter-of-fact statement that most people understand. Imagine that it instead had announced: “The Federal Open Market Committee decided today to keep buying government bonds at about the same rate as before.”
The second version says essentially the same thing as the first, and it is technically more accurate, but less easily understood by the general public. Virtually everyone knows that the Fed “sets” interest rates. Few people understand exactly how they do it.
In reality, the Fed does not set interest rates — it influences them. It does so by varying the amount of money in circulation.
Economics professors often talk about increasing or decreasing the money supply. In the real world, it usually is a question of slower money supply growth vs. faster growth. True decreases in money are infrequent.
BONDS ARE MAIN TOOL
The principal tool the Fed uses to boost or constrict the amount of money in the economy is by buying and selling government bonds. These are the same federal IOUs that many households own, either directly or through a mutual fund, pension plan or whole life insurance policy.
Like households, banks or other entities, the Federal Reserve can buy or sell U.S. Treasury bonds on any working day.
The Fed’s objective in buying and selling such bonds is very different, however, from that of people or financial institutions.
Private investors buy bonds when they want a safe investment. They sell bonds when they want to use these invested funds for other purposes.
The Fed, in contrast, buys and sells bonds to increase and decrease the growth in the money supply. While it holds bonds, it gets the interest due on them, just like any other bondholder.
But this is an incidental detail. If you or I or our banks or insurers buy a bond, we have to come up with the money somehow. We have to save it up or sell some other asset. The Fed can simply create it.
It buys and sells bonds in the same open bond markets that everyone else uses. That is why the committee that sets Fed money policy is called the Open-Market Committee. But when it pays for purchased bonds, the payment flow differs from ours.
If I buy a bond, I write out a check to a bond broker. The brokerage deposits my check in its bank, which forwards it to the district federal bank for the region where the broker operates.
That Fed district puts money into the check clearing account that the broker maintains at that Fed. It then takes an equal amount of money out of the check clearing account of my bank and sends my bond payment check on to my bank. When my bank posts the check, the same sum is taken out of my account.
I now own a bond, but my bank account is smaller by the amount of the bond and any broker’s commission. I have a bond instead of cash; the broker has cash instead of a bond. The total amount of money in the economy hasn’t changed a whit.
When the Fed buys a bond, it also writes a check to the bond broker. The bond broker deposits the Fed check in its bank. The bank forwards the check to its regional Fed bank for clearing. All this is the same as when I bought the bond.
Once the Fed’s check to the brokerage gets to the Fed, things start to differ. I write checks through a commercial bank where I have an account. The Fed essentially writes checks on itself. When the broker’s bank submits the Fed’s bond payment check to the district bank, this regional Fed once again credits the check clearing account of the broker’s bank.
But it does not have to take money out of the account of any other bank. It just creates the money paid to the broker’s bank out of thin air. It didn’t exist before and does not come from anyone or anywhere else.
Note that none of this is apparent to either the broker or the commercial banks involved. For them, the transaction is exactly the same as if I had bought the bond instead of the Fed. The broker accepted a check and gave up a bond. The bank accepted a deposited check and was credited for it just as it would be for a check made out to a grocery store.
As a result, there is more money in the economy. The money supply is now larger than it was before.
If the Fed buys enough bonds, the extra money available will translate into an increased supply of funds for investing or lending and interest rates will drop. The amount of the drop will depend on the volume of Fed bond purchases relative to other savings and to demand for money for lending.
REDUCING THE MONEY SUPPLY
The process is reversed when the Fed sells a bond. The bond broker that buys such a bond writes a check to the Fed. The Fed takes that money out of the clearing account of the broker’s bank and sends them the check. The bank posts checks received from the Fed and takes the money out of the broker’s account.
The money that the Fed takes out of the broker’s bank’s account does not go anywhere, however. It simply disappears. The broker now has a bond instead of money, but no one else in the economy has money instead of a bond.
The total money supply has shrunk.
If the Fed sells enough bonds, interest rates will rise. When the Fed says it will “keep its target for the federal funds rate at 1 percent,” it means: “We will buy or sell government bonds as necessary to keep the federal funds rate at about 1 percent. If it goes above this target, we will buy bonds. If it goes below it, we will sell.”
Note that the Fed only announces a target for one interest rate, which is a very short-term one. The Fed has kept its target for that rate the same during the last six weeks, when mortgage interest rates went up by more than a fifth. How and why that happened is a story for another day.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.