Expectations, Open Market Operations, and Changes in the Federal Funds Rate

Abstract

The process through which Federal Reserve decisions about monetary policy are transmitted to the federal funds market has changed significantly in recent years. In 1994 the Federal Open Market Committee (FOMC) began to issue a public statement whenever it increased or decreased its target for the federal funds rate. This target is now the focus of activities at the Trading Desk at the Federal Reserve Bank of New York. In particular, the FOMC directs the Trading Desk to buy and sell securities so that conditions in the federal funds market are consistent with an average federal funds rate near this target. While FOMC decisions in earlier years were made in terms of a federal funds rate target, these decisions were communicated to the market in a less explicit way than they are now, and the communications were misinterpreted on a number of occasions.1 Now, when the FOMC publicly announces changes in its funds rate target, the market reacts very quickly and sometimes without any immediate open market purchases or sales by the Trading Desk to alter the supply of Fed balances.2 As stated by Meulendyke (1998, p. 142), “The rate has tended to move to the new, preferred level as soon as the banks knew the intended rate.” There have also been regulatory and technological changes affecting the federal funds market. Starting in July 1998 the Federal Reserve changed from a contemporaneous system of reserve accounting to a lagged system similar to a policy in place years ago. Under the new lagged reserve requirements, the two-week reserve maintenance period begins 17 days after the end of the two-week reserve computation period. This has probably led to better estimates of reserve requirements by the Trading Desk and the banks, but it has also eliminated the possibility of any contemporaneous response of required reserves to the interest rate. Another significant change made possible by computer technology is the ability of financial institutions to efficiently “sweep” their consumers’ accounts from those with reserve requirements into those without reserve requirements. These sweeps have allowed required reserve balances to decline sharply from about $30 billion in 1990, to $15 billion in 1996, to only about $5 to 6 billion today. As a result, holding Fed balances to facilitate interbank payments is of greater importance for many banks than holding reserves for legal requirements. At the same time, technology has improved the speed and accuracy with which banks can keep track of their payment inflows and outflows and thereby may have reduced the demand for Fed balances.3 In December 1999 the FOMC further expanded and clarified its public announcement policy. It began to issue a public statement after every meeting indicating not only its current decision about the federal funds rate target, but also which factor— “the risks of heightened inflation pressures or economic weakness in the foreseeable future”— is likely to affect upcoming decisions about the target. Although the statement about possible future actions is not part of the FOMC’s directive to the Trading Desk, it could have indirect effects on the Desk’s transactions if it affected the demand for Fed balances. See Federal Reserve Board (2000) for a summary of the announcement policies from 1994 to 2000. The purpose of this paper is to develop a simple model of the federal funds market that reflects some of these changes and that can be used to investigate other changes. The model makes use of a “Trading Desk reaction function” to describe the changes in the supply of Fed balances over time. The model also makes use of important recent microeconomic research by Furfine (1998, 2000a) and by Guthrie