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.

 

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