Making Sense of the Federal Reserve
The Fed Implements Monetary Policy
Once the FOMC lowers the target range, the Fed uses its monetary policy tools to implement, or carry out, the new stance of policy. In other words, the Fed uses its tools to ensure that market interest rates, especially the federal funds rate, move in the direction of the new target range. That helps steer the economy toward the Fed’s dual mandate goals. The key tools are “administered rates” that the Fed sets.
The Primary New Tool: Interest on Reserve Balances
Interest on reserve balances is just that—interest paid on funds that banks hold in their reserve balance accounts at their Federal Reserve bank. Because interest on reserve balances offers banks a risk-free option, it serves as a “reservation rate”—the lowest rate at which a bank will be willing to lend out its funds. As a result, the federal funds rate should not fall below the interest on reserve balances rate. Because the interest on reserve balances rate is an administered rate, the Fed can steer the federal funds rate by adjusting the interest on reserve balances rate. In fact, interest on reserve balances is the primary tool the Fed uses to adjust the federal funds rate.
The Supplementary Tool: Overnight Reverse Repurchase Agreement Facility
Not every financial institution that operates in the federal funds market can earn interest on its reserve balances. So, it’s possible that the federal funds rate could fall below the interest on reserve balances rate. To provide support, the Fed offers the overnight reverse repurchase agreement facility to a broader set of large financial institutions: They can earn the overnight reverse repurchase agreement offering rate, or ON RRP rate, by depositing funds with the Fed at this facility. So, this second administered rate helps set a floor for the federal funds rate.
Discount Rate: Setting a Ceiling for the Federal Funds Rate
The discount rate is the interest rate charged by the Fed for loans it makes through the Fed’s discount window. Because banks will not likely borrow at a higher rate than they can borrow from the Fed, the discount rate acts as a ceiling for the federal funds rate.
In short, the Fed adjusts two administered rates, interest on reserve balances and ON RRP, to keep the federal funds rate within the target range determined by the FOMC. And the Fed adjusts the discount rate to serve as a ceiling. The Fed usually adjusts the three administered rates (interest on reserve balances, ON RRP and discount) by the same amount and at the same time so they move up and down together.
And one more tool is necessary to ensure that these administered rates are effective.
Open Market Operations: Maintaining Ample Reserves
Open market operations are the buying and selling of government securities by the Federal Reserve. And, in particular, when the Fed buys a security, it pays for it by crediting the appropriate bank’s reserve account at the Fed. So, open market operations change the level of reserves in the banking system. The Fed’s administered rates are the key tools for monetary policy when reserves in the banking system are ample. So, the Fed uses open market operations periodically to ensure the level of reserves in the banking system remain large enough so that it can continue to lean on its administered rates to implement monetary policy.
For a more complete discussion of the Fed’s monetary policy tools, read the Page One Economics essay “The Fed’s New Monetary Policy Tools.”