12.4 The Fed’s New Monetary Policy Tools

The Federal Reserve, the central bank of the United States, uses monetary policy to promote maximum employment and price stability. In the previous section we examined the traditional tools employed by the Federal Reserve during a period when there were limited reserves within the banking system.  New tools have become necessary now that banks hold large amounts of reserves. Since 2008 unconventional monetary policy tools have been needed to support the flow of credit to households and businesses.

In the previous section we learned how the Federal Reserve’s Federal Open Market Committee (FOMC) adjusts monetary policy to match economic conditions either buying or selling bonds to raise or lower its target range for the federal funds rate, the rate that banks charge each other for overnight loans. In 2008 the Federal Reserve began paying interest on excess reserves (IOER) to help steer the effective federal funds rate within a desired rate. In July 2020 the Federal Reserve created a single interest rate on both excess reserves (IOER) and required reserves (IORR) that is now call interest on reserve balances (IORB). The Federal Reserve now uses the IORB rate as its principal tool for guiding the federal funds rate within the target range.  

Prior to 2008 when there was no interest paid on reserve balances there was no incentive for banks to maintain excess reserves. this represented a period of limited reserves. During the time of limited reserves a small change in the supply of money would result in a significant change in the federal funds rate (FFR).  Open market purchases or sales of treasuries described in the previous section could move the money supply enough to impact interest rates and speed up or slow down the economy.

Once the Federal Reserve began paying interest on reserve balances depositing excess reserves at the Fed became a safe and attractive option for banks. This was particularly important coming out of the Great Recession when foreclosures were at an all time high, banks were reluctant to offer loans, and regulations on lending were becoming more strict.  The interest rate paid on reserve balances is an administered rate that is set directly by the Federal Reserve so it can be used as a tool, increased to encourage banks to hold more reserves or decreased to encourage banks to look at other options such as treasuries or loans.

Since 2008 the supply of reserves has grown and now intersects demand in the flat portion of the demand curve. This was the period of time when interest rates were already extremely low so any increase or decrease in the supply of reserves had little or no effect on the FFR.  This meant the traditional tools of monetary policy, open market operations, changing the discount rates, and adjusting the reserve requirement, were no longer having an impact on the economy.  This can happen when when an economy reaches a zero-bound interest rate, rates can not go below zero so there is no way to stimulate the economy.  Since moving the money supply to the left or the right will have no impact on the FFR the federal reserve as turned to the use of the administered interest rate on reserve balances as a tool to drive the FFR up or down.

Although banks have several short-term investment options for their money (Figure 4), the IORB rate offers them a safe overnight option. Because IORB makes cash deposited at the Fed a risk-free investment option, banks are unlikely to lend reserves in the federal funds market for less than the IORB rate. In other words, the IORB rate serves as a reservation rate for banks—the lowest rate that banks are likely willing to accept for lending out their funds. And, if the FFR were to fall very far below the IORB rate, banks would be likely to borrow in the federal funds market and deposit those reserves at the Fed, earning a profit on the difference. This is known as arbitrage, an important aspect of the way financial markets, and monetary policy, work. Arbitrage ensures that the FFR does not fall much below the IORB rate.

These financial incentives (i.e., the reservation rate and arbitrage) are such that when the Fed raises or lowers the IORB rate, the FFR also moves up or down. As such, the Federal Reserve can steer the FFR into the target range set by the FOMC by adjusting the IORB rate. And, because the Fed sets the IORB rate directly, IORB serves as an effective monetary policy tool. Currently, IORB is the primary tool used by the Fed for influencing the FFR. In March of 2022 the federal reserve increased the IORB from .15% to 0.40%, a total of 25 basis points, which in turn drove the FFR from 0.08% to 0.33%.  This was the first major step taken to fight inflation which had risen to a 40 year high of 7.9% in February 2022.

Temporary Open Market Operations

Open market operations conducted by the FOMC are a traditional tool explained in the previous section. Since 2014 the FOMC has directed the New York Fed to increase overnight bank reserves by purchasing securities from financial institutions through temporary open market operations. This move was taken because not all institutions with reserve accounts can earn interest on their deposits at the Federal Reserve and not all important institutions in financial markets are allowed to have an account at the Fed.

Overnight repurchase agreements, which is the technical name of these temporary open market operations, are either repurchase agreements (repos) or reverse repurchase agreements (reverse repos). Under a repo, the New York Fed buys a security today under an agreement to resell that security to the same seller tomorrow. This is a short-term collateralized loan by the Federal Reserve that increases reserves in the banking system. Under a reverse repo, the New York Fed sells a security today under an agreement to buy that security back from the purchaser tomorrow. This is short-term collateralized borrowing by the Federal Reserve that decreases reserves in the banking system. Both repos and reverse repos are temporary because their effect on bank reserves is reversed automatically without further action.

The Fed’s response to the COVID-19 pandemic was similar to its response to the Financial Crisis of 2007-09. With the ultimate goal of stimulating the economy, it lowered the FFR target range to 0 to 25 basis points; lowered the IORB and ON RRP rates to near zero; and took other, often unconventional, actions to help markets function, support credit flows to households and businesses, and lower longer-term interest rates.

Quantitative Easing or Large-Scale Asset Purchases

Another major change in monetary policy that began in late 2008, as the U.S. economy struggled with recession, was the Feds decision to adopt an innovative and nontraditional policy known as quantitative easing (QE) or large-scale asset purchase (LSAP). 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.  This additional tool was necessary since the Federal Reserve had already reduced the interest rate to near-zero and more traditional tools had become ineffective.

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. 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) has occurred in four 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.
4. On March 15, 2020, at the onset of the COVID-19 pandemic in the United States, a fourth LSAP program was announced. This program was expanded on March 23 with the addition of agency debt securities to the previously planned purchases of U.S. Treasury and mortgage-­backed securities.

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 but they appear to have permanently changed the asset portfolio held by the Federal Reserve. 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 that the process of quantitative easing may prove more difficult to reverse than it was to enact seems evident when examining the amount of Mortgage-Backed Securities still held in the federal reserve asset portfolio.

The strategy to manage monetary policy since 2008 has included employing new tools. Some of these, like the use of IORB, have permanently replaced previous tools. Other existing tools, such as temporary open market operations, are now used more frequently. Finally, unconventional tools, in the form of LSAP programs, have been used on four different occasions to support the flow of credit to households and businesses and promote the stability of the financial system itself.