Importance of the Federal Reserve: its Role in Stabilizing the Economy

The Federal Reserve System, commonly known as “the Fed,” is the central banking system of the United States. It consists of the Board of Governors, the Federal Open Market Committee (FOMC), and 12 US Reserve Banks. The Fed manages monetary policies, interest rates, and the money supply in the country. It also supervises and regulates domestic banks and provides financial services to the U.S. government and financial institutions.

The Federal Reserve and financial markets: The main goal of the Federal Reserve is to determine and implement monetary policies to maintain the stability of the financial system in the United States. Hence, his decisions can have a significant impact on financial markets such as stocks, forex, bonds and commodities.

The Fed can influence the bond and forex markets by controlling short-term interest rates. By adjusting the federal funds rate (the interest rate at which Fed banks borrow and lend to each other), it can affect corporate bond prices. By raising interest rates, he can make the US dollar more attractive, which increases demand for the currency and thus its exchange rate in the Forex market.

In addition, the Fed can influence market sentiment by increasing or decreasing investor confidence. For example, if the Fed announces that it will lower interest rates in the future, investors may anticipate an economic slowdown and adjust their portfolios and strategies accordingly. On the other hand, if he announces that he will raise interest rates, investors may expect economic growth and adjust their portfolios and strategies accordingly.

But four elements of this simple explanation suggest that the problem may be more systemic. First, there is usually a huge increase in uninsured bank deposits when the US Federal Reserve engages in quantitative easing.

Deposit inflows increased from less than $5 billion in the third quarter

In a paper presented at the Federal Reserve’s annual Jackson Hole conference in August 2022, we (along with my co-authors) drew attention to this underappreciated fact. As the Federal Reserve resumed its quantitative easing policy during the pandemic, uninsured bank deposits rose from approximately $5.5 trillion at the end of 2019 to more than $8 trillion by the first quarter of 2022.

Silicon Valley Bank witnessed an increase in deposit inflows from less than $5 billion in the third quarter of 2019 to a rate of $14 billion per quarter during the period in which it adopted the quantitative easing policy. But when the Fed ended quantitative easing, raised interest rates, and quickly turned to quantitative tightening, these flows reversed. Silicon Valley Bank began to notice an increase in outflows of uninsured deposits (some of which coincided with the downturn in the technology sector, as the bank’s concerned clients began to withdraw cash reserves).

Second, taking advantage of the flood of deposits, many banks bought long-term liquid securities, such as Treasuries and mortgage-backed securities, in order to generate a profitable yield: an interest rate differential that generated higher returns than the banks had to pay for deposits. Usually, this is not risky. Long-term interest rates have not risen to significant rates for a long time; Even if they do start to rise, bankers realize that depositors are often complacent, and will accept low deposit rates for a long time, even when market interest rates rise. Thus, banks felt safe based on past experiences and thanks to depositors.

Uninsured deposits are unstable

Things were different this time, because the issue concerned unstable uninsured deposits. Because they were created by the Fed, they were always vulnerable to outflow whenever the Fed changed course. Because large depositors can easily coordinate among themselves, actions taken by a few of them can trigger another chain of actions. Even in sound banks, depositors who have paid attention to the banks’ risks and seen the best interest rates offered by money market funds will want to be compensated with high interest rates. Huge interest rate differentials between investments and “dormant deposits” would be threatened, weakening banks’ profitability and ability to repay. As a financial industry saying goes, “The road to hell is paved with positive borrowing.”

The third concern is that these two previously mentioned elements have been magnified today. The last time the Fed turned to quantitative easing and raised interest rates, during the period 2017-2019, the increase was surprising and less large; The volume of interest-sensitive securities held by banks declined. So the losses that banks’ balance sheets had to absorb were small, and there were no deposits, even though many of the same factors were in place.

This time, the rate and pace of interest rate increases and banks’ holdings of interest rate-sensitive assets have increased so much that the Federal Deposit Insurance Corporation has suggested that unrealized losses on holdings of held-to-maturity securities alone could exceed $600. Billion dollar. The fourth concern is unintended supervisory coordination with the sector. It is clear that many supervisors did not recognize banks’ increasing exposure to interest rate risks, or were unable to force banks to reduce their exposure to those risks. If supervision were more effective (we are still trying to measure the extent of its failure), fewer banks would be in trouble today.

Financial stability concerns

The upshot is that while many of the vulnerabilities in the banking system were created by the bankers themselves, the Fed also contributed to the problem. Periodic bouts of quantitative easing have stretched banks’ balance sheets, stuffing them with more uninsured deposits, making banks increasingly dependent on easy liquidity. This dependency is compounded by the difficulty of reducing quantitative easing and tightening monetary policy. The larger the amount of quantitative easing and the longer its duration, the more time the Fed must have when it normalizes its balance sheet and, ideally, raises interest rates.

Unfortunately, these financial stability concerns conflict with the Fed’s anti-inflation mandate. Markets now expect the Fed to cut interest rates at a time when inflation rates are well above target, and some observers are calling for a halt to quantitative easing. The Fed is again providing liquidity in large quantities using the discount window and other channels. If financial sector problems do not slow economic growth, such measures could prolong and increase the cost of the fight against inflation.

The bottom line is clear: the Fed cannot afford to ignore the role of its monetary policies (particularly quantitative easing) in creating the current difficult conditions as it reconsiders its behavior and supervisory role.

Related Articles