How Does the Fed Expand Credit?

Easy money. Credit expansion. Lower interest rates. Most people understand these ideas, but how does the Fed actually accomplish this? This article will go over how the Fed uses its power to print credit money in order to influence the economy. How the Fed introduces new money into an economy was explained in a previous article.

There are 4 ways in which the Fed expands credit:

  1. Federal Funds Rate (FFR) by printing money
  2. The discount window
  3. Term auction facility
  4. Change of the reserve ratio

The utilization of most of these measures emanates from the Fed’s ability to print money. As we’ll see, the Fed needs to print money in order to manipulate the FFR. It also needs to print money in order to discount loans during the discount window. It similarly needs new money for the term auction facility. Only the changing of reserve ratios does not require new money from the Fed.

Federal Funds Rate

Despite its name, the Federal Funds Rates (FFR) is not the rate at which the Fed lends to member banks. The FFR is actually the rate at which private banks lend deposits to each other, usually on an overnight basis to meet immediate liquidity needs, such as maintaining reserve ratios. If one bank needs reserves while another has too much in reserves, the latter lends to the former. This rate is comparable to what LIBOR (London Interbank Offered Rate) is in Europe.

By law, banks must maintain a certain amount of deposits at the Federal Reserve or as cash in their vault. This is called the reserve ratio, and a typical reserve ratio is around 10% for most banks. This means that if a bank has $1 billion dollars deposited there, it only needs to keep $100 million in its reserves. This system of keeping only a fraction of deposits on hand for redemption is called the fractional reserve banking system. What and how fractional reserve banking works can be found in my previous article.

When you hear people say that the Fed “has lowered interest rates”, they are referring to the FFR. The Fed determines whether or not to change the interest rates at every meeting of the FOMC (Federal Open Market Committee), a 12-member board that determines key decisions affecting the cost and availability of money. Manipulating the FFR is the primary way that the Fed expands credit. But how does the Fed actually influence the FFR?

The Fed influences the FFR by the buying and selling of government bonds (Treasury bonds or T-bonds for short). If the Fed wishes to lower the FFR, then it will buy T-bonds (at a premium) from what is called the open market. If the Fed wishes to raise the FFR , then it will sell T-bonds (at a discount) in the open market. The open market is simply the independent bond market (banks and dealers) for T-bonds. Usually, the Fed buys T-bonds from the banks to stimulate the economy, and gives them new money in exchange for the bonds.

What happens next is that banks now have more money in their reserves. The Fed cannot directly lower interest rates; it can only indirectly lower them by increasing the reserves of banks. If the banks have more money on hand, they will want to lend it out to earn more interest. They can only lend to more people by offering more attractive rates, which means reducing the interest debtors have to pay and/or lowering lending standards. Thus it is the banks that directly lower interest rates under indirect pressure created by the Fed.

The Fed’s 2 goals are unemployment and price stability (price inflation). Depending on these 2 conditions, the Fed will set a FFR range as a target (say 0.25%-0.50%). Because central banking isn’t exact, a range must be set as a target. The Fed tries to keep unemployment somewhere between 4%-5%, while trying to keep annual inflation rate between 1%-3%.

Here’s how the FFR target is determined:

  1. If inflation rates are expected to increase, the FFR target range is raised; the Fed sells Treasury bonds in order to raise the interest rate.
  2. If unemployment is above a desired rate, the FFR target range is lowered; the Fed purchases Treasury bonds in order to lower the interest rate.

What happens if price inflation is expected to increase and unemployment is above a desired rate? This given formula becomes self-contradictory. This is what happened in the 1970s, a period the Keynesians would like you to ignore. The short answer is that central banking cannot solve these problems (but bless their hearts the Fed still tries).

The discount window

The second method, though generally not used much before 2007, is the use of the discount window. This means that the Fed acts as the lender of last resort. If Alpha Bank desperately needs reserves but no other bank is willing to lend it their excess reserves, Alpha Bank can then approach the Fed for a last resort loan. The Fed then lends money to Alpha Bank at a rate slightly higher than the FFR. The rate at which the Fed lends to desperate banks through the discount window is called the discount rate.

The purpose of the Fed is to prevent member banks from bank runs. A bank run simply means that the bank has too few reserves to meet current demands for customers that wish to redeem their credits with the bank in physical cash. This is the inherent problem of a fractional reserve banking system; $10 are lent out for every $1 held on reserve at the bank. If just 10% of deposits were redeemed by customers, the bank would have no deposits left.

As with the FFR and the buying of T-bonds, this method of credit expansion also relies on the Fed’s ability to print money (figuratively, not literally, as only 3% of money actually physically exists; the rest exists electronically). If the Fed wishes to lend, it must print the money, otherwise, it couldn’t lend.

The third method, the Term auction facility (TAF), is similar to the discount window, except the banks bid for a certain quantity of reserves that the Fed is willing to loan to banks. If the Fed wants to expand the money supply, it auctions off new deposits to the highest bidders.

Reserve ratios

The last measure of expanding credit is reducing the reserve ratios of banks. With a fractional reserve banking system, banks only need to keep a fraction of money lent out on reserve. For example, if $100 is lent out, only $10 of it is actually held at the bank. This mean that the bank’s reserve ratio is $10/$100 = 10%. This means that if all deposits wished to withdraw their money from the bank simultaneously, only 10% of the clients’ money would actually be paid out.

The legal limit set on reserve ratios for banks is 10%. The Fed can induce banks to expand the money supply by lowering the reserve ratio. Suppose it is lowered from 10% to 5%. From our previous example, a $10 deposit can create $100 in money assuming a 10% ratio. With a 5% ratio, the bank can now create $200 from a $10 deposit. It is not very common for the Fed to alter reserve ratios, but the avenue does exist.

Credit expansion leads to price inflation. Furthermore, manipulating prices and values in the economy causes further distortions. The precise effects will be discussed later in a separate article.