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.
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.
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.
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.
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.