MONETARY POLICY TOOLS AND THE FEDERAL FUNDS RATE BASIC INFORMATION

Until the financial crisis of 2007–2009, the Fed primarily relied on three monetary policy tools. During the financial crisis, the Fed announced several new policy tools. In the fall of 2010, two of these new policy tools were still active.We first consider the Fed’s three traditional policy tools:

1. Open market operations. Open market operations are the Fed’s purchases and sales of securities in financial markets. Traditionally, the Fed concentrated on purchases and sales of Treasury bills, with the aim of influencing the level of bank reserves and short-term interest rates. During the financial crisis, the Fed began purchasing a wider variety of securities to affect long-term interest rates and to support the flow of credit in the financial system.

2. Discount policy. Discount policy includes setting the discount rate and the terms of discount lending. When Congress passed the Federal Reserve Act in 1913, it expected that discount policy would be the Fed’s primary monetary policy tool. The discount window is the means by which the Fed makes discount loans to banks, and serves as the channel to meet banks’ short-term liquidity needs.

3. Reserve requirements. The Fed mandates that banks hold a certain fraction of their checkable deposits as vault cash or deposits with the Fed. These reserve requirements are the last of the Fed’s three traditional monetary policy tools. The required reserve ratio is a determinant of the money multiplier in the money supply process.

During the financial crisis, the Fed introduced two new policy tools connected with bank reserve accounts that were still active in the fall of 2010:

1. Interest on reserve balances. In October 2008, the Fed introduced a new tool when it began for the first time to pay interest on banks’ required reserve and excess reserve deposits. Reserve requirements impose an implicit tax on banks because banks could otherwise receive interest on the funds by lending them out or by investing them.

The Fed reduces the size of this tax by paying interest on reserve balances. The Fed also gains a greater ability to influence banks’ reserve balances. By raising the interest rate it pays, the Fed can increase banks’ holdings of reserves, potentially restraining banks’ ability to extend loans and increase the money supply. By reducing the interest rate, the Fed can have the opposite effect.

2. Term deposit facility. In April 2010, the Fed announced that it would offer banks the opportunity to purchase term deposits, which are similar to the certificates of deposit that banks offer to households and firms. The Fed offers term deposits to banks in periodic auctions. The interest rates are determined by the auctions and have been slightly above the interest rate the Fed offers on reserve balances.

For example, in October 2010, the interest rate on the Fed’s auction of $5 billion in 28-day term deposits was 0.27%, which was higher than the interest rate of 0.25% the Fed was paying on reserve deposits. The term deposit facility gives the Fed another tool in managing bank reserve holdings. The more funds banks place in term deposits, the less they will have available to expand loans and the money supply.