Monetary Policy Implementation

The Federal Reserve sets U.S. monetary policy in accordance with its mandate from Congress: to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.

The Federal Reserve achieves these goals by managing the level of short-term interest rates—specifically, by setting a target (or target range) for the federal funds rate, which is an overnight, unsecured, interbank borrowing rate. The level of short-term interest rates then influences the availability and cost of credit in the economy, and, ultimately, the economic decisions made by businesses and households.

The Federal Reserve has a variety of tools for implementing monetary policy. The Board of Governors of the Federal Reserve System (Board of Governors) is responsible for tools such as the discount rate, reserve requirements, and interest on reserves; and the Federal Open Market Committee (FOMC) is responsible for open market operations.

Since 1936, the FOMC has annually selected the New York Fed to execute transactions for the System Open Market Account (SOMA)—the largest asset on the Federal Reserve's balance sheet—and issued a directive to the New York Fed's Open Market Trading Desk (the Desk) to undertake open market operations. The Desk executes operations as authorized and directed by the FOMC to achieve specific objectives, such as the target federal funds rate or a size or composition for SOMA securities holdings. The FOMC selects a manager of the SOMA to report to the Committee on SOMA transactions and financial market conditions.

The FOMC's approach to implementing monetary policy has evolved over time.

Pre-Crisis Policy Implementation

Before the financial crisis, the FOMC achieved its federal funds rate target by directing the New York Fed to actively manage the supply of reserves in the banking system. The Desk purchased and sold Treasury securities outright or through repurchase and reverse repurchase agreements to bring the supply of reserves in the banking system in line with the estimated quantity of reserve balances demanded at the FOMC's target rate.

The Desk calibrated its open market operations on a daily basis based on estimates of various elements affecting the supply of and demand for reserves. Purchases of securities added reserves to the system, putting downward pressure on short-term interest rates, sales of securities drained reserves, putting upward pressure on short-term rates.

With this approach, there was a relatively low aggregate level of reserves in the banking system. Therefore, small variations in the aggregate supply of reserves could cause meaningful changes in the level of rates in the federal funds market. Each day banks traded reserves to meet their reserve requirements and avoid overdrafts, trying to neither incur the penalties associated with falling short nor bear the opportunity cost of holding excess reserves, which at that time did not earn interest.

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Policy Implementation During and After the Financial Crisis

The financial crisis prompted several important changes in monetary policy implementation. As part of its effort to counteract the economic effects of the crisis, the FOMC reduced its target for the federal funds rate in a number of steps from 5¼ percent in mid-2007 to a range of zero to ¼ percent in December 2008. With short-term interest rates effectively constrained at the zero lower bound, the FOMC shifted the focus of its monetary policy implementation directives to the SOMA portfolio. Changes in the size and composition of the portfolio allowed for further easing of monetary conditions.

Starting in late 2008, the FOMC began to direct the Desk to make large-scale purchases of longer-term assetsU.S. Treasury securities, agency mortgage-backed securities, and agency debt—to put downward pressure on longer-term interest rates, support mortgage markets, and make broader financial market conditions more accommodative.

Due both to this expansion of the SOMA portfolio and various temporary programs the Federal Reserve used to support the liquidity of financial institutions and foster improved conditions in the financial markets, reserve balances grew sharply during the financial crisis. The effective date of the statutory authorization of the Federal Reserve's ability to pay interest on reserves held by depository institutions, originally set for October 2011, was accelerated by Congress to October 2008. Given the increased supply of reserve balances, this additional tool helped keep short-term interest rates from falling below the FOMC's target range.

To address the sluggish recovery that followed the financial crisis, the FOMC directed further expansions of the SOMA portfolio. From 2008 through 2014, the FOMC directed three rounds of large-scale asset purchase programs—often referred to as quantitative easing—and a program to extend the maturity of its portfolio of Treasury securities. For all but a brief period, it maintained its sizable securities holdings by reinvesting principal payments received on securities held in the SOMA portfolio.

With short-term rates constrained by the zero lower bound, the FOMC also provided policy accommodation through forward guidance—communications about the future path of the federal funds rate—to shape market expectations for short-term interest rates.

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Policy Normalization

In 2014, the FOMC indicated that there would be two main components to monetary policy normalization: gradually raising the target range for the federal funds rate to more normal levels and gradually reducing the SOMA's securities holdings. The FOMC outlined its intended approach to these objectives in a statement of Policy Normalization Principles and Plans, initially published in September 2014 and periodically updated with additional details.

In December 2015, the FOMC raised its target range for the federal funds rate for the first time since the financial crisis and indicated that adjustments to short-term interest rates once again would be the primary tool for adjusting the stance of monetary policy. Yet with an abundant supply of reserve balances, implementation of monetary policy required a new operational approach, because small variations in the supply of reserves would no longer cause meaningful changes in the federal funds rate.

In September 2017, the FOMC announced its intention to begin normalizing the SOMA portfolio in October 2017, by gradually and predictably reducing its reinvestment of principal payments received from SOMA securities.

The framework developed to support monetary policy implementation with an abundant supply of reserves uses a system of rates administered directly by the Federal Reserve to influence the level of short-term interest rates without necessarily adjusting the supply of reserves. Specifically, the Federal Reserve uses the rate of interest on reserve balances held by depository institutions as its primary tool for keeping the federal funds rate in its target range. It supplements this tool, as necessary, by offering overnight reverse repos (through open market operations conducted by the New York Fed) at a specified offering rate to eligible money market funds, government-sponsored enterprises, banks, and primary dealers. These administered rates establish important investment options for a wide range of bank and non-bank participants in U.S. money markets. Encouraging competition, these instruments support interest rate control by setting a floor on rates, beneath which financial institutions with access to these facilities should be unwilling to lend funds.

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Additional Operations

To support the effective conduct of open market operations, the Desk lends eligible Treasury and agency debt securities held in the SOMA on an overnight basis. Also, in order to maintain its readiness to operate in any of the ways that the FOMC might direct in the future, the Desk conducts small value exercises from time to time across a range of operation types as a matter of prudent advance planning. These operations do not represent a change in the stance of monetary policy.

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