Federal Reserve Tools and How They Work

toolbox.jpg
The Fed has many tools to implement monetary policy. Photo: Howard Kingsnorth/Getty Images

The Fed funds rate is perhaps the most well-known Federal Reserve tool. But the U.S. central bank has many more monetary policy tools, and they all work together. 

Reserve Requirement

The reserve requirement refers to the amount of deposit that a bank must keep in reserve at a Federal Reserve branch bank. On December 30, 2010, it set at 10% of all bank liabilities over $58.8 million. The lower this requirement is, the more a bank can lend out.

It stimulates economic growth by putting more money into circulation. A high requirement is especially hard on small banks since they don't have as much to lend out in the first place. For that reason, there is no requirement for banks with liabilities under $10.7 million. The requirement is only 3% for liabilities between $10.7 million and $58.8 million.

The Fed rarely changes the reserve requirement. For one thing, it is very expensive for the banks to change their policies and procedures to conform to a new requirement. More important, adjusting the Fed funds rate achieves the same result with less disruption and cost.

Fed Funds Rate

If a bank doesn't have enough on hand to meet the reserve requirement, it will borrow from other banks. The Federal funds rate is the interest banks charge each other for these overnight loans. The amount lent and borrowed is known as the Fed funds. The Federal Open Market Committee (FOMC) targets a particular level for the Fed funds rate at its regularly scheduled meetings.

Here's the Current Fed Funds Rate.

Interest on Reserves

In 2008, the Fed agreed to pay interest on the reserve requirement and any excess reserves. It can now use this rate to change the Fed funds rate. Banks won't lend Fund funds for less than what they receive from the Fed for their reserves. (Source: "Why Did the Federal Reserve Agree to Pay Interest Rates on Reserve Balances?

" Federal Reserve Bank of San Francisco.)

Reverse Repos

In 2013, the Fed began to issue reverse repos to banks. The Fed "borrows" money from banks overnight. It pays them interest for this "loan." It uses its holdings of U.S. Treasuries as collateral. Like all repurchase agreements, banks don't record it as a loan. The interest it pays will support the Fed funds rate as the Fed gradually raises it.

Margin Requirements

On November 12, 2015, the world's central banks agreed to develop margin requirements in lockstep with the Fed. Any financial firm that lends money for investors to buy securities must require a percent, or margin, to be held back as collateral. For example, if a trader wants to borrow $100 for a day, the bank will require him to borrow $105. The extra five bucks is the margin. 

Bank lending for securities is a $4.4 trillion market. The margin would apply to loans for repos, stocks, bonds, and other risky securities. It would not apply to loans to purchase Treasuries or other safe securities. They make up two-thirds of the securities lending market.

The Fed has this authority from the 1934 Securities Exchange Act but hasn't used it since the 1970s. The Fed is reviving this power to reduce the kind of risk-taking exposed by the 2008 financial crisis.

Critics say it may also lessen the number of traders. That would increase price volatility if there aren't enough financial firms to help traders buy and sell in a market crash.  (Source: "Fed Eyes Old Rule to Bolster Oversight," WSJ, January 11, 2016.)

Open Market Operations

The open market operations tool is how the Fed makes sure banks lend at its targeted Fed funds rate. The Fed uses open market operations when it buys or sells securities, such as Treasury notes or mortgage-backed securities, from the member banks. Buying or selling securities is the same as removing or adding them to the open market. The Fed will buy securities from banks when it wants them to drop the Fed funds rate to meet its target. They will because they now have more money on hand and must lower rates to lend out all the extra capital.

When the Fed wants rates to rise, it does the opposite. It sells securities to banks, reducing their capital. Since there's less to lend, they can comfortably raise the Fed funds rate.

Discount Window

The Fed uses the discount window to lend money to banks at the Fed's discount rate to meet the reserve requirement. The Fed's discount rate is higher than the fed funds rate. Banks usually only use the discount window when they can't get overnight loans from other banks. For that reason, the Fed usually only uses this tool in an emergency. Examples include the Y2K scare, after 9/11 and the Great Recession. For more, see Financial Crisis Timeline.

Discount Rate

The discount rate is the rate that the Federal Reserve charges banks to borrow at its discount window. It is usually a percentage point above the Fed funds rate. That's because the Fed wants to discourage excessive borrowing.

Money Supply

The money supply is the total amount of currency held by the public, and is reported by the Fed weekly as:

  • M1, which is currency and check deposits
  • M2, which includes M1 plus money market funds, CDs and savings accounts.

The Fed increases the money supply by lowering the fed funds rate, which lowers the banks’ cost of maintaining reserve requirements. This gives them more money to loan, which gives consumers more money in their pockets.​

Fed's Alphabet Soup

The Fed created many new and innovative programs to combat the financial crisis. They were created quickly, so the names described exactly what they did in technical terms which may have made sense to bankers, but very few others.

The acronyms resulted in an alphabet soup of programs, such as MMIF, TAF, CPPF, ABCP, MMF Liquidity Facility. Although these tools worked well, they confused the general public, creating mistrust about the Fed's intentions and actions. Now that the Great Recession is over, these tools have been discontinued. Click on the hyperlink to learn more about them.