Supply of Federal Reserve Balances
The supply of Federal Reserve
balances to depository institutions comes from three sources: the Federal
Reserve’s portfolio of securities and repurchase agreements; loans from the
Federal Reserve through its discount window facility; and certain other items on
the Federal Reserve’s balance sheet known as autonomous factors.
Securities Portfolio
The most important source of
balances to depository institutions is the Federal Reserve’s portfolio of
securities. The Federal Reserve buys and sells securities either on an outright
(also called permanent) basis or temporarily in the form of repurchase
agreements and reverse repurchase
agreements. Purchases or sales of securities by the Federal Reserve, whether
outright or temporary, are called open market operations, and they are the
Federal Reserve’s principal tool for influencing the supply of balances at the
Federal Reserve Banks. Open market operations are conducted to align the supply
of balances at the Federal Reserve with the demand for those balances at the
target rate set by the FOMC.
Purchasing securities or arranging a repurchase
agreement increases the quantity of balances because the Federal Reserve creates
balances when it credits the account of the seller’s depository institution at
the Federal Reserve for the amount of the transaction; there is no
corresponding offset in another institution’s account. Conversely, selling
securities or conducting a reverse repurchase agreement decreases the quantity
of Federal Reserve balances because the Federal Reserve extinguishes balances
when it debits the account of the purchaser’s depository institution at the
Federal Reserve. There is no corresponding increase in another institution’s
account. In contrast, when financial institutions, business firms, or
individuals buy or sell securities among themselves, the credit to the account
of the seller’s depository institution is offset by the debit to the account of
the purchaser’s depository institution; so existing balances held at the Federal
Reserve are redistributed from one depository institution to another without
changing the total available.
Discount Window
Lending
The supply of Federal Reserve balances
increases when depository institutions borrow from the Federal Reserve’s
discount window. Access to discount window credit is established by rules set
by the Board of Governors, and loans are made at interest rates set by the
Reserve Banks and approved by the Board. Depository institutions decide to
borrow based on the level of the lending rate and their liquidity needs.
Beginning in early 2003, rates for discount window loans have been set above
prevailing market rates. As a result, depository institutions typically will borrow from the
discount window in significant volume only when overall market conditions have
tightened enough to push the federal funds rate up close to the discount rate.
Overall market conditions tend to tighten to such an extent only infrequently,
so the volume of balances supplied through the discount window is usually only a
small portion of the total supply of Federal Reserve balances. However, at
times of market disruptions, such as after the terrorist attacks in 2001, loans
extended through the discount window can supply a considerable volume of Federal
Reserve balances.
Autonomous
Factors
The supply of balances can vary substantially
from day to day because of movements in other items on the Federal Reserve’s
balance sheet. These so called autonomous factors are generally outside the
Federal Reserve’s direct day to day control. The most important of these factors
are Federal Reserve notes, the Treasury’s balance at the Federal Reserve, and
Federal Reserve float.
The largest autonomous factor is Federal
Reserve notes. When a depository institution needs currency, it places an order
with a Federal Reserve Bank. When the Federal Reserve fills the order, it debits
the account of the depository institution at the Federal Reserve, and total
Federal Reserve balances decline. The amount of currency demanded tends to grow
over time, in part reflecting increases in nominal spending as the economy
grows. Consequently, an increasing volume of balances would be extinguished,
and the federal funds rate would rise, if the Federal Reserve did not offset the
contraction in balances by purchasing securities. Indeed, the expansion of
Federal Reserve notes is the primary reason that the Federal Reserve’s holdings
of securities grow over time. Another important factor is the balance in the
U.S. Treasury’s account at the Federal Reserve. The Treasury draws on this
account to make payments by check or direct deposit for all types of federal
spending. When these payments clear, the Treasury’s account is reduced and the
account of the depository institution for the person or entity that receives the
funds is increased. The Treasury is not a depository institution, so a payment
by the Treasury to the public (for example, a Social Security payment) raises
the volume of Federal Reserve balances available to depository institutions.
Movements in the Treasury’s balance at the Federal Reserve tend to be less
predictable following corporate and individual tax dates, especially in the
weeks following the April 15 deadline for federal income tax payments.
Federal Reserve float is created when the
account of the depository institution presenting a check for payment is
credited on a different day than the account of the depository institution on
which the check is drawn is debited. This situation can arise because credit is
granted to the presenting depository institution on a preset schedule, whereas
the paying institution’s account is not debited until the check is presented to
it. Float temporarily adds Federal Reserve balances when there is a delay in
debiting the paying institution’s account because the two depository
institutions essentially are credited with the same balances. Float temporarily
drains balances when the paying institution’s account is debited before the
presenting institution receives credit under the schedule. Float tends to be
quite high and variable following inclement weather that disrupts the normal
check delivery process.