Federal Reserve Open Market Operations Research Articles

Whither the liquidity effect: The impact of Federal Reserve open market operations in recent years

Previous research indicated that the daily liquidity effect, or the change in the federal funds rate associated with an exogenous change in Fed balances, varies with several factors including the day of the maintenance period. In this paper, we examine data from 1998 to 2007, the recent period of increased Federal Reserve transparency before the financial crisis, and find that the liquidity effect stabilized across days of the maintenance period. We conclude that the liquidity effect may be a function of the uncertainty about banks’ end-of-day balances, as well as pure maintenance period effects. Moreover, we find that increased transparency led to a larger liquidity effect on the days prior to an FOMC meeting.

Whither the Liquidity Effect: The Impact of Federal Reserve Open Market Operations in Recent Years

Previous research indicated that the daily liquidity effect, or the change in the federal funds rate associated with an exogenous change in Fed balances, varies with several factors including the day of the maintenance period. In this paper, we examine the data over the recent period of increased Federal Reserve transparency and find that the liquidity effect stabilized across days of the maintenance period. Rather, the liquidity effect may be a function of the uncertainty about banks' end-of-day balances. Moreover, we find that increased transparency led to a larger liquidity effect on the days prior to an FOMC meeting.

Preliminary evidence on the determinants of Federal Reserve open market operations

In the absence of a fixed policy rule, the Federal Reserve Bank (Fed) has significant discretion in setting monetary policy. The existence of professional "Fedwatchers" attests to the fact that Fed policy actions are difficult to interpret. Recent literature has focused on the motivations behind Fed policy making and the need for secrecy and ambiguity. We investigate one aspect of Fed behavior: the propensity of the Fed to buy and sell government securities beyond that required to implement stated policies. Milton Friedman (1982: 26) called attention to this issue when he wrote:

The policy effectiveness of open market operations in the 1920s

This paper tests high tide and reserve position hypotheses about the effect of Federal Reserve open market operations on Federal Reserve credit and the money supply during the 1920s. The evidence supports the reserve position hypothesis that open market sales (purchases) led to increases (decreases) in member bank borrowing from the Fed that kept Federal Reserve credit constant. Federal Reserve banks could not use open market operations to control their own assets, much less the macroeconomy during this decade.

A theory of the bureaucratic value of Federal Reserve operating procedures

Beginning in the mid-1960s and continuing since there has raged a prolonged argument over the proper method, or operating strategy, for carrying out open market operations. This argument has led the Federal Reserve to experiment with and abandon a number of strategies. However, until the most recent experiment, which began in October 1979, all these strategies had one common component: all utilized some money market interest rate as the immediate target of OMO. Undoubtedly the Federal Reserve's reluctance to give up its money market target was founded on economic theoretic grounds. The Keynesian model, which was dominant throughout the 1950s and 1960s and into the 1970s, concentrated on interest rates, not monetary aggregates. Economists trained in this tradition naturally would be slow to discard the received knowledge of the era. This paper sets out another reason for the Fed's tenacity in holding to the money market mode of operation. It analyzes the Federal Reserve System as a bureau, run by individuals who seek to maintain the autonomy of their organization. From this perspective the choice of an operating strategy will be made not only on economic grounds but also on political. Since the political attractiveness of various strategies may differ considerably, the Fed may be substantially influenced by non-economic factors in its choice of methods. Section 1 sets out the theory of bureaucracy used to analyze Federal Reserve behavior. Section 2 describes a model of Federal Reserve information provision developed by B.M. Friedman (1978). The third section briefly reviews the history of Federal Reserve open market operations since the 1950s, paying special attention to the Fed's choice of operating strategies and the criticisms of those strategies by insiders and outsiders. Section 4 presents evidence that the policy followed by the Fed during the 1970s did indeed provide considerable information about future plans, enabling the

Is the Federal Reserve's Monetary Control Policy Misdirected?

On October 6, 1979, the chairman of the Board of Governors of the Federal Reserve System announced a new operating procedure by which Federal Reserve open market operations were to be conducted to control unborrowed bank reserves directly rather than to control the Federal funds rate as previously. Subsequently there was increased variability in both interest rates and monetary growth. Why this happened and what if anything can be done to improve monetary control were the subjects of the Journal of Money, Credit, and Banking Debate held on April 30, 1981, at the Ohio State University in Columbus.

ASSET MANAGEMENT AND COMMERCIAL BANK PORTFOLIO BEHAVIOR: THEORY AND PRACTICE

THIS PAPER REPORTS the results of an investigation we have conducted regarding two aspects of commercial bank portfolio management. With regard to the first aspect, two alternative hypotheses regarding bank behavior are tested. These are the implied in the commercial loan theory of banking and the maximization implied in recent developments in bank portfolio theory and related research. The second aspect is an investigation into the proposition that there has been a significant change in bank portfolio behavior in recent years. Knowledge of the first aspect of commercial bank behavior is important for monetary management. The accommodation principle implies that the demand for bank loans determines bank portfolio behavior. On the other hand, the profit maximization principle implies that commercial bank responses to market forces determine their portfolio behavior. Expectations of bank response to actions of the Federal Reserve System differ according to which principle is accepted. For example, under the accommodation principle, Federal Reserve openmarket operations slowing growth in the reserve base could have little effect on growth in the volume of bank loans if the demand for such loans, at given interest rates, was expanding rapidly. Such would be the case if economic activity was expanding rapidly. Thus, loans could continue to rise at the previous rate or even to accelerate if demand should strengthen. Banks would tend to accommodate such demand by shifting out of investments. By comparison, in such circumstances of Federal Reserve restraint, profit maximization would induce banks to reduce the rate of growth of both loans and investments, at given interest rates, with loan growth continuing at its previous rate only if interest rates on loans rose relative to interest rates on investments. Changes in bank portfolio behavior, the second aspect of this investigation, have important implications for monetary management. A change in commercial bank portfolio behavior may be reflected in a shift in a function, a change in the shape of the function, or both. For example, with regard to bank loans, a shift in the function explaining the desired level would be reflected in a change in its intercept. A change in its shape would be a change in the elasticity of the desired level of loans with regard to one or more of its arguments. Monetary authorities, when attempting to forecast the asset behavior of banks in response to a given change in monetary policy, must take into consideration empirical evidence bearing on these questions. If the central bank

From Bills Only to Operation Twist: A Study of Federal Reserve Open-Market Operations for the Period 1953-1964

From Bills Only to Operation Twist: A Study of Federal Reserve Open-Market Operations for the Period 1953-1964

THE FEDERAL RESERVE SYSTEM';S “BILLS ONLY” POLICY*

THE CENTRAL PROBLEM of the present study is a policy initiated by the Federal Reserve System in March, 1953, and followed, with brief interruptions, until February, 1961. The principal provisions of the policy were: (1) restriction of Federal Reserve open market operations to the purchase and sale of short-term United States government securities, preferably Treasury bills, except for the correction of disorderly markets; (2) conduct of Federal Reserve open market operations solely to influence the reserve positions of member banks, with no attempt to influence particular yield structures in the market; and (3) discontinuance of Federal Reserve support of Treasury financings, a provision which carried with it a corollary prohibition against System swapping operations either to clear the way for new Treasury issues or to affect the yield curve on government securities. These three principal provisions were embodied in the Federal Reserve System's only policy. The present study attempted to discover the appropriateness of such a policy for the effective execution of the responsibilities of the Federal Reserve in its role as the nation's central bank. Examination of the historical setting of the bills policy revealed that the policy was the product of several factors, including: (1) System reaction to years of subservience to the Treasury; (2) a concept of free markets; and (3) a desire by the Federal Reserve to strengthen the government securities market. Early defenses of bills centered largely around its desirability as a means of strengthening the government securities market; but later defenses also emphasized the compatibility of the policy with the primary responsibilities of the Federal Reserve. A review of the arguments and 'empirical studies dealing with various aspects of bills suggests that the opponents of the policy have the stronger theoretical and empirical case. The subject of the term structure of interest rates was examined because neither the Federal Reserve nor other proponents of bills have stated explicitly the theory of the determination of the interest rate pattern which bills assumes. The factors which determine the prevailing rate structure at any given time were examined in an effort to discover the implications for the execution of monetary policy. The theory of the term structure accepted in the present study emphasizes both expectations and the preferences displayed by both issuers and investors for certain types of securities. A review of economic conditions and monetary policy during the 1953-1962 interval provides empirical support for the accepted theory of the term structure of rates, and examines the appropriateness of monetary policy within that context. The review suggests that there were numerous instances when a departure from bills would have seemed advisable. Both the inability and unwillingness of the Federal Reserve to take what would seem to have been the

The Deposit Relationship and Commercial Bank Investment Behavior

D ESPITE the growth in importance of other financial institutions the behavior of the commercial banking system remains a principal consideration in most discussions of national monetary affairs. Explanations of the way in which the Federal Reserve System exerts its influence on the cost and availability of credit in the economy continue to rely heavily on hypotheses about the loan and investment policy of the commercial banking system. For example, the postwar doctrine of credit rationing appears to rest primarily on the observed behavior of commercial bankers in dealing with their loan customers. Less exclusively but still significantly, the effectiveness of debt management and Federal Reserve open market operations in influencing the terms of credit to private borrowers has been linked to the responsiveness of commercial bankers to changes in market prices and yields of government securities. concept of the commercial bank which undergirds the argument for the sensitivity of commercial bankers to yield differentials is basically similar to that of an individual investor concerned with the yield, risk, and liquidity of alternative financial instruments. By an appropriate development of risk considerations' and by (rather general) allusion to oligopolistic imperfections of competition within the banking industry,2 this model has been extended to cover the rationing of bank credit by nonprice means. Nevertheless, the state of our understanding of commercial bank behavior is not entirely satisfactory. If commercial bankers are sensitive to yield changes on government securities why have they moved so freely out of these securities whenever the demand for bank loans was strong? 3 If oligopolistic conditions within the banking industry occasion nonprice rationing of bank credit what is their specific nature and how do they exert their influence? purpose of this article is to contribute to our understanding of commercial bank behavior by examining some implications for bankers of the demand deposit relationship of their loan customers. Anyone who troubles to inquire of commercial bankers will discover that the deposit relationship of a loan customer is a primary consideration in determining the cost and availability of bank credit to that customer. Despite this fact, the literature of monetary economics has little or nothing to say about the deposit relationship as one of the determinants of the investment behavior of commercial banks. Rather, as I have mentioned, we have preferred to carry forward the discussion in terms of the broader analytical categories of yield, risk, and liquidity applicable to any investor. But a discussion of commercial banks which is couched in these more general terms abstracts from some of the essential features of commercial banks as specialized financial institutions. In particular it neglects the role of deposits as the principal source of an individual bank's power to lend and invest. In what follows we shall examine the significance of the deposit relationship for the individual bank and then explore its influence on such broader issues as the cost and availability of bank cred* This article is drawn from a more comprehensive study of commercial bank loan and investment policy supported by Merrill Foundation for the Advancement of Financial Knowledge, Inc. author wishes to acknowledge the helpful criticism of Professors James Duesenberry, John Lintner, Lawrence Thompson, and Dr. Parker Willis. 1 For examples see Ira 0. Scott, The Availability Doctrine: Theoretical Underpinnings, Review of Economic Studies, xxv (October I957); and my own Risk and Credit Quarterly Journal of Economics, LXXIV (May I960). 2 For examples see John H. Kareken, Lenders' Preferences, Credit Rationing, and the Effectiveness of Monetary Policy, this REVIEW, xxxix (August I957); Monetary Policy and Management of the Public Debt, Joint Committee on the Economic Report, 82d Congress, 2d Session, Statement of Paul Samuelson; and Warren L. Smith, On the Effectiveness of Monetary Policy, American Economic Review, XLVI (September I956), esp. 593-96. 'This movement is chronicled and discussed in John H. Kareken, Post-Accord Monetary Developments in the United States, Banca Nazionale del Lavoro (Rome), Quarterly Review, September I956, 588-607; and Warren L. Smith, op. cit., esp. 597.