Monetary Policy Implementation

The Federal Reserve sets U.S. monetary policy and the New York Fed plays a central role in implementing it.

The Fed’s economic goals prescribed by Congress are to promote maximum employment, stable prices, and moderate long-term interest rates. The Federal Open Market Committee (FOMC or Committee) is responsible for monetary policy decisions to achieve these goals. The goals of maximum employment and price stability, commonly known as the “dual mandate”, create the conditions for moderate long-term interest rates. The FOMC determines the appropriate position or “stance” of monetary policy, which reflects how “accommodative” (encouraging economic growth) or “restrictive” (slowing economic growth) it should be. Once the FOMC determines the appropriate stance of policy, the Committee issues directives to the Open Market Trading Desk at the New York Fed (Desk) to implement the policy.

Monetary policy works by influencing short-term interest rates to affect the availability and cost of credit in the economy and, ultimately, the economic decisions businesses and households make. Monetary policy can also affect financial conditions more broadly as measured by financial asset prices such as stock and bond prices, longer term interest rates, and the exchange rate of the U.S. dollar against foreign currencies. This all affects economic activity and, ultimately, the Federal Reserve’s key goals of maximum employment and price stability.

The framework for implementing monetary policy includes two key parts:

• The FOMC’s primary tool for adjusting the monetary policy stance is through changes to the target range for the federal funds rate, its key policy rate. To maintain the federal funds rate well within the target range, the Federal Reserve sets two key administered rates.
• The FOMC directs the Desk to execute open market operations—purchases and sales of securities, either outright or through repurchase agreements with primary dealers and the New York Fed’s other trading counterparties. These transactions affect the size and composition of the Federal Reserve’s balance sheet, which supports the FOMC’s monetary policy stance.

In addition, the FOMC at times issues forward guidance, or communications about the economic outlook and likely future course of monetary policy to shape market expectations about interest rates and financial conditions more broadly. Forward guidance is typically communicated through FOMC statements and policymaker remarks.

The FOMC announces the target range for the federal funds rate after each of the Committee’s eight meetings per year. The federal funds rate is the interest rate on transactions between banks and other eligible entities to borrow and lend their account balances at the Federal Reserve on an overnight, unsecured basis. These account balances, or reserve balances, are deposits held by eligible institutions for multiple reasons, including to meet payment obligations, manage their liquidity risk, and comply with associated regulatory ratios.

With an ample supply of reserves in the banking system, the Federal Reserve controls the federal funds rate primarily through the setting of administered rates, and active management of the supply of reserves is not required.

On a daily basis, the New York Fed publishes the Effective Federal Funds Rate (EFFR), which is calculated as a volume-weighted median of the previous business day’s overnight federal funds transactions.

The Federal Reserve sets two administered rates at levels to help keep the federal funds rate well within the target range and support smooth functioning of short-term funding markets. Together, these rates help establish a floor under overnight interest rates, including the EFFR, below which banks and other money market participants should not be willing to lend. Modest adjustments to these rates within the target range may occur to help support rate control, but they do not represent a change in policy stance.

• The rate of interest on reserve balances (IORB), set by the Board of Governors of the Federal Reserve System (Board of Governors), is the rate paid to banks and other eligible entities on their Federal Reserve account balances, or reserves. By raising or lowering the IORB rate, the Federal Reserve sets a floor under the rates at which banks are willing to lend excess cash in their reserve accounts at the Federal Reserve to private counterparties. Given the safety and convenience of holding reserves, banks have little incentive to lend their reserves to private-sector counterparties at rates lower than the IORB rate.
• The rate on the Overnight Reverse Repo Facility (ON RRP), set by the FOMC, is the interest rate the Federal Reserve pays on an ON RRP operation. The ON RRP facility, operated by the Desk, offers a broader range of money market participants an overnight investment that enhances their bargaining power on short-term private investment transactions. Participants include counterparties who are not eligible to earn the IORB rate (e.g., money market funds, government-sponsored enterprises). In general, counterparties to the facility should be unwilling to invest funds overnight in money markets at rates below the ON RRP rate.

Liquidity backstop tools play an important role in supporting the effective implementation of monetary policy by limiting the potential for pressures in overnight funding markets to push the EFFR above the FOMC’s target range.

• The discount window, operated at all 12 Reserve Banks, provides a backstop source of liquidity for banks and promotes financial stability. By providing access to temporary funding, the discount window assists banks in managing their liquidity risks and in turn helps support the flow of credit to households and businesses. Primary Credit is one of the key lending programs within the discount window. It is available to banks in generally sound financial condition and with eligible collateral pledged to a Reserve Bank. There are no restrictions on banks’ use of borrowed funds. The primary credit rate has been set at the top of the federal funds target range since March 2020.
• The Standing Repo Facility (SRF), operated by the Desk, serves as a backstop in domestic money markets to support smooth market functioning. The SRF, which is open to primary dealers and eligible depository institutions, is designed to limit the potential for pressures in the repo market from spilling over to the federal funds market. The SRF’s pricing is set to allow robust private market activity under most market conditions, while limiting upward pressure on overnight interest rates in stressed market conditions.
• The Foreign and International Monetary Authorities (FIMA) Repo Facility helps to address pressures in global dollar funding markets that could otherwise affect financial market conditions in the United States. Under this backstop facility, approved FIMA account holders can enter into overnight repo transactions with the Federal Reserve against Treasury securities held in their custody accounts at the New York Fed. The rate on the FIMA repo facility, like the SRF rate, is designed to generally be above market repo rates when markets are functioning well.
• Standing U.S. dollar and foreign currency liquidity swaps lines, operated by the Desk, with five other major central banks help to ease strains in global funding markets and mitigate the effects of such strains on the supply of credit to households and businesses worldwide. The U.S. dollar swap lines, which involve a temporary exchange of currencies between two central banks, provide foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions during times of market stress.

Changes in the size or composition of the balance sheet are an important part of the monetary policy implementation framework. At the direction of the FOMC and on behalf of the System Open Market Account (SOMA)—the Federal Reserve’s portfolio of securities—the Desk purchases securities in the open market.

There are different reasons that the FOMC may direct the Desk to conduct asset purchases.

• Reserves Management: Asset purchases in an ample reserves regime are used to maintain a level of reserves in the banking system to support interest rate control. The Federal Reserve closely monitors the level of reserves and other liabilities on its balance sheet. The Desk may offset decreases in reserves, such as those caused by the issuance of currency, through reserve management purchases. For example, during the last quarter of 2019 and first quarter of 2020, the FOMC directed the Desk to purchase securities to help maintain an ample supply of reserves in the banking system.
• Policy Accommodation: Asset purchases can be used to directly influence financial conditions, including further easing financial conditions when the policy rate is near zero. Such asset purchases put downward pressure on longer-term interest rates by reducing the stock of privately held debt. For example, in September 2020, the FOMC expanded its objective for asset purchases to include fostering accommodative financial conditions in response to the economic impact of the COVID-19 pandemic.
• Market Functioning: Asset purchases can be used to address severe disruptions to market functioning by easing balance sheet constraints of private market participants to restore two-way trading and more normal market functioning. For example, in March 2020, as COVID-19 disrupted financial markets, the FOMC directed the Desk to purchase Treasury securities and agency mortgage-backed securities at an unprecedented scale and speed to support smooth market functioning.

The FOMC may also direct the Desk to reduce the size of the balance sheet, which can tighten monetary policy. This includes limiting reinvestment of proceeds from maturing securities or selling securities. For example, starting in June 2022, the FOMC directed the Desk to begin allowing Treasury and agency mortgage-backed securities holdings to mature without reinvestment up to specified amounts, which guided the pace of balance reduction.

To support effective open market operations, the Desk lends eligible Treasury and agency debt securities owned by the Federal Reserve on an overnight basis. Also, to support its operational readiness to implement future directives from the FOMC, the Desk conducts very small purchases or sales of securities from time to time across a range of operation types. These operations do not represent a change in the stance of monetary policy.

The approach to controlling the federal funds rate changed during and after the Global Financial Crisis of 2008–2009 in a few key ways:

• Target range: In late 2008, when the federal funds rate approached zero for the first time, the FOMC set a range for the federal funds rate target—instead of a specific number. The range communicated the FOMC’s monetary policy stance.
• Balance sheet policies: Also starting in late 2008, the FOMC began to direct the Desk to make large-scale asset purchases to put downward pressure on long-term interest rates, support mortgage markets, and ease financial market conditions. These transactions sharply increased reserve balances and the size of the Federal Reserve’s balance sheet.
• IORB: In late 2008, under new Congressional authority, the Federal Reserve began to pay interest on reserves to keep the EFFR within its target range given the increased supply of reserves from balance sheet expansion. In connection with the reduction of reserve requirements to zero in March 2020, the Board of Governors introduced the IORB effective July 2021, which replaced the rate of interest on excess reserves and the rate of interest on required reserves.
• ON RRP facility: In 2014, the FOMC announced that it would use the ON RRP facility as needed to help control the federal funds rate. This facility works by reinforcing the floor on overnight interest rates, since not all money market participants can earn IORB.

Before the Global Financial Crisis, the Federal Reserve used a scarce reserves system to implement monetary policy. In this system, the FOMC achieved its federal funds rate target by directing the Desk to actively manage the supply of reserves in the banking system to meet the demand for reserves at the intended federal funds rate.

Unlike today’s framework for monetary policy implementation, the pre-crisis framework did not pay banks interest on their reserve balances. That incentivized banks to hold just enough reserves to meet their reserve requirements and avoid overdrafts. Under the pre-crisis framework, there was a relatively low aggregate level of reserves in the banking system, prompting banks to rely on borrowing and lending reserves in an active interbank federal funds market to meet their individual reserve needs.

The Desk would purchase and sell Treasury securities, on an outright basis or through repurchase and reverse repurchase agreements, to bring the supply of reserves in line with the estimated level needed for the EFFR to print close to the FOMC’s target. Small changes in the aggregate supply of reserves through market operations could cause meaningful changes in the level of rates in the federal funds market. Securities purchases added reserves to the system, putting downward pressure on short-term interest rates; securities sales drained reserves, putting upward pressure on short-term rates.