Federal Reserve Monetary Policy Tools: Open Market Operations, Discount Lending, and Reserve Requirements

The wealth of any society can be maximized by optimizing the economy so that it does not run too hot, causing inflation, or too slow, causing unemployment and the underutilization of economic resources. Optimizing the economy maximizes economic growth. Central banks, such as the Federal Reserve, can optimize the economy by using monetary policy tools. For instance, the economy can be expanded or contracted by changing either the money supply or the interest rate. The term monetary policy refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit as a means of helping to promote national economic goals. A 1977 amendment to the Federal Reserve Act stipulated that the Federal Reserve should promote the goals of maximum employment, stable prices, and moderate long-term interest rates.

In the United States, monetary policy is made by the Federal Open Market Committee (FOMC), which consists of the members of the Board of Governors of the Federal Reserve System and 5 Reserve Bank presidents. The FOMC holds 8 regularly scheduled meetings during the year and other meetings as needed.

Federal Reserve's Monetary Policy Toolbox

The Federal Reserve (Fed) implements monetary policy using 3 major tools, called monetary policy instruments:

The Fed controls 2 primary interest rates: the federal funds rate, which is the rate that banks charge each other for overnight loans and the discount rate, which is the interest rate that the Fed charges on loans it makes to banks.

By setting a target federal funds rate and using the tools of monetary policy — open market operations, discount window lending, and reserve requirements — to equalize the market rate with the target rate, the Federal Reserve and the FOMC seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," as required by the Federal Reserve Act.

Controlling The Interest Rate By Setting The Target Federal Funds Rate

The primary monetary policy instrument that the Federal Reserve uses to control the interest rate is using open market operations to constrain the market federal funds rate, which is the interest rate that banks actually charge each other in the interbank market for overnight loans, to closely approximate the target federal funds rate, which the FOMC has set based on the consensus of the committee members, which is based on information gathered from the regional Federal Reserve banks.

Banks borrow reserves in the federal funds market to meet reserve requirements set by the Federal Reserve and to ensure adequate balances in their accounts at the Fed to cover checks and electronic payments processed by the Fed on their behalf.

The term federal funds comes from the fact that banks trade their deposits held at Federal Reserve banks. Because each bank has a different balance of reserves at the end of the day, those with excess reserves lend to those with deficiencies. Because federal funds are not backed by collateral, banks must be creditworthy to borrow in the interbank market; otherwise, it must borrow from the Fed, which will alert the Fed that the bank is having financial difficulties.

The market federal funds rate is often published as an effective federal funds rate, which is the average of the interest rates charged in the interbank lending market weighted by the size of the transactions.

Changes in the federal funds rate changes other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and, ultimately, a range of economic variables, including employment, output, and the prices of goods and services.

The Open Market Trading Desk estimates the demand for reserves at the target rate each morning, then supplies that quantity for the day, which keeps the daily supply curve for reserves vertical until it reaches the discount rate, then it becomes horizontal, because then the banks will simply borrow from the Fed rather than pay higher rates from each other.

The Federal Reserve conducts open market operations with primary dealers — government securities dealers who have an established trading relationship with the Federal Reserve. So while the target policy rate is the uncollateralized lending rate between banks (fed funds), the Fed operates in the collateralized lending market with 20 primary security dealers (repo). This structure works because the primary dealers have accounts at clearing banks, which are depository institutions. So when the Fed sends and receives funds from the dealer's account at its clearing bank, this action adds or drains reserves to the banking system.

The Federal Reserve Act requires that the Fed buy securities only in the secondary market — United States Treasuries can only be bought from the government's auctions directly to replace Treasuries that are maturing.

The federal funds rate can also have a significant influence on the stock market, though it is not the only factor. Rising rates can depress the stock market, while falling rates can stimulate the stock market. This chart shows how the S&P 500 Index declined as the federal funds rate increased during the latter half of 2018. After the Federal Reserve indicated that it would pause increasing interest rates further, the stock market started to recover from the beginning of 2019.
Chart of the S&P 500 Index plotted against the federal funds rate between June 1, 2018 and June 1, 2019, showing how the S&P 500 Index fell as the federal funds rate rose.

Discount Window Lending — Providing Liquidity For Banks

The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from the lending facility of their regional Federal Reserve District Bank — the discount window. By law, the board of directors of each Reserve Bank sets the discount rate independently every 14 days subject to the approval of the Board of Governors. Originally, each Reserve Bank set its discount rate to reflect the banking and credit conditions in its own District. Over the years, the transition from regional credit markets to a national credit market has gradually produced a national discount rate, which is uniform across all Reserve Banks.

The main purpose of discount lending is to ensure short term financial stability, to prevent bank panics, and to prevent the sudden collapse of financial institutions experiencing a liquidity crisis, such as those that occurred following the stock market decline of October 1987, the international debt crisis in the fall of 1998, and the terrorist attacks in September 2001, when on September 12, 2001, discount lending greatly increased to $45.5 billion. In January, 2007, before the 2008 - 2009 Great Recession, discount window loans amounted to $1.3 billion; by October, 2008, discount lending peaked at $111 billion. Thus, because of its ability to create any amount of money, the Federal Reserve can act as lender of last resort.

Primary, Secondary, and Seasonal Credit

The Federal Reserve Banks offer 3 types of discount loans — all secured — to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate that is established by each Reserve Bank's board of directors, subject to the review and determination of the Board of Governors of the Federal Reserve System.

Primary credit is extended short-term, usually overnight, to banks with CAMELS ratings of 1 or 2. The interest rate for primary credit may be as high as 100 basis points above the federal funds target rate, called the primary discount rate. Primary credit is provided to make up for errors in market forecasts by the FOMC. Primary lending provides liquidity and interest rate stability by preventing the market federal funds rate from spiking too far above the target federal funds rate.

Secondary credit is generally set at 50 basis points above the primary discount rate and is available only to banks that do not qualify for primary credit. Unless they have short-term liquidity deficiencies, banks will not ask for secondary credit unless they are having long-term difficulties that they cannot overcome, since it indicates that the bank may be having financial difficulties.

Seasonal credit is extended to many small agricultural banks in the Midwest and to small banks in seasonal resort communities to provide liquidity when needed. The seasonal discount credit rate is an average of selected market rates.

Discount Window Lending Will Be Disclosed by the Federal Reserve

The discount window has been available to banks since 1913, when Congress created the Federal Reserve. However, the list of banks that have borrowed from it and the amounts have always been kept secret, because it was feared that if the public knew which banks were borrowing from the discount window, then they may withdraw their money from those banks, worsening their financial position. Furthermore, because there is a certain stigma from using the discount window among banks, a lack of secrecy would prevent banks from using the discount window when they really needed it, possibly causing their failure. The stigma resulted from the fact that the Federal Reserve only allowed the banks to use discount window when they had no other available source of credit. Since banks generally need to borrow from other banks, using the discount window would indicate that they were not creditworthy.

In fact, to avoid using the discount window during the Great Recession, banks paid higher interest rates by bidding on loans from the Term Auction Facility (TAF), which was set up to provide emergency lending during the crisis, and provided banks with $493 billion in short-term credit.

However, since 2003, the Federal Reserve has allowed banks to borrow from the discount window without first exhausting all other sources of credit.

The secrecy surrounding discount window lending will also be changing. As a result of the lawsuit filed by Bloomberg and Fox News Network, the Fed must disclose which banks borrowed from its discount window during the 2008-2009 Great Recession. However, the Fed does not have to disclose the collateral that it accepted, which would have revealed the risks that it took.

The Dodd-Frank financial reform law, signed into law on July 21, 2010, also requires the Fed to disclose discount window lending after a 2-year delay.

Reserve Requirements

Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. The Federal Reserve Board has been authorized, since 1935, to set reserve requirements, which is the minimum level reserves that banks must hold either in their accounts at the Federal Reserve or in their vaults. Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements.

Although the money supply depends on required reserves, adjusting the reserve requirements is not an effective way to control the economy:

  1. The money multiplier expands or contracts the money supply for small changes in the reserve requirements.
  2. The Fed has no control over how much excess reserves the banks would hold, so there will not necessarily be a correlation between the reserve requirement and the actual amount of reserves held by the banks.
  3. Computing required reserves is complex because of what is called lagged reserve accounting, implemented in August, 1998, which was developed so that the Federal Reserve could better forecast reserve demand so that the market federal funds rate closely approximated the target rate.

The reserve requirement is first determined by taking the average balance in transaction deposits, such as checking and savings accounts, where the account holder can make withdrawals at any time without penalty, over a 2-week period called the computation period, which ends every 2nd Monday. The reserve requirements are then applied to the average balance over a 2-week period, called the maintenance period, which begins on the 3rd Thursday after the end of the computation period. Thus, banks have 16 days to determine their reserve requirement based on their actual deposits.

The 1980 Monetary Control Act allowed the Federal Reserve to set reserve requirement ratios between 8% and 14% of the transaction deposits. The accounting rules also allow banks to carry some excess reserves forward or backward for one maintenance period to satisfy the reserve requirement.

The reserve ratio depends on the amount of transactions accounts at the depository institution. The Garn-St Germain Act of 1982 exempted the first $2 million of reservable liabilities from reserve requirements, adjusted each year according to a formula specified by the Act. Also, the Monetary Control Act of 1980 created a low-reserve tranche where the 1st $25 million, adjusted for inflation, has a reserve ratio of 3%, and a reserve ratio of 10% for the remaining amounts. Hence, smaller banks will have a smaller effective reserve ratio than larger banks.

Reserve Requirements
Liability Type Requirement
Net Transaction Accounts % of Liabilities Effective Date
$0 to $10.7 million 0 12/30/2010
More than $10.7 million to $58.8 million 3% 12/30/2010
More than $58.8 million 10% 12/30/2010
Nonpersonal time deposits 0 12/27/1990
Eurocurrency liabilities 0 12/27/1990
Source: https://www.federalreserve.gov/monetarypolicy/reservereq.htm

How the Federal Reserve Responded to the Great Recession

Between 1987 and 2007, the Fed's response to changing inflation and unemployment had closely followed Taylor's rule, but with the advent of the Great Recession that began in 2007, Taylor's rule would have implied a negative federal funds rate, since the output gap, which is the difference between real GDP and its potential, was almost -8%, so the Federal Reserve followed a more ambitious policy to stimulate the economy. Short-term credit markets, namely the money market mutual funds and the commercial paper market, ceased to function because, especially after Lehman's bankruptcy, savers were fearful that the economic downturn would increase the likelihood that borrowers would be unable to repay the funds, even over the short term, so the Fed provided secure loans to the issuers of commercial paper and money market mutual funds. The Fed also supplied short-term secured loans to security dealers, like the loans provided to banks through the discount window. As a result, short-term credit markets greatly improved in 2009. The Fed also provided loans to institutions deemed too big to fail, including J.P. Morgan, Citigroup, Bank of America, and AIG. To increase consumer confidence in the banking system, the Fed expanded deposit insurance.

To increase interbank lending, the Fed provided 1- to 3-month discount loans to banks, including dollar-denominated loans to foreign banks, and created a temporary liquidity facility that guaranteed newly issued bank debt. To restore confidence in the banking system, the Fed also started conducting stress tests to ensure that banks can weather bad economic conditions, and if not, then they were forced to raise new capital.

To stimulate the economy, the Fed started buying longer-term Treasury securities and mortgage-backed securities, called quantitative easing, to increase the available funds for banks and to lower long-term interest rates. The Fed also created the Term Asset-Backed Securities Loan Facility, to lend to institutions that securitized asset-backed loans, including consumer loans, student loans, auto loans, and business loans.
Although many feared that the Fed's massive stimulus would stoke inflation, inflation remained low until 2018. By then, the Fed was pursuing a policy of gradually increasing interest rates to slow the overheating economy.

Interest Rates Paid on Required and Excess Reserves

In October 2008, the Federal Reserve began paying interest on required reserve and excess balances. Hence, the holding of excess reserves can be regulated through the interest rate, which is determined by the Board, giving the Federal Reserve an additional tool for the conduct of monetary policy.

Term Deposit Facility

The Term Deposit Facility (TDF) was a program through which the Federal Reserve offered interest-bearing term deposits, which are deposits with a specific term, usually 84 days or less, paying a fixed rate of interest, to eligible institutions. The aggregate quantity of reserve balances held by depository institutions can be regulated by the term deposits, since any money so deposited is removed from reserves during the term.

Term deposit offerings will be issued primarily through competitive single-price auctions, but will also include a noncompetitive bidding option to ensure access to term deposits for smaller institutions.