A typical day in the conduct of open market operations

Each weekday morning, two groups of Federal Reserve staff members, one at the Federal Reserve Bank of New York and one at the Board of Governors in Washington, D.C., prepare independent pro­jections of the technical factors affecting reserve availability for the next few days and for several weeks to come. At 11:15 a.m., the Manager of the System Open Market Account and the group in New York are linked in a telephone conference call with members of the senior staff at the Board of Governors and with a Federal Reserve Bank president who is currently a member of the FOMC. Participants in the call discuss staff forecasts for reserves, recent developments in financial markets, and the latest data on the monetary and credit aggregates. They pay special attention to trading conditions in the reserves market, particularly to the level of the federal funds rate in relation to the level expected to be con­sistent with the reserve conditions specified in the policy directive. In light of this information, they determine a program of open market operations. After the call, which usually ends around 11:30 a.m., all FOMC members as well as all nonmember Bank presidents are in­formed of the actions the Federal Reserve intends to take during the day.

When the Federal Re­serve has decided to un­dertake a particular op­eration, members of the staff at the Domestic Trading Desk (the Desk) at the Federal Reserve Bank of New York contact dealers trading in U.S. Treasury and federal agency securities. Approximately three dozen dealers that actively trade in U.S. Treasury and federal agency securities have relationships with the Desk; thus, the Fed­eral Reserve normally encounters no difficulty in promptly com­pleting its large orders. Once the transaction is executed, the re­serve account of each dealer's bank is credited or debited accordingly,and the supply of reserves to the banking system changes.

The discount window

The Federal Reserve's lending at the discount window serves two key functions:

· It complements open market operations in managing the re­serves market day to day and in implementing longer-term monetary policy goals.

· It facilitates the balance sheet adjustments of individual banks that face temporary, unforeseen changes in their asset-liability structure.

The role of the discount window in the conduct of monetary policy has changed substantially since the early years of the Fed­eral Reserve. In the 1920s, the discount window was the primary conduit for monetary policy and for the provision of reserves to the depository system. As U.S. financial markets developed, how­ever, providing reserves primarily through open market opera­tions became feasible and more efficient. As a result, discount window lending has for many years accounted for a relatively small fraction of total reserves.

Despite the comparatively small volume of borrowed reserves, the discount window remains an important factor in re­serves market management and in the broader implementation of monetary policy. It serves as a buffer in the re­serves market against unexpected day-to-day fluctuations in reserves demand and supply. When the demand for re­serves is unexpectedly high or the supply is unexpectedly low, banks can turn to the window for reserves. Thus, the availability of the window helps to alleviate pressures in the reserves market and to reduce the extent of unexpected movements in the federal funds rate. Moreover, adjustments to the basic discount rate can be important in signal­ing and implementing shifts in the Federal Reserve's monetary policy stance.

Apart from its role in monetary policy, discount window lending enables individual banks to adjust their balance sheets. Open market operations could not easily duplicate the discount window's role in facilitating certain balance sheet adjustments. Although discount window loans and open market operations have comparable effects on aggregate reserve availability, the loans are uniquely suited to the task of meeting the temporary liquidity needs of individual depositories. Conversely, open mar­ket operations are better suited to implementing the short-term adjustments to the availability of aggregate reserves that are nec­essary in conducting monetary policy.

Interest rates

The structure of interest rates charged on discount window credit has changed over the years. However, the rate for adjustment credit, which is the basic discount rate, has always been the most significant for monetary policy. Today, separate, market-related rates generally apply for seasonal credit and extended credit.

The basic discount rate that each Federal Reserve Bank charges on its loans is established by the Bank's board of directors, subject to review and determination by the Board of Governors. Originally each Federal Reserve Bank set its discount rate independently, to reflect the banking and credit conditions in its own District. Over the years, however, the transition from regional credit markets to a national credit market has gradually produced a national discount rate. As a result, the Federal Reserve maintains a uniform struc­ture of discount rates across all Reserve Banks.

The basic discount rate is adjusted from time to time, in light of changing market conditions, to complement open market operations and to sup­port the general thrust of monetary policy. Changes in the discount rate are made judgmentally rather than automatically and may somewhat lag changes in market rates. The imme­diate response of market interest rates to a change in the discount rate—the announcement effect—depends partly on the extent to which the change has been anticipated. If rates have adjusted in anticipation of a change in the discount rate, the actual event may have only moderate effects on market condi­tions. Generally, the response of market rates to a change in the discount rate will be largest when the market views the adjust­ment as signaling a basic shift in the stance of monetary policy. In­deed, given the generally small volume of discount window credit, the direct effect of a discount rate change on the funding costs of depository institutions is quite small. Thus, the effect of changes in the discount rate must be interpreted in the context of existing economic and financial conditions and in relation to other policy actions. For example, the response of market rates will also depend on actions taken in open market operations.

The basic discount rate is applied on all adjustment credit. Sur­charges above the basic discount rate have at times been applied to larger institutions that relied too frequently on adjustment bor­rowing as a source of funding. In 1980 and 1981, for example, the Federal Reserve applied a surcharge (varying between 2 and 4 percentage points) to adjustment borrowing by institutions hav­ing deposits of $500 million or more that appeared to be borrow­ing more frequently than necessary. The surcharges were intended to encourage these institutions to adjust their portfolios more quickly.

Before 1990, the basic discount rate also applied to all loans under the seasonal credit program. In early 1990, after careful review of the program, the Board implemented a market-related rate on sea­sonal credit. The move was designed to eliminate the implicit sub­sidy associated with the discount rate, which is a below-market rate, while still providing a reliable source of funds for institutions lacking access to national money markets. The market-related rate applied to seasonal credit is based on an average of recent federal funds rates and ninety-day certificate of deposit (CD) rates, but it is never less than the discount rate applicable to adjustment credit. The market-related rate is reestablished periodically.

At the discretion of each Federal Reserve Bank, the basic discount rate may be applied to extended credit loans for as long as thirty days. A flexible rate somewhat above market rates, and always 50 basis points above the rate charged for seasonal credit, is ap­plied to extended credit loans that are outstanding for more than thirty days. In practice, the flexible rate is often applied to ex­tended credit loans outstanding for less than thirty days.

Borrowing eligibility

Before the passage of the Monetary Control Act of 1980, only banks that were members of the Federal Reserve System enjoyed regular access to the discount window. The Monetary Control Act extended reserve requirements to nonmember institutions and provided that any institution holding deposits subject to reserve requirements (such as transaction accounts and nonpersonal time deposits) would have the same access to the discount window that member institutions have.

Institutions eligible to borrow at the discount window include do­mestic commercial banks, U.S. branches and agencies of foreign banks, savings banks, savings and loan associations, and credit unions. Many depository institutions meet the eligibility criteria —about 11,000 banks (including U.S. branches and agencies of for­eign banks) and 16,000 thrift institutions (including credit unions) at the end of 1993. Eligibility to borrow is in no way contingent upon or related to the use of Federal Reserve priced services.

Borrowing procedures

Institutions that expect to borrow at the discount window typi­cally execute a set of legal documents with the Federal Reserve that specify the terms and conditions under which discount win­dow credit will be granted and the requirements for collateral pledged to secure such loans.

All discount window credit must be secured to the satisfaction of the Federal Reserve Bank that is providing the credit. Satisfactory collateral generally includes U.S. Treasury and federal agency se­curities and, if of acceptable quality, mortgage notes covering one-to four-family residences; state and local government securities; and business, consumer, and other customer notes. Although col­lateral is generally held in safekeeping at the Federal Reserve Banks or by acceptable third-party custodians, borrowers in good financial condition may be permitted to hold their own collateral, appropriately earmarked; lending against borrower-held collat­eral, however, is usually of only short duration.

Federal Reserve Banks ensure that the value of collateral pledged to secure a discount window loan exceeds the amount of the loan. The extra cushion of collateral helps protect the Reserve Banks against loss in the event that a borrower defaults.

Technically, discount window credit can be extended as a discount of eligible paper (notes, drafts, and bills of exchange) or as an ad­vance secured by collateral. Although these are two distinct forms of credit, both practices are customarily referred to as discounting, and the interest rate charged on such borrowing is called the dis­count rate. When obtaining credit in the form of a discount, the borrowing depository institution transfers eligible paper carrying its legal endorsement to the Federal Reserve Bank. In return, the borrower is credited in an amount equal to the discounted value of the eligible paper at the current discount rate. When the dis­counted paper matures, it is returned to the borrower, and the borrower's reserve account is debited by the full amount of the paper. An advance is simply a loan by a Federal Reserve Bank to the borrowing institution on its note secured by adequate collat­eral. At one time, discounts were the predominant form of dis­count window credit. From an operational perspective, however, advances are more convenient, and thus for many years all dis­count window credit has been in the form of advances.

The Federal Reserve most often makes a loan by crediting the re­serve account of the borrowing institution. For borrowers that do not maintain accounts with the Federal Reserve, credit is ex­tended by increasing the reserve account of the borrower's corre­spondent bank (a bank that has agreed to accept the deposits of, and perform services for, another); essentially, the Federal Re­serve writes a check on itself, which the borrower then deposits with its correspondent bank. All loans, whether adjustment, sea­sonal, or extended credit, are technically demand notes and hence have no real maturity. As a matter of convenience, discount offic­ers may arrange to extend credit for a period of time without re­quiring the borrowing institution to make a formal request to re­new the loan each day.