| We hear a lot about interest rates, and not only in my | | | | prescribed percentages of their checkable deposits. |
| professional field of expertise. Interest rates are | | | | Compliance with the requirements is regularly tested, |
| everywhere to be found in our daily lives: credit card | | | | every two weeks for banks accounting for the bulk of |
| interest, interest on deposits, car loan interest, personal | | | | deposits. Reserve tests are the fulcrum of monetary |
| loan interest, treasury bond interest. The other day I | | | | policy. Banks need "federal funds" (currency or |
| received a spam e-mail that said: "Need new socks ? | | | | deposits at Federal Reserve System) to pass the |
| Apply for our Family Loan - competitive interest rates". | | | | reserve tests, and the Fed controls the supply. When |
| Since I am single and own approximately fifty pairs of | | | | the Fed buys securities from banks or their depositors |
| socks - they seem to be the preferred Christmas | | | | with base money, banks acquire reserve balances. |
| present in my household - I decided not to push the | | | | Likewise the Fed extinguishes reserve balances by |
| 'Click Here' button. But just what are the mechanics of | | | | selling Treasury securities. These are open-market |
| interest rate setting? Who decides which interest rate | | | | operations, the primary modus operandi of monetary |
| to charge to whom - and how? | | | | policy. A bank in need of reserves can borrow |
| Paul Volcker, while chairman of the Board of | | | | reserve balances on deposit in the Fed from other |
| Governors of the Federal Reserve System (1979-87), | | | | banks. Loans are made for one day at a time in the |
| was often called the second most powerful person in | | | | "federal funds" market. Interest rates on these loans |
| the United States. Volcker triggered the "double-dip" | | | | are quoted continuously. Central Bank open-market |
| recessions of 1979-80 and 1981-82, vanquishing the | | | | operations are interventions in this market. Banks can |
| double-digit inflation of 1979-80 and bringing the | | | | also borrow from the Federal Reserve Bank at the |
| unemployment rate into double digits for the first time | | | | announced discount rate. The setting of the discount |
| since 1940. Volcker then declared victory over inflation | | | | rate is another instrument of central bank policy. |
| and piloted the economy through its long 1980s | | | | Nowadays it is secondary to open-market operations, |
| recovery, bringing unemployment below 5.5 percent, | | | | and the Fed generally keeps the discount rate close to |
| half a point lower than in the 1978-79 boom and helping | | | | the federal funds market rate. However, announcing a |
| Ronald Reagan convert the American people to | | | | new discount rate is often a convenient way to send |
| Reaganomics. Volcker was powerful because he was | | | | a message to the money markets. |
| making monetary policy. Central banks are powerful | | | | How is the Fed's control of money markets |
| everywhere for the same reason, although few are | | | | transmitted to other financial markets and to the |
| as independent of their governments as the Fed is of | | | | economy? How does it influence spending on goods |
| Congress and the White House. Central bank actions | | | | and services? To banks, money market rates are |
| are the most important government policies affecting | | | | costs of funds they could lend to their customers or |
| economic activity from quarter to quarter or year to | | | | invest in securities. When these costs are raised, |
| year. | | | | banks raise their lending rates and become more |
| Monetary policies are technically demand-side | | | | selective in advancing credit. Their customers borrow |
| macroeconomic policies. They work by stimulating or | | | | and spend less. The effects are widespread, affecting |
| discouraging spending on goods and services. | | | | businesses dependent on commercial loans to finance |
| Economy-wide recessions and booms reflect | | | | inventories; developers seeking credit for shopping |
| fluctuations in aggregate demand rather than in the | | | | centers, office buildings, and housing complexes; home |
| economy's productive capacity. Monetary policy tries | | | | buyers needing mortgages; consumers purchasing |
| to damp, perhaps even eliminate, those fluctuations. It is | | | | automobiles and appliances; credit-card holders; and |
| not a supply-side instrument. Central banks have no | | | | municipalities constructing schools and sewers. Banks |
| handle on productivity and real economic growth. A | | | | compete with each other for both loans and deposits. |
| central bank is a "bankers' bank." The customers of | | | | Because banks' profit margins depend on the |
| the Federal Reserve Bank are not ordinary citizens but | | | | difference between the interest they earn on their |
| "banks" in the inclusive sense of all depository | | | | loans and other assets and what they pay for |
| institutions--commercial banks, savings banks, savings | | | | deposits, the two move together. Thanks to its control |
| and loan associations, and credit unions. They are | | | | of money markets and banks through monetary policy, |
| eligible to hold deposits in and borrow from the Federal | | | | the Fed influences interest rates, asset prices, and |
| Reserve System and are subject to the Fed's reserve | | | | credit flows throughout the financial system. Arbitrage |
| requirements and other regulations. The same | | | | and competition spread increases or decreases in |
| relationship exists in Canada between the Bank of | | | | interest rates under the Fed's direct control to other |
| Canada and the individual banking institutions. | | | | markets including, of course, real estate. |
| Banks are required to hold reserves at least equal to | | | | |