The term "
monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence economic activity (the
overall demand for goods and services) to help promote national economic goals. The
Federal Reserve Act of 1913 gave the Federal Reserve authority to set monetary policy in the United States. The Fed's mandate for monetary policy is commonly known as the dual mandate of promoting maximum employment and stable prices, the latter being interpreted as a stable inflation rate of 2 percent per year on average. The Fed's monetary policy influences economic activity by influencing the general level of
interest rates in the economy, which again via the
monetary transmission mechanism affects households' and firms' demand for goods and services and in turn employment and inflation. vs
Inflation vs
Inverted yield curve Interbank lending The Federal Reserve sets monetary policy by influencing the
federal funds rate, which is the rate of interbank lending of
reserve balances. The rate that banks charge each other for these loans is determined in the
interbank market, and the Federal Reserve influences this rate through the "tools" of monetary policy described in the
Tools section below. The federal funds rate is a short-term interest rate that the FOMC focuses on, which affects the longer-term interest rates throughout the economy. The Federal Reserve explained the implementation of its monetary policy in 2021: Changes in the target for the federal funds rate affect overall financial conditions through various channels, including subsequent changes in the market interest rates that commercial banks and other lenders charge on short-term and longer-term loans, and changes in
asset prices and in currency
exchange rates, which again affects
private consumption,
investment and
net export. By easening or tightening the stance of monetary policy, i.e. lowering or raising its target for the federal funds rate, the Fed can either spur or restrain growth in the overall US demand for goods and services. • Interest on reserve balances (IORB) • Interest paid on funds that banks hold in their reserve balance accounts at their Federal Reserve Bank. IORB is the primary tool for moving the federal funds rate within the target range. Helps put a ceiling on the FFR. The Federal Reserve System usually adjusts the federal funds rate target by 0.25% or 0.50% at a time.
Interest on reserve balances The interest on reserve balances (IORB) is the interest that the Fed pays on funds held by commercial banks in their reserve balance accounts at the individual Federal Reserve System banks. It is an administrated interest rate (i.e. set directly by the Fed as opposed to a
market interest rate which is determined by the forces of supply and demand). The Federal Reserve's objective for open market operations has varied over the years. During the 1980s, the focus gradually shifted toward attaining a specified level of the
federal funds rate (the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed), a process that was largely complete by the end of the decade. Until the
2008 financial crisis, the Fed used open market operations as its primary tool to adjust the supply of reserve balances in order to keep the federal funds rate around the Fed's target. This regime is also known as a limited reserves regime.
Discount window and discount rate The Federal Reserve System also directly sets the
discount rate, which is the interest rate for "discount window lending", overnight loans that member banks borrow directly from the Fed. This rate is generally set at a rate close to 100
basis points above the target federal funds rate. The idea is to encourage banks to seek alternative funding before using the "discount rate" option. The equivalent operation by the
European Central Bank is referred to as the "
marginal lending facility". Both the discount rate and the federal funds rate influence the
prime rate, which is usually about 3 percentage points higher than the federal funds rate.
Term Deposit facility The Term Deposit facility is a program through which the Federal Reserve Banks offer interest-bearing
term deposits to eligible institutions. It is intended to facilitate the implementation of monetary policy by providing a tool by which the Federal Reserve can manage the aggregate quantity of reserve balances held by depository institutions. Funds placed in term deposits are removed from the accounts of participating institutions for the life of the term deposit and thus drain reserve balances from the banking system. The program was announced December 9, 2009, and approved April 30, 2010, with an effective date of June 4, 2010. Fed Chair Ben S. Bernanke, testifying before the House Committee on Financial Services, stated that the Term Deposit Facility would be used to reverse the expansion of credit during the Great Recession, by drawing funds out of the money markets into the Federal Reserve Banks. It would therefore result in increased market interest rates, acting as a brake on economic activity and inflation. The Federal Reserve authorized up to five "small-value offerings" in 2010 as a pilot program. After three of the offering auctions were successfully completed, it was announced that small-value auctions would continue on an ongoing basis.
Quantitative easing (QE) policy A little-used tool of the Federal Reserve is the quantitative easing policy. Under that policy, the Federal Reserve buys back corporate bonds and mortgage backed securities held by banks or other financial institutions. This in effect puts money back into the financial institutions and allows them to make loans and conduct normal business. The bursting of the
United States housing bubble prompted the Fed to buy mortgage-backed securities for the first time in November 2008. Over six weeks, a total of $1.25 trillion were purchased in order to stabilize the housing market, about one-fifth of all U.S. government-backed mortgages.
Expired policy tools Reserve requirements An instrument of monetary policy adjustment historically employed by the Federal Reserve System was the fractional
reserve requirement, also known as the required reserve ratio. The required reserve ratio set the balance that the Federal Reserve System required a depository institution to hold in the Federal Reserve Banks. The required reserve ratio was set by the board of governors of the Federal Reserve System. The reserve requirements have changed over time and some history of these changes is published by the Federal Reserve. As a response to the
2008 financial crisis, the Federal Reserve started making interest payments on depository institutions' required and excess reserve balances. The payment of interest on excess reserves gave the central bank greater opportunity to address credit market conditions while maintaining the federal funds rate close to the target rate set by the FOMC. The reserve requirement did not play a significant role in the post-2008 interest-on-excess-reserves regime, and in March 2020, the reserve ratio was set to zero for all banks, which meant that no bank was required to hold any reserves, and hence the reserve requirement effectively ceased to exist, though the legal framework exists for it to be reinstated at any time.
Temporary policy tools during the 2008 financial crisis In order to address problems related to the
subprime mortgage crisis and
United States housing bubble, several new tools were created. The first new tool, called the
Term Auction Facility, was added on December 12, 2007. It was announced as a temporary tool, Creation of the second new tool, called the
Term Securities Lending Facility, was announced on March 11, 2008. The main difference between these two facilities was that the Term Auction Facility was used to inject cash into the banking system whereas the Term securities Lending Facility was used to inject
treasury securities into the banking system. Creation of the third tool, called the
Primary Dealer Credit Facility (PDCF), was announced on March 16, 2008. The PDCF was a fundamental change in Federal Reserve policy because it enabled the Fed to lend directly to
primary dealers, which was previously against Fed policy. The differences between these three facilities was described by the Federal Reserve: Some measures taken by the Federal Reserve to address the
2008 financial crisis had not been used since the
Great Depression.
Term auction facility The Term Auction Facility was a program in which the Federal Reserve auctioned term funds to depository institutions. The creation of this facility was announced by the Federal Reserve on December 12, 2007, and was done in conjunction with the
Bank of Canada, the
Bank of England, the
European Central Bank, and the
Swiss National Bank to address elevated pressures in short-term funding markets. The reason it was created was that banks were not lending funds to one another and banks in need of funds were refusing to go to the discount window. Banks were not lending money to each other because there was a fear that the loans would not be paid back. Banks refused to go to the discount window because it was usually associated with the stigma of bank failure. Under the Term Auction Facility, the identity of the banks in need of funds was protected in order to avoid the stigma of bank failure.
Foreign exchange swap lines with the
European Central Bank and
Swiss National Bank were opened so the banks in Europe could have access to
U.S. dollars.
Term securities lending facility The Term securities Lending Facility was a 28-day facility that offered Treasury general collateral to the Federal Reserve Bank of New York's primary dealers in exchange for other program-eligible collateral. It was intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. Like the Term Auction Facility, the TSLF was done in conjunction with the
Bank of Canada, the
Bank of England, the
European Central Bank, and the
Swiss National Bank. The resource allowed dealers to switch debt that was less liquid for U.S. government securities that were easily tradable. The currency swap lines with the
European Central Bank and
Swiss National Bank were increased. The TSLF was closed on February 1, 2010.
Primary dealer credit facility The Primary Dealer Credit Facility (PDCF) was an overnight loan facility that provided funding to primary dealers in exchange for a specified range of eligible collateral and was intended to foster the functioning of financial markets more generally.
Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility The Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (ABCPMMMFLF) was also called the AMLF. The Facility began operations on September 22, 2008, and was closed on February 1, 2010. All U.S. depository institutions, bank holding companies (parent companies or U.S. broker-dealer affiliates), or U.S. branches and agencies of foreign banks were eligible to borrow under this facility pursuant to the discretion of the FRBB. Collateral eligible for pledge under the Facility was required to meet the following criteria: • was purchased by Borrower on or after September 19, 2008, from a registered investment company that held itself out as a money market mutual fund; • was purchased by Borrower at the Fund's acquisition cost as adjusted for amortization of premium or accretion of discount on the ABCP through the date of its purchase by Borrower; • was rated at the time pledged to FRBB, not lower than A1, F1, or P1 by at least two major rating agencies or, if rated by only one major rating agency, the ABCP must have been rated within the top rating category by that agency; • was issued by an entity organized under the laws of the United States or a political subdivision thereof under a program that was in existence on September 18, 2008; and • had stated maturity that did not exceed 120 days if the Borrower was a bank or 270 days for non-bank Borrowers.
Commercial Paper Funding Facility On October 7, 2008, the Federal Reserve further expanded the collateral it would loan against to include commercial paper using the
Commercial Paper Funding Facility (CPFF). The action made the Fed a crucial source of credit for non-financial businesses in addition to commercial banks and investment firms. Fed officials said they would buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify. There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the market , according to the most recent data from the Fed. That was down from $1.70 trillion in the previous week. Since the summer of 2007, the market had shrunk from more than $2.2 trillion. This program lent out a total $738 billion before it was closed. Forty-five out of 81 of the companies participating in this program were foreign firms. Research shows that
Troubled Asset Relief Program (TARP) recipients were twice as likely to participate in the program than other commercial paper issuers who did not take advantage of the TARP bailout. The Fed incurred no losses from the CPFF. In response to the economic disruptions caused by the COVID-19 pandemic, the Federal Reserve reintroduced the Commercial Paper Funding Facility (CPFF) on March 17, 2020, to support the flow of credit to households and businesses by purchasing eligible commercial paper. The CPFF was modeled after the 2008 crisis-era facility and aimed to stabilize the commercial paper market. The facility ceased operations on March 31, 2021, and is not in place as of April 2025. The facility ceased issuing new loans in June 2010 and was fully wound down by 2015. As a significant tool during the 2008 financial crisis, TALF focused on ABS markets rather than direct banking system liquidity, distinguishing it from other crisis-era facilities. == History ==