Teaching the New Tools of Monetary Policy: Frequently Asked Questions

The Federal Open Market Committee (FOMC) conducts monetary policy by setting the target range for the federal funds rate. The target range is typically 25 basis points wide. The Fed then implements policy by using its monetary policy tools to ensure this target range transmits to market interest rates, keeping the market-determined federal funds rate within the FOMC’s target range. For more discussion, see: “Making Technical Adjustments: The Difference Between ‘Conducting’ and ‘Implementing’ Monetary Policy.”

The federal funds rate is the interest rate at which depository institutions and government-sponsored entities—Fannie Mae, Freddie Mac and the Federal Home Loan Banks (FHLBs)—trade funds held in their reserve balance accounts at Federal Reserve banks with each other overnight. When one of these institutions has surplus balances in its reserve account, it may choose to lend funds to another institution that needs more balances. The rate that the borrowing institution pays to the lending institution is determined between the two parties; the weighted average rate for all these types of negotiations is called the effective federal funds rate. For more discussion, see: “How Does the Fed Use Its Monetary Policy Tools to Influence the Economy?”

The Fed’s primary tool for implementing monetary policy is interest on reserve balances (IORB), with its associated IORB rate, which is the interest rate that the Fed pays on the funds that banks hold in their reserve balance accounts at their Federal Reserve banks. For more discussion, see: “The Fed’s New Monetary Policy Tools.”

Open market operations (OMOs) are still part of the Fed’s toolkit. However, they are not the primary tool. There are two ways OMOs are used. First, in normal, day-to-day activities, there are forces in the economy that slowly drain reserves from the banking system. The Fed monitors the level of reserves and, when deemed appropriate, conducts OMOs (where it purchases securities and injects reserves into the banking system) to keep the level ample. Second, in times of severe stress, the Fed may do large-scale asset purchases, where sizable purchases of securities assist with financial stability and put downward pressure on longer-term interest rates. The Fed took this action during both the Global Financial Crisis (GFC) and COVID-19 pandemic.

OMOs are a long-standing tool of the Fed. They were the key tool used before the GFC, when the Fed implemented policy with limited reserves. Today and going forward, periodic OMOs are an important tool in the ample reserves framework the Fed has chosen to maintain for its operations.

Since March 2020, reserve requirement ratios have been set to zero, so banks do not have any required reserves. With this policy, all banks’ reserves are classified as excess. For more information on reserve balances see: Interest on Reserve Balances.

Many teaching materials suggest that banks loan out all funds that are not required reserves, which generates a money multiplier that links required reserves to the money supply. With reserve requirements eliminated in 2020, this explanation no longer works, and, mathematically, the textbook money multiplier equation is undefined. What to do? Instructors should teach that banks make loans with profits, risks and regulatory considerations in mind. When deposits come in, banks can hold the funds as reserves at the Fed or use them to make loans or invest in other assets. Some of these investment options increase the money supply. Also teach that the Fed influences banks' decision-making—about setting deposit and loan rates as well as lending and investment options—through the interest on reserve balance rate (a reservation rate for banks). For more discussion, see: “Teaching the Linkage Between Banks and the Fed: R.I.P. Money Multiplier.”

Today and over the longer run, the Fed has stated that it plans to implement monetary policy with ample reserves in the banking system and will ensure control over the level of the federal funds rate and other short-term interest rates through setting its administered interest rates. For more information, see: Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization.

At the same time that the FOMC sets the target range for the federal funds rate, the Fed determines the appropriate settings of its administered rates to ensure short-term interest rates, especially the federal funds rate, are at the desired levels. As described in the Federal Reserve Act, the FOMC sets the overnight reverse repurchase (ON RRP) offering rate and standing repurchase agreement facility (SRF) rate, whereas the Federal Reserve Board sets the interest on reserve balances (IORB) rate and discount window rate. The settings of the administered rates are found in the Fed’s implementation note that is released at the same time as the FOMC statement. FOMC statements and implementation notes can be found on the Federal Reserve System’s Board of Governors website.

The interest on reserve balances (IORB) rate does not set a floor on short-term interest rates. In fact, the effective federal funds rate is frequently less than the IORB rate. A key reason is that not all institutions eligible for accounts at the Fed earn interest. Government-sponsored entities—Fannie Mae, Freddie Mac and the Federal Home Loan Banks (FHLBs)—have accounts at the Fed that earn no interest. So, these institutions are willing to lend funds to a depository institution at an interest rate below the IORB rate but above zero. When this transaction occurs it is called arbitrage, and this action brings the federal funds rate close, but not equal, to the IORB rate.