How central banks manipulate interest rates?
Do they simply buy or sell securities (mostly short-term bonds), or do they lend money directly to banks?
Thanks.
The Fed lends money directly to the banks.
Originally Posted by Swordsmyth
They can do both. They directly set the Discount Rate. That is the rate at which banks can borrow money directly from the Fed (this is usually just over night or very short term loans to banks to help them meet reserve requirements- say they issued to many loans one day comared to what their deposits would allow them to- they borrow enough to balance the books that day and try to adjust loans and deposits the next day). Borrowing here is very low. These loans requlre collateral. Next is the Fed Funds Rate. This is the rate banks charge each other to borrow instead of going to the Fed. The Fed can try to influence that by changing their Discount Rate- if it is cheaper to borrow from the Fed than each other this will encourage the banks to lower their rate to compete. These are the typical interest rates the Fed uses.
During this crisis, they have greatly increased their balance sheets to also target longer (beyond overnight) rates by buying US Treasuries. US Treasuries are sold at auction to investors and the Fed can later buy from selected intermediary dealers in the open market (not directly from the US Treasury). At first they were buying shorter term Treasuries but in the last year have targeted more long term Treasuries. Things like mortgage rates are more closely tied to long (ten years or more) Treasury rates.
The Fed purchases increases the demand which raises the prices for the securities and higher prices means lower interest rates for them (the Treasury notes have a face value- say $10,000 and buyers make an offer of how many they want to buy and what price they are willing to pay- the Treasury sells them at the highest price which will allow them to get rid of all they want to sell in that auction- the difference between the selling price and the face value determines the interest rate when expressed as a percent).
Sometimes they lend directly to the banks but mostly, banks prefer not to do that because it's seen as a sign of an unhealthy bank if fellow banks aren't willing to lend it. Not to mention, they'd have to pay higher interest when borrowing from Fed. So usually Fed simply buys Treasury securities whenever it wants to increase moneysupply & thereby lower the price of borrowing money (aka interest).
There is enormous inertia — a tyranny of the status quo — in private and especially governmental arrangements. Only a crisis — actual or perceived — produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes politically inevitable
- Milton Friedman
Thank you for the detailed answer!
I have a few follow up questions:
1. What's the point of reserve requirements if the banks can always borrow money from the Fed to keep them? In other words, what are the incentives for banks NOT to borrow money from the Fed?
2. You said "These loans require collateral". Could you explain this please?
3. Why would the Fed want to buy short term treasuries from the banks to decrease interest rates if it can just change the discount rate?
4. Do you know if between 2001 and 2007, the Fed bought any US treasuries from the banks in order to decrease interest rates, or it changed the discount rate to do that?
Thanks a lot.
Prior to 2008, the Fed kept a basically flat balance sheet (portfolio of assets)- mostly Treasury notes. When notes expired or matured, they used the money to buy replacements (rolling the notes over). The chart below doesn't go back all the way to 2001 but it shows what it looked like before they began their expansion in 2008. They did mostly use the Discount Rate and Fed Funds rate targets to try to influence intrest rates during that time. Chart (list not graph) for both: http://www.newyorkfed.org/markets/st...s/fedrate.html Between December 2001 and June 2006 the Fed Discount Rate went from 1.25% to 6.25%. (this period covers much of the US housing bubble). But these are short term rates and mortgage rates don't always follow short term rates (and in this case they did not).
http://seekingalpha.com/article/1396...-balance-sheet
The bluish area is their Treasury holdings. It took a dip at the start of their economic bailouts as they trade their good quality debt (Treasuries) for what was at the time "bad" debt of mortgage backed securities (the debt wasn't all bad- it was just that the bundles of mortgages were so mixed up that good assets were impossible to desern from bad ones so there was no market for any of it).
I think there were a couple of things to discourage banks from borrowing money from the Fed. One is stigma- if you are borrowing a lot from the Fed to balance your books regularly, you probably aren't running your business very well and that would scare away customers- both depositors and borrowers. Then there is the interest costs of borrowing (though you could perhaps get more in return on an investment than the cost of the loan) and the third would be the collateral. Collateral would be things like other securities you turn over to the Fed in exchange for the loans. More info on this topic:
http://www.frbdiscountwindow.org/ple...l=pledging.cfm
More at link.What types of assets can I pledge to the Discount Window?
The following types of assets are most commonly pledged to secure discount window advances:
Obligations of the United States Treasury
Obligations of U.S. government agencies and government sponsored enterprises
Obligations of states or political subdivisions of the U.S.
Collateralized mortgage obligations
Asset-backed securities
Corporate bonds
Money market instruments
Residential real estate loans
Commercial, industrial, or agricultural loans
Commercial real estate loans
Consumer loans
The first thing you need to get a grasp of is the money is fake. Once you can relate to the fact the money is fake everything else will start to get clear. Until then you are chasing your tail.
Saying a certain type of money is "fake" because one doesn't like it or that it isn't as good as some other is facetious!
So of course, government-money is "real money" ("common money" to be more precise).....for now.....because "money" is whatever people BELIEVE it is, afterall, people have used salt, tobacco, seashells, animal-skin & what not as "money".
Of course, there are some things that are better suited for being used as "money" like gold, silver & such but that does NOT mean that other types of "money" can't exist or that they are "fake".
There is enormous inertia — a tyranny of the status quo — in private and especially governmental arrangements. Only a crisis — actual or perceived — produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes politically inevitable
- Milton Friedman
You are conflating currency with money. Money must be a real tangible item. Currency can be whatever people BELIEVE is currency... accounting digits, bitcoins, paper, promises, or real money, whatever. I could promise to give you 10 ounces of gold, but until you hold them in your hand it is a fake promise... it becomes real when you take possession.
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