Not surprisingly then, Fedwire is central to the nation’s money supply and health of the economy. But not only does it move massive amounts of money around, it is also the mechanism through which the Federal Reserve’s interest rate policy is implemented. When Fed Chair Janet Yellen announces that interest rates will increase/decrease, Fed traders get on their computers and sell/buy financial instruments to reach the desired interest rate target. These are known as Open Market Operations(OMO). [2]

The Federal Reserve was created in the aftermath of a devastating financial crisis in 1907. Although the crisis was alleviated, primarily by the actions of the infamous New York banker JP Morgan, it drew public anger and calls for reform. The next year, Teddy Roosevelt pushed for the Aldrich–Vreeland Act that formed the National Monetary Commission to study banking systems around the world. Banking elites drew up a new system of money control over the next few years. A few months after JP Morgan died, President Woodrow Wilson signed the “Currency Bill” or Federal Reserve Act of 1913 on Dec 23 of that year. It opened the next year on November 16 with assets from the sale of shares in the Federal Reserve Banks to stockholders of subscribing national banks.

Federal Reserve Banks began moving funds and information electronically in 1915 but it was not until 1918 that they created the proprietary telecommunications system known as Fedwire. The telegraph system connected the Federal Reserve Board in Washington DC to the US Treasury and all 12 Reserve Banks with lines leased from telegraph companies. Initially it was used for settling gold accounts without physical transfer and within a couple of years for transferring Treasury securities electronically. Over the next 40 years Fedwire migrated from Morse code telegraph systems to teletype and telex switched networks and eventually to proprietary telecommunications networks.

During the 1960s, the entire global financial system began to face a “paper crisis” and pushed the move to computerized information solutions. As transactions increased across the sector due to a thriving economy, paper-based record keeping and transfer just could not keep up. Banks, insurance, and securities companies began to automate their activities with computers. Also clearinghouses and exchanges saw the necessity of moving to computers and data networks. The Fed also began to implement automated computer operations starting with Xerox Sigma computers that allowed banks to enter their sales directly into the Fed’s books without additional human intervention. The pressure continued when the US went off the gold standard under President Nixon and the two oil crises dramatically increased the amount of US dollars in global circulation leading to extraordinary double-digit inflation.

President Jimmy Carter appointed Paul Volcker as the new Chair of the Fed in October of 1979. Volcker immediately enacted some tough measures that increased interest rates by “targeting” the amount of money in the economy and in bank reserves. Overnight interest rates for banks borrowing of Fed Funds increased to 11.2% in 1979 and later to a peak of 20% in June 1981.[3] Carter had also signed the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA or MCA) that brought all banks in the country under Fed control. The Act required the Fed to price and charge for most financial services including funds transfers, check clearing, currency and coin services. It was required to provide access to these services to nonmember depository institutions, and other financial services. This encouraged private-sector competition while also standardizing computer systems and connecting the network throughout the entire financial system. Internet protocol (IP) and distributed processing technologies were integrated in the 1990s and the Fed’s open market operations even replaced their famous chalkboards with computers.

How does the Fed try to control interest rates? Banks borrow money from each other through the Fed Funds Market over the Fedwire so they can increase their loan portfolios. If they determine they can make a profit by borrowing the money from other banks and lending it out at an advantageous rate, they will likely do that. Alternatively, they may decide that it is advantageous to hold interest-bearing bonds with their deposits rather than lend out the money. These transactional equations form the operational rationale for the FOMC policy prescriptions and the trading operations they direct.

The FOMC does not set the rate of interest but rather it sets a target that actual trading operations are instructed to meet in order to influence the money and credit conditions in the economy. It does this through the trading desks at the Open Market Operations located at the New York Fed. Workday mornings, around 9:30 AM, with the exact time of intervention determined by chance, the traders at the OMO intervene to influence the Fed Funds Market and guide the Fed Funds Rate towards the FOMC’s target rate.

The traders buy or sell government securities through the OMO to influence the banking system’s lending behavior, but it would be a mistake to think that the OMO trade directly in the federal funds market. Instead, the Fed participates in the Treasuries market and more recently agency debt, especially debt from Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Home Loan Banks. What they do is influence the amount of excess reserves banks have to lend overnight. The basic economic logic looks like the below.

– Fed Purchases
• Inc Bank Reserves
• Dec Fed Funds Rate
– Fed Sells
• Dec Bank Reserves
• Inc Fed Funds Rate

The OMO conducts both permanent operations, holding debt for long periods; and temporary operations, using repurchase agreements with maturities of less than a week. It does this through trades with the 19 primary dealers that act as intermediaries with the larger banking system. They trade with some 21 primary dealers including Barclays Capital, Citigroup, Credit Suisse Securities, Goldman Sachs, J.P. Morgan Securities, Morgan Stanley, UBS Securities, and Daiwa Securities America. Two primary dealers were lost with the collapse of Bear Sterns and Lehman Brothers in 2008. If the Fed’s OMO purchase bonds from the primary dealers, it will inject money into the banking system and decrease the incentive to borrow from the Fed Funds Market, consequently reducing interest rates. If they sell bonds through the primary dealers it will absorb money from the banks and increase the incentive to borrow through the Fed Fund Market and thus increase interest rates. So the result is that trading operations directly increase or decrease the level of Fed balances, not the flow of federal funds transactions among banks.

The buying and selling of U.S. government securities from these primary dealers influence the price of money bankers are lending to each other overnight. If the Fed purchases bonds it will increase bank reserves and decrease the Fed Funds interest rate. If they sell bonds to the primary dealers it will draw money out of bank reserves and increase the Fed Funds interest rate. By making it attractive for banks to buy government securities from them, the Fed can “tighten” the money supply; conversely, the purchase of bonds will inject money into the economy. It is this inverse relationship between OMO trades and the Fed Funds Rate that guides the nation’s money supply. If bank reserves increase because the banks have sold their government bonds to the Fed, the prices of interest rates, the amount lenders will charge for borrowing that money, will decrease. Likewise, if bank reserves fall because banks prefer to use that money to buy interest-bearing government bonds from the Fed, that action will increase the Fed Funds rate.

Whatever you think about the Federal Reserve, it is central to our current financial infrastructure. Very few people understand the processes of the central bank or the impact it can have on the economy. Others fear the Fed and the power it has over the economy. In any case, it is important for people to come to grips with this dominating institution and the way it structures our current political economy. Currently the Fed Funds Rate is near zero until unemployment decreases and the Fed purchases an additional $75 billion dollars a month in mortgage-backed securities and treasury bills to provide additional stimulus.[4]

Notes
[1] Fedwire transfer figures from http://www.federalreserve.gov/paymentsystems/fedfunds_ann.htm and include daily numbers which averaged U$S2.4 trillion dollars a day.
[2] This video takes you inside the New York Fed’s OMO.
[3] More information on the Fed’s handling of inflation in the late 1970s and early 1980s.
[4] For additional economic stimulus, The Fed has been buying a combination of treasury securities and mortgage-backed assets at a rate of $85 billion a month. In December of 2013 they announced the first “tapering” of $10 billion, reducing the monthly rate to $75 billion.

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Anthony J. Pennings, PhD recently joined the Digital Media Management program at St. Edwards University in Austin TX, after ten years on the faculty of New York University.