In the previous article, The Federal Reserve System & Structure of the Fed, we mentioned the authority of the Federal Open Market Committee (FOMC), which meets eight times a year to set policies based on the economic conditions at the time. These policies and subsequent market operations aim to achieve the stability of the Fed's dual mandate.
These "policies" are mainly implemented using various tools available to the FOMC. But what exactly are these tools, and how do they influence the market to achieve the FOMC’s ultimate goals? In this article, Fiisual will guide you through the significance of each tool in policy-making and how these tools are utilized.
To begin, let’s start with a basic overview of the Fed's core policies.
The Policies of FOMC
Like central banks worldwide, the U.S. Federal Open Market Committee (FOMC) uses various "monetary policies" to stabilize the economy and achieve its dual mandate. By operating the Fed’s tools, the FOMC conveys these monetary policy messages to the financial markets and the broader economy.
The Fed primarily manages the economy’s level of tightness or ease by setting the Federal Funds Rate (FFR), which influences the cost and availability of money.
What is the Federal Funds Rate?
The Federal Funds Rate (FFR) is the interest rate that banks use for overnight lending between each other. It’s one of the shortest-term interest rates and serves as a benchmark for setting prices on various assets.
In simple terms, the FFR directly affects the lending costs and capacities of depository institutions, influencing business investment costs, consumer loans, and overall spending. By adjusting this rate, the Fed can steer the economic direction and growth.
The policy tool’s of FOMC
According to the instructions on the official website of Federal Reserve, the primary tools are the following three:
Open Market Operations (OMOs)
One of the main tools for implementing these policies is Open Market Operations (OMOs), where the FOMC buys or sells U.S. Treasury securities to adjust the amount of money circulating in the economy.
When the FOMC decides to use OMOs, the operations are carried out by the New York Fed’s trading desk. They conduct transactions of buying or selling bonds with eligible dealers and depository institutions such as member banks. Once the transaction is complete, the funds and bond amounts are settled through the Settlement Account, transferring funds to the seller and bonds to the buyer.
The purpose of OMOs is to actively influence the level of reserves in the financial system, thereby impacting the "price" of interbank lending. When reserve levels at depository institutions decrease, their ability to lend decreases, leading to a rise in the cost of capital and vice versa.
Interestingly, the FOMC doesn’t directly set this “price” but targets the Federal Funds Rate (FFR) to guide it. Instead of a fixed rate, the FFR is actually a range—known as the Federal Funds Rate Target Range—since adjustments post-2008. This range typically has a 0.25% interval.
Currently, the FOMC manages this range using two tools: the Interest Rate on Reserve Balances (IORB) and the Overnight Reverse Repurchase Agreement (ON RRP). The actual interbank lending rate is then determined by market transactions among institutions, within the bounds set by these two tools. More details on these tools will follow in later sections.
In simple terms, the FOMC acts as a dealer, setting the "maximum" and "minimum" prices for overnight borrowing. Banks can then determine the actual rate within this range based on supply and demand.
The market-driven rate is known as the Effective Federal Funds Rate (EFFR), often referred to as the "overnight lending rate," and serves as a standard for short-term borrowing costs. As the shortest-term lending rate, it also forms the basis for asset pricing, making it a key indicator of short-term liquidity in the market.
In summary, “the FOMC controls the FFR range through OMOs, which influences the EFFR, ultimately affecting the ease of lending between banks and tightening or loosening financial conditions to control market liquidity.”
When the FOMC decides to lower rates (reduce the FFR range), the New York Fed purchases bonds, releasing funds to banks and giving them more liquidity to lend. With ample funds, banks lend more actively. Thanks to the upper and lower range set by the FFR, eventually brings the EFFR within the target range, achieving an expansionary monetary policy effect. Conversely, when the Fed raises rates, it tightens market liquidity.
Over time, the targets of OMOs have evolved, so let’s continue exploring how these changes impact monetary policy!
Supplementary Reading: EFFR vs. SOFR
EFFR (Effective Federal Funds Rate) is the overnight lending rate for unsecured loans between commercial banks, based on the trading price in the federal funds (reserve) market from the previous business day. This rate is determined by each depository institution's individual supply and demand, meaning that each institution’s overnight rate may vary. The EFFR is calculated by taking all depository institutions' transaction rates (overnight lending rates) and applying a volume-weighted median. The New York Federal Reserve publishes the EFFR daily.
SOFR (Secured Overnight Financing Rate) is an overnight lending rate secured by U.S. Treasury securities, using the Treasury repurchase (repo) market as its basis. Since SOFR is backed by U.S. Treasury securities, it is often considered a risk-free rate and represents the cost of bank operations. Banks use their Treasury holdings as collateral to borrow from other institutions, agreeing to repurchase the securities after a set period. This repurchase rate is the SOFR and published by New York Federal Reserve.
Discount Window
For depository institutions, liquidity shortfalls can quickly become self-fulfilling, leading to bank failures and potential financial crises. To prevent this, central banks have established a "Discount Window" as an alternative borrowing facility, providing a safety net for institutions facing liquidity issues. In the U.S., this mechanism is part of the Federal Reserve System and is administered by the regional Reserve Banks. Each regional bank offers three types of credit, each with its own interest rate:
- Primary Credit: For financially sound institutions with solid repayment abilities.
- Secondary Credit: For institutions with lower financial or operational health, typically at a rate higher than Primary Credit.
- Seasonal Credit: Designed for institutions in regions with seasonal economic patterns, such as agriculture, where lending and deposit demands fluctuate due to seasonal activities.
Despite its availability, institutions generally avoid borrowing from the Fed. Besides the Discount Window’s higher interest rates compared to the FFR, using it can send a signal that the institution has exhausted all other funding options (e.g., selling short-term assets, interbank borrowing) and is facing broader issues, such as operational or solvency challenges. This can lead to "labeling" by the market and the Fed itself.
For this reason, the Fed is often called the "Lender of Last Resort," and the Discount Window rate is viewed as the upper limit for short-term market rates. If short-term borrowing costs exceed the Discount Window rate, it would be cheaper for institutions to borrow directly from the Fed.
Reserve Requirement (Required Reserve Rates)
As highly leveraged financial intermediaries, banks are required by central banks to keep a certain percentage of their deposits as reserves in central bank accounts when conducting investments and lending activities. This reserve, known as the Required Reserve, is maintained at a specific rate—the Required Reserve Rate.
In the U.S. Federal Reserve System, member banks must maintain a reserve account at their regional Reserve Bank, which serves as an emergency buffer. Banks may also hold additional reserves, called Excess Reserves, which are optional.
When the central bank wants to stimulate the economy or counter a downturn, it can lower the reserve requirement rate, encouraging banks to lend more and stimulate consumer spending—a policy approach known as "easing." Conversely, if the economy is overheating, the central bank can raise the reserve requirement to curb spending and cool down the economy—referred to as "tightening."
However, since the 2008 financial crisis and the introduction of quantitative easing, excess reserves have become so abundant that the practical significance of reserve requirements has diminished. As a result, the current reserve requirement in the U.S. is set at 0%.
In addition to these three traditional monetary policy tools, the complexity of modern economies has led central banks to develop new tools with similar objectives and market effects.
Quantitative Easing (QE), QE Tapering, and Quantitative Tightening (QT)
Following the 2008 financial crisis, the FOMC lowered the FFR range close to zero (0%-0.25%) to stimulate consumption and investment. However, with the financial system in disarray and lending tightened, traditional interest rate adjustments through OMOs had limited effect.
Unable to further reduce the FFR, the FOMC adopted a strategy inspired by Japan’s early 2000s approach: purchasing long-term assets (such as bonds and MBS) on a large scale from depository institutions. This policy, known as Quantitative Easing (QE), injected liquidity into banks while driving down yields on long-term securities to lower long-term interest rates. QE aimed to stimulate consumption and create an environment conducive to long-term investment, helping to rebuild the economy. During the pandemic, the Fed announced “unlimited QE” to boost liquidity and market confidence.
Unlike OMOs, which target short-term interbank lending rates, QE includes longer-term securities to lower long-term interest rates across the board. However, this extensive asset buying also led to asset price distortions.
Once the FOMC is satisfied with economic recovery and market stability, it begins reducing asset purchases to avoid creating unnecessary liquidity—gradually tapering QE until it stops altogether. This reduction process is known as QE Tapering. It’s important to note that QE Tapering is different from QT.
After QE Tapering ends, if the economy overheats or inflation rises, the FOMC may actively sell assets and bonds into the market, absorbing excess liquidity and pushing interest rates up naturally to cool the market. This phase, known as Quantitative Tightening (QT), is the final step in the quantitative policy cycle.
In simplified terms, the cycle is: QE ⇒ QE Tapering ⇒ QT
However, this cycle may not always follow the same sequence depending on the macroeconomic situation at the time, since economic conditions are unpredictable in practice.
Interest Rate on Reserve Balance (IORB)
In our discussion of the three traditional monetary policy tools, we introduced the concept of reserve requirements. Before 2008, the Fed did not pay interest on reserves. However, after the 2008 financial crisis and the onset of large-scale QE programs, both short-term and long-term interest rates were lowered, resulting in excess reserves within depository institutions.
To effectively communicate policy and influence interest rates in a low-rate environment, the Fed introduced the Interest Rate on Reserve Balance (IORB) as one of its tools, alongside the Overnight Reverse Repurchase Agreement (ON RRP), which will be discussed shortly.
Some may wonder why there is no emphasis on separate rates for required and excess reserves. Initially, when interest on reserves was introduced in October 2008, the Fed set both an Interest Rate on Required Reserves (IORR) and an Interest Rate on Excess Reserves (IOER). However, as QE cycles after 2008 and 2020 led to large reserve holdings across institutions, the practical importance of required reserves diminished, and the reserve requirement rate was eventually set to zero. Consequently, the Fed consolidated IORR and IOER into a single Interest Rate on Reserve Balance (IORB) to simplify matters.
If depository institutions hold their excess reserves in accounts provided by the Fed, they earn interest at the IORB rate. This mechanism serves as a lower bound for market interest rates: if market borrowing costs fall below the IORB, institutions would prefer to keep their reserves at the Fed rather than lend them at lower rates.
However, the Fed did not anticipate that IORB would only apply to institutions within the Federal Reserve System. Institutions outside this system, unable to earn IORB, would lend at lower rates in the market, thus undermining the IORB's role as a lower bound for interest rates.
To address this issue, the Fed introduced another monetary policy tool—the Overnight Reverse Repurchase Agreement (ON RRP)—which is accessible to all institutions.
Overnight Reverse Repurchase Agreement (ON RRP)
Following the 2008 financial crisis, the FOMC lowered the FFR to a 0%-0.25% range and implemented large-scale QE to inject liquidity by purchasing long-term bonds. This influx of funds led to excess liquidity in depository institutions.
As the economy began to recover, the abundance of funds caused short-term borrowing demand to lag behind supply, potentially driving short-term borrowing rates below the FFR target range set by the FOMC.
To reestablish an effective lower bound for interest rates, the Fed introduced the ON RRP tool in September 2013 and officially incorporated it as a monetary policy tool in September 2014.
Under the ON RRP framework, the Fed acts as the seller, selling specific assets to eligible depository institutions to absorb excess short-term liquidity. The Fed agrees to repurchase these assets at a later date, typically the following day (hence the term “overnight”), at the original price plus an additional percentage. This percentage generally represents the short-term interest rate the Fed aims to set.
With ON RRP, if lenders find borrower rates too low, they can opt to transact with the Fed to earn a better return, thereby raising the market’s overnight lending rate to align with the ON RRP rate.
Currently, the Fed uses Interest on Excess Reserves (IOER) and ON RRP transactions to manage the upper and lower bounds of the FFR target range.
These are some of the most common and frequently used monetary policy tools. Additional tools, like the Bank Term Funding Program (BTFP), the Summary of Economic Projections (SEP) report, and various special policies, each have distinct implications for the market. We’ll delve into these in more detail in future posts!
