Discount computer desk

I. INTRODUCTION

The textbook view of the monetary transmission mechanism rests on the central bank's ability to manipulate the overnight interest rate by controlling the reserve supply, followed by a rational-expectations mechanism that ensures that movements in the overnight rate reverberate into longer maturity rates. However, while few dispute the fact that the central bank controls the overnight rate effectively, the notion that it does so via a liquidity effect and the nature of term structure relationships needs to be reexamined.

Modern central banking is generally characterized by public announcements of an interest rate target, such as the federal funds rate target in the United States. In some cases, central banks (such as the Bank of Australia and the Bank of England) also disclose an inflation target, while in extreme cases, the banks (such as the Reserve Bank of New Zealand) disclose the parameters of the policy reaction function. These actions constitute a significant departure from traditional central banking.

It is natural to question why central banks have abandoned their once-secretive behavior in favor of public disclosures of policy moves. Likely reasons include the desire for better and more precise control of the overnight rate, and, more important, enhanced communication of future policy moves--in essence, the Holy Grail of controlling long rates by also manipulating expectations.

This paper investigates these issues as they relate to the U.S. Federal Reserve. In particular, we focus on how the Federal Reserve's 1994 policy change--by which it began announcing the target level for the federal funds rate--had an impact on the liquidity effect and the manner in which the central bank uses open market operations to control the federal funds market. We also examine what effect this policy change may have had on the behavior of the term structure.

Prior to the Federal Reserve's Federal Open Market Committee (FOMC) meeting in February 1994, monetary policy objectives for the federal funds rate and the outcome of the FOMC meeting itself had been confidential and had never been announced. (1) After the policy change occurred, and inspired by similar developments in other central banks, Demiralp and Jorda (2000), Guthrie and Wright (2000), Taylor (2001), Thornton (2001), and Woodford (2000) began to investigate a central bank's ability to control the overnight rate--not merely through traditional open market operations, but by effectively communicating the desired level of the overnight rate and standing ready to enforce that level. As Meulendyke (1998) observes, "the [federal funds] rate has tended to move to the new preferred level as soon as the banks know the intended rate." In this paper, we term this method of controlling the overnight rate the announcement effect (following Demiralp and Jorda [2000]); this effect differs from the conventional liquidity effect in that the volume of open market operations required to signal the new target level is substantially smaller because of expectations.

The strategy we pursue to investigate the announcement effect consists of using two types of controls. The first is to analyze the data with two primary subsamples: one predating and the other postdating the 1994 policy change. The second is to compare, within a subsample, the pattern of open market operations surrounding days in which the target was changed relative to the rest of the subsample.

Most of the time, open market operations conducted by the Trading Desk of the Federal Reserve Bank of New York ("the Desk") are designed to accommodate variations in the reserve needs that stem from a variety of factors, such as changes in currency holdings, float, and large Treasury balances; to manage currency in circulation; and to accommodate other variations in the supply of reserves. Based on a particular type of variation (unexpectedly large Treasury balances), Hamilton (1997) calculates the interest rate elasticity to an unanticipated shortfall in reserves. In contrast to Hamilton, we measure the elasticity of different types of open market operations to variations in the reserve needs, expectations of a target change, and enforcement of a new target level.

The expectation that policy decisions about whether to change the federal funds rate target typically will follow FOMC meetings introduces a natural discipline in term rates, and, more specifically, in the manner in which expectations regarding future rates are updated according to the FOMC calendar. Consequently, we investigate whether the market indeed follows this discipline and whether the response of term rates on the FOMC calendar is consistent with the rational-expectations hypothesis of the term structure.

Our paper is organized as follows. Section II describes the nature of the announcement effect and the role of expectations in the context of a simple model of the reserves market proposed by Taylor (2001). Based on the insights of this model, deviations of the federal funds rate from its target value emerge as indicators of the Desk's forecast error of the reserve needs. These deviations can therefore be used to assess how the Desk manages different types of open market operations to keep the funds rate on target as well as to signal changes in this target. Thus, Section III reviews the behavior of the deviation of the funds rate from target over the maintenance period while Section IV presents detailed evidence of the emergence of the announcement effect since 1994. The same mechanism that ties the formation of expectations around the FOMC calendar and gives rise to the announcement effect determines the behavior of term interest rates. Section V documents how movements in term rates are closely tied to the expectations formation associated with the FOMC calendar. Section VI summarizes our main findings.

II. THE FEDERAL FUNDS MARKET AND OPEN MARKET OPERATIONS

The stylized model of the reserves market (discussed, for example, in Gilbert [1985], Heller [1988], and Goodfriend and Whelpey [1993]) describes a downward-sloping demand schedule of reserves as a function of the federal funds rate. This relationship reflects the demand for reservable deposits on behalf of depository institutions and therefore reserve requirements and excess reserves. The supply of reserves is depicted as a kinked schedule: a perfectly inelastic supply-of-reserves section corresponding to the level of nonborrowed reserves determined by open market operations, and an upward-sloping section corresponding to discount-window borrowing. The slope of the latter section of the supply schedule is characterized by the spread between the discount rate and the federal funds rate along with the administrative costs of having tapped a resource that is directly rationed by the corresponding regional Federal Reserve Bank. Under this simple framework, an open market sale has the effect of reducing nonborrowed reserves, thus shifting the supply schedule to the left and increasing the equilibrium level of the federal funds rate along with the amount of discount-window borrowing.

Recent developments in the reserves market require that we refine this canonical model. First, the collapse of the Continental Illinois Bank and Trust Company and other similar failures in the mid-1980s have made banks significantly more reluctant to use the discount window (although extended credit reached volumes in excess of $7 billion at the height of the crisis, this volume has remained essentially at zero levels throughout the 1990s). As a consequence, the supply of reserves is now better characterized by its inelastic section, which is determined by nonborrowed reserves alone.

Second, banks hold reserves primarily for two reasons: to meet legal reserve requirements and to facilitate interbank payments. Reserve requirement ratios were reduced in 1990 and 1992. In addition, a clarification of Fed policy and advances in computer technology since 1994 have encouraged banks to be more aggressive in "sweeping" customer deposits subject to reserve requirements into instruments exempt from such requirements. (2) These events have significantly reduced reserve requirements, from $20 billion in 1990 to $10 billion in 1996 and to $4 billion today. However, banks still need reserves to meet interbank payments and to meet the demand for currency. Third, and more important, since the February 1994 FOMC meeting, the Fed has publicly disclosed its target level for the federal funds rate. This has had a significant effect on the price-discovery process in the federal funds market and on the manner in which the market forms expectations about future policy moves.