The structure of the United States Federal Reserve is complicated, and the nuances of how it makes policy are even more complex. Thus, most news stories focus on the Fed chairman’s personality or his utterances rather than substantive questions.
The Federal Open Market Committee meets Tuesday. Most pundits expect another baby-step increase in interest rates at what will be Chairman Alan Greenspan’s last meeting. After the meeting, these pundits will parse every line in the press release to glean indications of what will happen at the next meeting (March 28). And yet they will ignore a critical indicator buried at the bottom of the announcement ¿ which and how many of the 12 district banks asked for an increase in the discount rate.
The role of these regional banks is entirely ignored in coverage of the Fed, and it should not be. It is impossible to explain why without a short history lesson.
The district banks constituted the key operational component when the system was established in 1913. They were to make monetary policy independently for their respective districts. Subsequent reorganization diminished their apparent power, but they retain substantial latent influence that is key at times like now.
Direct lending from these reserve banks to commercial banks within their district was the tool for providing an “elastic currency” in the words of the act. Take, for example, a bank in my hometown, Chandler, Minn. If the Chandler bank had credit-worthy customers who wanted loans but it had no money to lend out, it could ask the Federal Reserve Bank of Minneapolis for a loan.
From the Chandler bank’s perspective, it was a commercial transaction. It had to present collateral and had to pay interest at the so-called “discount rate.” The loan had to be repaid, with interest, when due.
Things were different from the Minneapolis bank’s end of things. Unlike an ordinary commercial bank that needs deposits before it can make a loan, the new Reserve Banks could simply create money out of thin air to make such loans. That was why they were established.
Within a few decades, the buying and selling of government bonds supplanted discount lending as the key tool for changing the money supply. But such lending still exists.
By law, the board of directors of each district bank must vote each month on what interest rate they want for their bank. However, the same discount rate now must apply across all districts. The Fed Board of Governors must approve any changes.
There is a neat counterbalance. The board cannot make any change until one or more district banks request one. But the districts cannot change the rate without board approval. To most eyes, this implies that discount rate changes are a bureaucratic formality.
They send important signals, however. Whenever the FOMC raises its target for short-term rates, the board approves a parallel request to raise the discount rate. It always lists the district that submitted requests for an increase. The number of banks submitting a request is a measure of the views of the district bank presidents. All 12 presidents participate in FOMC meetings. Five vote at meetings in an annual rotation.
In 2005, all 12 banks requested an increase in six out of the eight meetings. (Ten and seven requested increases at the other two meetings.) Such near-unanimity is unusual in the history of the system.
Now, in early 2006, it would be highly unusual for all the 12 banks that requested increases as recently as December to suddenly want no change at all. If more than a few banks continue to request discount rate hikes, the ability of either Greenspan or successor Ben Bernanke to stop interest rate increases is circumscribed.
The fact that motions made by Fed chairs seldom are defeated in FOMC votes misleads many. Chairs win votes because they are savvy enough to never make motions that more than one or two members will oppose. Strong stands by committee members “including the five voting district bank presidents” can keep even strong-willed chairs from mandating monetary policy.
District banks¿ requests for changes in the discount rate are strong indicators of how the five voting presidents and seven nonvoting ones view conditions. Numerous requests tell the chair and other governors that there is strong support for change from a set of committee members whose votes ultimately must be swung to some consensus position.
Unfortunately, not all of this is visible to the public. The Board of Governors announces rate change approvals. It does not disclose when it receives requests that it does not act on. So while FOMC members can read the tea leaves in real time, the public must wait until after the dust settles.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.