Understanding the Federal Reserve, Part Six: Monetary Policy Tools

David Frost // Better Investing, Blog


March 11  

This is part six of a series on the Federal Reserve. This part focuses on the Fed’s monetary policy tools, such as reserve requirements and deposit facility. Click here for part one. Click here for part two on the history. Click here for part three on the Fed’s structure. Click here for part four on interest rates. Click here for part five on open market operations.

The four main tools the Federal Reserve uses to adjust monetary policy are open market operations, the discount rate, reserve requirements and interest on reserves. However, they aren’t the only tools used by policymakers. The Fed has used a variety of different tools over the years, some of which are still used, although some tools have expired. 

We’ve already covered interest rates and open market operations in depth, so now we will look at the other policy tools used by the Fed, including some that have expired.

Reserve requirements

The Federal Reserve requires banks and other financial institutions to keep a certain amount of cash in their vaults and their accounts with their regional Federal Reserve Banks. This amount is given as a percentage of the banks’ deposits. The Fed can change the amount of reserves financial institutions are required to keep, thereby adjusting the amount of money that’s available to loan. 

Decreasing the reserve requirements is an expansionary move because it increases the amount of money financial institutions can loan to consumers and businesses. The increase in money supply results in a decline in interest rates and frees up cash to be borrowed for major purchases like homes or vehicles. Businesses benefit from the increase in available cash because they can afford to expand and hire more employees, resulting in a decrease in unemployment. 

On the other hand, increasing the reserve requirement is a contractionary move because it reduces the amount of money that’s available for loans. An increase in the reserve requirement causes an increase in interest rates because there is less money available. Businesses will no longer expand, and the economy will begin to slow a bit, preventing it from overheating. 

The Fed very rarely changes reserve requirements, so this tool isn’t used very often. However, when it is used, the central bank’s Board of Governors makes the decision.

Interest on reserve balances

The newest tool available to the Federal Reserve is interest on excess reserve balances. Congress introduced this tool after the 2007-2009 financial crisis, and it’s used quite frequently. While the Fed requires that banks keep a percentage of the money on deposit with them as reserves at the regional Reserve Banks, most banks also keep extra money in their accounts with the regional Reserve banks. The Fed pays interest on these excess reserves held at the regional Reserve Banks. 

The central bank can adjust the interest it pays on those extra reserves, thereby making it less or more advantageous for banks and other financial institutions to hold extra money in their regional Reserve accounts. If the Fed increases the interest rate it pays on excess reserves, banks might be less willing to lend their extra money. However, if the Fed cuts the interest rate, banks become more willing to loan money because they will earn more interest on loans than they will from the Federal Reserve. 

Term deposit facility

Under the term deposit facility, the regional Federal Reserve banks offer deposits which bear interest and have set maturity dates. The term deposit facility offers yet another way for the Fed to adjust the size of the reserve balances held by banks and other financial institutions.

Any funds which are placed in term deposits are then removed from the financial institutions’ reserve accounts for a set amount of time. This decreases the amount of funds available on reserve in the financial system. The regional Reserve Banks offer term deposits to all institutions which are eligible to receive earnings on their Reserve balances. The regional Reserve Banks award term deposits through a single-price auction. 

Overnight reverse repurchase agreement facility 

The Federal Open Market Committee introduced the overnight reverse repurchase agreement facility in September 2014. This tool is used to adjust the federal funds rate and move it toward the target set by the FOMC. The committee has said it will use this tool sparingly and will phase it out when it’s no longer needed.

Under an overnight reverse repurchase agreement, the Fed sells a security to another party while agreeing to purchase that same security back the following day. This agreement temporarily reduces reserve balances on the liability side of the Fed’s balance sheet. The FOMC sets the offering rate for this agreement, which is the highest interest rate the central bank is willing to pay on such an agreement. However, an auction determines the actual interest rate the financial institution will pay. 

Expired policy tools

The Federal Reserve has also introduced tools to deal with financial crises. Although these tools are expired, it doesn’t mean they will never make a comeback at some point. There is always a chance that the Fed could bring them back in another time of extended difficulty.

One such expired tool is the Primary Dealer Credit Facility, which was an overnight loan facility which provided funds to primary dealers. In exchange, they provided eligible collateral. This tool was used to improve the functioning of the financial market in the U.S., and it expired in 2010.

Another expired tool is the Term Auction Facility. Using this tool, the Fed auctioned term funds to banks and other depository institutions. Financial institutions that could borrow funds under the primary credit program were eligible to participate in the term auction facility. Each auction was for a set amount, and the auction process determined the rate. Financial institutions submitted their bids via phone through their regional Reserve Banks. This tool also expired in 2010. 

The Commercial Funding Paper Facility was designed to provide liquidity to issuers of commercial paper. By providing liquidity for the short-term funding markets, the Fed made more credit available to consumers and businesses. Under the process, the Federal Reserve Bank of New York financed the purchase of asset-backed commercial paper from highly-rated, eligible issuers. This tool also expired in 2010. 

The Money Market Investor Funding Facility provided liquidity to money market investors in the U.S. Using this tool, the Federal Reserve Bank of New York provided senior secured funding to certain special purpose vehicles to support a private-sector initiative to buy eligible assets from eligible investors. This tool expired in 2009.

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David Frost