FM for Actuaries

300 CHAPTER 9
Another important primary benchmark for short-term interest rate not shown in
Table 9.1 is the Euro Interbank Offered Rate (Euribor), which is a daily reference
rate published by the European Money Markets Institute. This is the average
interest rate at which Eurozone banks charge other banks for borrowing. 4
9.3 Inflation and Central Bank Policy
The Federal Reserve System (the Fed) is the central banking system of the U.S.
The Federal Reserve Act mandates the Fed with three duties: Sustain maximum
employment, maintain stable prices and moderate long-term interest rates.
The Fed has seven governors, who are appointed by the U.S. President. It is
comprised of twelve regional Federal Reserve Banks. 5 An important committee in
the Fed is the Federal Open Market Committee (FOMC), which consists of the
seven governors of the Fed, as well as the twelve presidents of the regional Federal
Reserve Banks. The FOMC is in charge of carrying out the monetary policies of the
Fed. However, only the seven governors and five Federal Reserve Bank presidents
vote at any given time. 6
The Fed influences the rate of interest (and hence the rate of inflation) through
controlling the amount of reserves commercial banks are required to hold. They
have the following three instruments to use in carrying out their mandate: Reserve
ratio, Discount Window lending and open market operation.
The reserve ratio is the fractional reserve requirement that a depository institution
needs to hold in the Federal Reserve Banks. By changing the reserve ratio,
the Fed can affect the money supply and hence the rate of interest. For example,
increasing the reserve ratio causes a contraction in the money supply and thus an
increase in the rate of interest. However, changing the reserve ratio is a very blunt
measure and it is rarely used. 7
The Fed has its own lending facility, namely, the Discount Window, through
which they lend directly to the commercial banks that need to boost their reserve
to meet short-term regulatory requirements. The Fed sets the rate of interest for
such borrowing. This rate has generally been about 100 basis points above the
target Federal funds rate. Commercial banks usually seek alternative borrowing
from other banks before using the Discount Window.
The Fed engages in open market operations through repurchase agreements
(repos). Under a repo the Fed buys U.S. Treasury securities, U.S. agency securities
4 Note that Euro LIBOR and Euribor are both interbank rates for borrowing euro. While the former
is based on banks in London, the latter is based on a panel of European banks.
5 Nationally chartered banks are required to hold stocks in the Federal Reserve Bank of their
region.
6 The president of the New York Fed and four other presidents rotate through 1-year terms.
7 Many countries, such as Canada and the U.K., have no reserve requirements.