We had a comment last week asking for an explanation of, roughly, what it is that the Federal Reserve does, so I thought that would be a good topic for a Beginners post. (For a complete list, go here.) This would have been a relatively easy question to answer a year ago, but since then it’s gotten considerably more complicated. Like all Beginners articles, I’m going to make a number of simplifications, for example generally treating the Federal Reserve as one big bank (it’s really twelve different banks). I’m also going to ignore many of the Fed’s functions; for example, the Federal Reserve is itself a bank regulator, but I’m not going to discuss that.

The Federal Reserve (Fed) is itself a bank, with assets and liabilities. Most but not all banks (by assets, not by number), including all the biggest ones, have accounts at the Fed, and those accounts have money in them. The Fed attempts to affect the behavior of the banking system through the policies governing the way it interacts with those banks. In recent history up to the current crisis, the most important tool of the Fed was its “open market operations” through which it influences the Fed funds rate.

The Fed funds rate is the interest rate at which banks lend money to each other overnight. It gets its name from the fact that the banks lend each other money by transferring it between their accounts at the Federal Reserve. You can think of this as the most fundamental kind of lending in the financial sector: if a lot of depositors take out their money from some bank on the same day, it needs more money, so it borrows it from another bank via its account at the Fed. The Fed funds rate matters because, in ordinary circumstances, it is the short-term cost of money for banks, and therefore influences the cost at which they lend money out to everyone else.

Because lending between banks is a private transaction, the Fed cannot dictate the Fed funds rate. Instead, it attempts to influence the rate by controlling the amount of money in the system. The Fed’s open market operations consist of buying and selling U.S. Treasury securities. When the Fed buys Treasuries from banks, it pays for them by crediting those banks’ accounts at the Fed. This increases the amount of money in those accounts, which lowers the price of money, meaning that the Fed funds rate goes down. Banks can exchange the amounts in their Fed accounts for “real,” paper money at any time, so this is how money is added to the economy. (Selling Treasuries does the reverse and makes the rate go up.) Another way to look at this is that the Fed cares about the amount of money in the system, and the Fed funds rate is the metric it uses to keep track of the amount of money.

As I said, for the last couple of decades this has been the primary policy instrument of the Fed. However, during the current crisis the Fed has arguably been more active in another role: as the lender of last resort.

Before the crisis, the Fed already had something called the “discount window,” which was a virtual teller window where banks could borrow money overnight at the “discount rate.” The discount rate is higher than the Fed funds rate – the idea being that banks should try to borrow from each other first before coming to the Fed. As a result, lending via the discount rate was historically minimal. However, as banks became increasingly unwilling to lend to each other, the Fed kept widening the discount window to make it easier for banks to get funding. I admit I needed Wikipedia to remind me of all of the new flavors:

• The Term Auction Facility lends short-term money to banks at a rate set by an auction. Loans must be collateralized, meaning that the bank must give securities to the Fed until it pays the loan back.
• The Term Securities Lending Facility is similar, except instead of money (increases to accounts at the Fed) the Fed is lending out Treasury securities; again, these loans are collateralized.
• The Primary Dealer Credit Facility, created at the time of the Bear Stearns collapse/bailout/acquisition, allows primary dealers (the banks that transact Treasury securities directly with the Fed) to borrow money, again in exchange for collateral.
• The Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, created immediately after the Reserve Fund broke the buck in the wake of the Lehman collapse, was intended to provide a market for commercial paper sold by money market funds, to help protect those funds against liquidity runs.
• The Commercial Paper Funding Facility, created a few weeks later, allowed the Fed to loan money directly to non-financial firms by buying their commercial paper (technically speaking I believe the Fed loans the money and takes the commercial paper as collateral), in order to get short-term funding to those firms (since the usual buyers had left the market).

The net effect of these changes has been to allow a broader range of institutions to borrow money from the Fed by handing over an ever-widening range of collateral, including many securities for which there is virtually no market. In effect, Ben Bernanke decided that the economy was not going to run out of liquidity on his watch. If this sounds vaguely like the original TARP plan, it should, since it means that institutions can hand over illiquid securities in exchange for cash or Treasuries; however, the big difference is that these are all short-term loans, which means that after some period of time (one day, or maybe 90 or 120 days at the upper end) the institution has to pay off its loan and take the illiquid securities back.

Now, to the question that I’m sure some of you have: Where does all this money come from? Ordinarily, if the Fed is taking in lots of securities and lending out lots of money, it does so by increasing the balances in banks’ accounts at the Fed, which creates money (and, therefore, inflation). In this case, however, for each billion dollars the Fed lends out into the economy, the Treasury Department is selling a billion dollars’ worth of securities, thereby sucking the same amount of money out of the economy (and into its account at the Fed). So, yes, this is being paid for by issuing more U.S. government debt, but if things ever settle down and the amount of Fed lending goes back down, the Fed (or Treasury – not sure here) should have the money to vacuum up that debt, assuming that institutions pay back their loans or their collateral is good.

(I got this last explanation from James Hamilton at Econbrowser, who is a good source for people who want to further plumb the mysteries of this topic.)

• Beginners