15.3 How a Central Bank Executes Monetary Policy

Open Market Operations

Since the early 1920s, the most common monetary policy tool in the U.S. has been open market operations. These take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer since the federal funds rate is the interest rate that commercial banks charge making overnight loans to other banks. As such, it is a very short term interest rate, but one that reflects credit conditions in financial markets very well.

The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations. The FOMC comprises seven members of the Federal Reserve’s Board of Governors. It also includes five voting members who the Board draws, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent FOMC voting member and the Board fills other four spots on a rotating, annual basis, from the other 11 districts. The FOMC typically meets every six weeks, but it can meet more frequently if necessary. The FOMC tries to act by consensus; however, the Federal Reserve's chairman has traditionally played a very powerful role in defining and shaping that consensus. For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy.

To understand how open market operations affect the money supply in a limited reserves environment, assume that Happy Bank starts with $460 million in assets, divided among reserves, bonds and loans, and $400 million in liabilities in the form of deposits, with a net worth of $60 million. When the central bank purchases $20 million in bonds from Happy Bank, the bond holdings of Happy Bank fall by $20 million and the bank’s reserves rise by $20 million. However, Happy Bank only wants to hold $40 million in reserves, so the bank decides to loan out the extra $20 million in reserves and its loans rise by $20 million. The central bank's open market operation causes Happy Bank to make loans instead of holding its assets in the form of government bonds, which expands the money supply. As the new loans are deposited in banks throughout the economy, these banks will, in turn, loan out some of the deposits they receive, triggering the money multiplier that we discussed in Money and Banking. To see the impact on Happy Bank's balance sheet, refer to the appendix How Open Market Operations Affect Balance Sheets in a Limited Reserves Environment.

Where did the Federal Reserve get the $20 million that it used to purchase the bonds? A central bank has the power to create money. In practical terms, the Federal Reserve would write a check to Happy Bank, so that Happy Bank can have that money credited to its bank account at the Federal Reserve. In truth, the Federal Reserve created the money to purchase the bonds out of thin air—or with a few clicks on some computer keys.

Open market operations can also reduce the quantity of money and loans in an economy. When Happy Bank purchases $30 million in bonds, Happy Bank sends $30 million of its reserves to the central bank, but now holds an additional $30 million in bonds. However, Happy Bank wants to hold $40 million in reserves, as in our previous example, so it will adjust down the quantity of its loans by $30 million, to bring its reserves back to the desired level. In practical terms, a bank can easily reduce its quantity of loans. At any given time, a bank is receiving payments on loans that it made previously and also making new loans. If the bank just slows down or briefly halts making new loans, and instead adds those funds to its reserves, then its overall quantity of loans will decrease. A decrease in the quantity of loans also means fewer deposits in other banks, and other banks reducing their lending as well, as the money multiplier that we discussed in Money and Banking takes effect. To see the impact on Happy Bank's balance sheet, refer to the appendix How Open Market Operations Affect Balance Sheets in a Limited Reserves Environment. What about all those bonds? How do they affect the money supply? Read the following Clear It Up feature for the answer.

The Federal Reserve was founded in the aftermath of the 1907 Financial Panic when many banks failed as a result of bank runs. As mentioned earlier, since banks make profits by lending out their deposits, no bank, even those that are not bankrupt, can withstand a bank run. As a result of the Panic, the Federal Reserve was founded to be the “lender of last resort.” In the event of a bank run, sound banks, (banks that were not bankrupt) could borrow as much cash as they needed from the Fed’s discount “window” to quell the bank run. We call the interest rate banks pay for such loans the discount rate. (They are so named because the bank makes loans against its outstanding loans “at a discount” of their face value.) Once depositors became convinced that the bank would be able to honor their withdrawals, they no longer had a reason to make a run on the bank. In short, the Federal Reserve was originally intended to provide credit passively, but in the years since its founding, the Fed has taken on a more active role with monetary policy.

Changing the Discount Rate

In the Federal Reserve Act, the phrase “...to afford means of rediscounting commercial paper” is contained in its long title. This was the main tool for monetary policy when the Fed was initially created. Today, the Federal Reserve has even more tools at its disposal, including quantitative easing, overnight repurchase agreements, and interest on excess reserves. This illustrates how monetary policy has evolved and how it continues to do so.

The second traditional method for conducting monetary policy in a limited reserve environment is to raise or lower the discount rate. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead call in loans to replace those reserves. Since fewer loans are available, the money supply falls and market interest rates rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.

In recent decades, the Federal Reserve has made relatively few discount loans. Before a bank borrows from the Federal Reserve to fill out its required reserves, the bank is expected to first borrow from other available sources, like other banks. This is encouraged by the Fed charging a higher discount rate than the federal funds rate. Given that most banks borrow little at the discount rate, changing the discount rate up or down has little impact on their behavior. More importantly, the Fed has found from experience that open market operations are a more precise and powerful means of executing any desired monetary policy.

Changing Reserve Requirements

A potential third method of conducting monetary policy in a limited reserves environment is for the central bank to raise or lower the reserve requirement, which, as we noted earlier, is the percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves, they have less money available to lend out. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out.

Until very recently, the Federal Reserve required banks to hold reserves equal to 0% of the first $14.5 million in deposits, then to hold reserves equal to 3% of the deposits up to $103.6 million, and 10% of any amount above $103.6 million. The Fed makes small changes in the reserve requirements almost every year. For example, the $103.6 million dividing line is sometimes bumped up or down by a few million dollars. Today, these rates are no longer in effect; as of March 2020 (when the pandemic-induced recession hit), the 10% and 3% requirements were reduced to 0%, effectively eliminating the reserve requirement for all depository institutions.

The Fed rarely uses large changes in reserve requirements to execute monetary policy; the pandemic was an exception for obvious reasons. Also, a sudden demand that all banks increase their reserves would be extremely disruptive and difficult for them to comply. While loosening requirements too much might create a danger of banks’ inability to meet withdrawal demands, the benefits of reducing the reserve requirements in March 2020 exceeded the risks.

In the following section, we will discuss how interest on excess reserves is used as a monetary policy tool.

Monetary Policy and Ample Reserves

As we noted previously, banks in the United States have historically had very little reason to keep more than their minimum required reserves because their regional Federal Reserve bank did not pay any interest on those reserves. This behavior changed dramatically during the 2008–2009 financial crisis.

During this period of time, 389 banks failed. The banks that survived responded to the financial crisis by increasing their reserves well beyond their required minimum. Combined with the measures undertaken by the FOMC and the U.S. government to respond to the financial crisis, banks’ reserves increased from around $15 billion in 2007, to $2.7 trillion by late 2014. While reserves did decrease to around $1.7 trillion by 2017, this was no longer an environment of limited reserves, but an environment of ample reserves. In fact, in 2019, the FOMC issued a statement indicating that monetary policy would be based on ample reserves. While it may be a good decision for banks to keep ample reserves, as we know, the banking system facilitates both short-term and long-term economic activity when it makes loans to finance consumption, for business investment and expansion, and to help fund and support innovation, among many other possibilities. In a sense, loans allow for the economy to ultimately become more productive, causing an increase in long-run economic growth. The point is that we need the banking system to be willing to make loans and not just keep ample excess reserves. However, when banks are keeping a trillion or more dollars as excess reserves, these are funds that they are choosing not to lend out, potentially causing the economy to grow at a slower rate than it otherwise might.

How then can the FOMC incentivize banks to lend out these excess reserves? This is where the interest rate on reserve balances (IORB) comes in. The IORB is the interest rate paid to banks for their holdings of excess reserves. Congress granted the Federal Reserve the ability to pay this interest in 2006. The policy was originally slated to begin in 2011, but the financial crisis accelerated its start date to 2008. (For a few years there were two separate rates, the interest rate on required reserves and the interest rate on excess reserves, but these two were combined into the IORB in 2021.) The FOMC controls the IORB directly. It sets the IORB at whatever rate it chooses, based on macroeconomic conditions and forecasts.

We can now explore how the IORB may affect banks’ decisions to hold more or fewer excess reserves. As we noted in our discussion of open market operations, the federal funds rate (FFR) is the specific interest rate targeted by the FOMC. The federal funds market is where banks borrow and lend their excess reserves from one another over a very short period of time, often described as overnight. It is a market, as we explained in Demand and Supply, with supply, demand, and a price. In the federal funds market, you can think of the FFR as the price a bank gets paid for lending (or selling) excess reserves in the federal funds market, and you can think of the FFR as the price a bank pays for borrowing (or buying) those excess reserves. The FFR is targeted by the FOMC because as the FFR increases and decreases, most other interest rates eventually increase or decrease too. In Monetary Policy and Economic Outcomes, we’ll show how changes in interest rates affect the macroeconomy.

To illustrate how changes in the IORB can affect the FFR, assume that the IORB is 2%, which means that a bank can earn 2% on its excess reserves, free of risk. Because in the federal funds market, the lending period is often very short-term, sometimes even shorter than one day, those loans are nearly risk-free. As a result, most banks view the IORB as a very close alternative to the FFR. If the FFR also pays 2% interest, generally, a bank will be indifferent to where it keeps its excess reserves.

Let’s say that macroeconomic conditions convince the FOMC to lower the FFR. To do this, it will lower the IORB. Let’s see why. If the IORB decreases to 1.75%, banks will generally choose to reduce their excess reserves holdings at their regional Federal Reserve bank and instead lend those excess reserves in the federal funds market in order to earn the currently higher FFR of 2%. But this increase in the supply of excess reserves in the federal funds market will act to lower the price in the federal funds market, which is the FFR.

When the FOMC lowers the IORB, it also tends to lower the discount rate at the same time. Some banks could then engage in arbitrage, which is the simultaneous (or near-simultaneous) purchase and sale of a good to profit from a difference in the price of that good across markets. In our example, if the discount rate also decreases from 2% to 1.75%, a bank could borrow excess reserves from the Federal Reserve at the 1.75% discount rate and then lend those same excess reserves in the federal funds market at 2%, earning $0.0025 on every $1.00 borrowed. (This may not seem like much, but multiply this by $1 million or $10 million and it adds up quickly.) But this arbitrage activity also ensures that the FFR will decrease as the FOMC desires because the increase in the supply of excess reserves will cause the FFR to decrease, and as banks leave the federal funds market to borrow from the Federal Reserve, the decrease in the demand for excess reserves will cause the FFR to decrease too.

Alternatively, let’s say that macroeconomic conditions convince the FOMC to raise the FFR. If the FOMC increases the IORB to 2.25%, banks will then choose to keep more excess reserves at their regional Federal Reserve bank and earn the higher IORB. This decrease in supply in the federal funds market will cause the FFR to increase as well.

Arbitrage will also ensure that the FFR increases. As the IORB increases, banks will borrow more excess reserves in the federal funds market and deposit them with their regional Federal Reserve bank in order to earn a profit on the difference between the IORB and the FFR. This increase in demand will then cause the FFR to increase as well.

Quantitative Easing

The most powerful and commonly used of the three traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate. In late 2008, as the U.S. economy struggled with recession, the Federal Reserve had already reduced the interest rate to near-zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing (QE). This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand.

Quantitative easing differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long term Treasury bonds, rather than short term Treasury bills. In 2008, however, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get. (Read the closing Bring it Home feature for more on this.) Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing.

This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed “toxic assets,” because when the housing market collapsed, no one knew what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both pushing long term interest rates down and also removing possibly “toxic assets” from the balance sheets of private financial firms, which would strengthen the financial system.

Quantitative easing (QE) occurred in three episodes:

1. During QE₁, which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.
2. In November 2010, the Fed began QE₂, in which it purchased $600 billion in U.S. Treasury bonds.
3. QE₃, began in September 2012 when the Fed commenced purchasing $40 billion of additional mortgage-backed securities per month. This amount was increased in December 2012 to $85 billion per month. The Fed stated that, when economic conditions permit, it will begin tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final $15 billion bond purchase, ending Quantitative Easing.

We usually think of the quantitative easing policies that the Federal Reserve adopted (as did other central banks around the world) as temporary emergency measures. If these steps are to be temporary, then the Federal Reserve will need to stop making these additional loans and sell off the financial securities it has accumulated. The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact. The evidence suggests that QE₁ was somewhat successful, but that QE₂ and QE₃ have been less so.

Fast forward to March 2020, when the Fed under the leadership of Jerome Powell promised another round of asset purchases which was dubbed by some as “QE4,” intended once again to provide liquidity to a distressed financial system in the wake of the pandemic. This round was much faster, increasing Fed assets by $2 trillion in just a few months. Recently, the Fed has begun to slow down the purchase of these assets once again through a taper, and the pace of the tapering is expected to increase through 2022. But as of the end of 2021, total Fed assets exceed $8 trillion, compared to $4 trillion in February 2020.