Not Just Crypto: How The Federal Reserve Works (5th Part)

By ☑️0🆇D̺͈͙͕̿ͧ̑ͣ🅰🆅🅸🅳eͤ | Darknet | 7 Oct 2023

In the previous 4 articles, I have talked about GDP, Commodity, Real Estate and Bond (1st), Cycles, Expansion and Recession (2nd), Correlations, Variables and Indicators (3rd) and Inflation, Deflation, Stagflation (4th Part). This is the fifth (penultimate) part on macro-economics and stocks. The main purpose of the Central Bank (Federal Reserve) is to issue money by keeping the inflation rate around 1.5%, a high employment rate and guaranteeing price stability. A higher money supply can stimulate a struggling economy but it can also lead to high inflation. Printing money does not automatically increase the amount of money for citizens and businesses because it is always interest rates and market conditions that lead to greater demand for loans (therefore incentives to spend leading to eventual economic growth).

Central banks therefore control:
-interest rates
-open market operations (OMO): buying and selling of government bonds to regulate the available money supply
-bank reserves
-LTRO (offer of long-term central bank loans to commercial banks, with subsidized interest rates to improve credit availability of the same)
-REPO (repurchase agreements and commitment to resell them in the future at a slightly higher price: this brings liquidity because commercial banks receive immediate cash to fulfill their needs)
-inverse REPO (reverse repurchase contracts: i.e. sale of securities with a commitment to repurchase them in the future at a slightly higher price. This decreases liquidity from the market)
-quantitative easing (government and debt securities are purchased on a regular basis to stimulate the economy. The reduction in the rate of purchase of government securities is called "tapering")
-quantitative tightening (occurs after expansive phases and serves to normalize the balance sheet, limiting the bubble condition caused by the easy access to credit generated by the previous situation: the quantity of money on the market is reduced)

The American interest rate is known as the Federal Funds Rate and concerns the lending of money between banks to meet their reserve needs (overnight: loans of very short duration, usually only one night). This interest rate is determined by the market by adding/subtracting money from the offer, the Fed tries to bring the Federal Funds into line with the pre-set interest rate. It pays no interest on reserves deposited with commercial banks, so there is no benefit to commercial banks in having large reserves. If a commercial "bank A" with 20% reserves wants to lend 5% to another "bank B" with 10% reserves, the overnight cost will be 10% per annum. If the target rate is lower/higher than that %, money is added/subtracted. If the target is 7%, the liquidity buffer for commercial banks and the money supply will be increased. The central bank will buy government bonds and debt on the open market from other nations, from investors, etc. This liquidity acquired from private individuals will be deposited in commercial banks by increasing their reserves and changing the overnight rate (lowering the rate at which these reserves are lent hence the cost of the coin). If, on the other hand, government bonds are sold, reserves and loan demand are reduced leading to an increase in the overnight rate and the cost of money.

The central bank can buy a security to resell it in the future (REPO) at a certain price (plus interest), trying to increase the amount of money in the system (lowering interest rates by encouraging investments and loans). On the other hand, in the reverse REPO, a government bond is sold to reduce the amount of money on the market (rates rise and this discourages spending and investments) and is committed to repurchasing it in the future at a certain price. More money in commercial banks lowers the cost of money (decreasing rates), while less money raises interest rates. Furthermore, the "real" currency (of citizens and businesses) must be distinguished from the "bank" one. The first allows economic growth and is regulated by governments by increasing/decreasing the quantity through incentives/taxes (if the productive sector is not sufficient to satisfy the demand, we have an increase in the cost of goods and services), it increases economic growth but also the inflation (it is represented by the liquidity of citizens and businesses in bank deposits; new liquidity is produced by commercial banks leading to inflation. The excess liquidity is balanced with investments in riskier assets with higher yields therefore a strong increase in money sees riskier assets, such as stocks and especially cryptocurrencies, perform better). The second, bank money, is used by commercial banks to carry out commercial transactions and does not fuel economic growth.
This is a brief summary of how the Central Bank operates and its interactions with commercial banks.