The Brave New World of Monetary Policy Operations

Prior to the Lehman failure in 2008, the Federal Reserve controlled the federal funds rate through open market operations that added to or subtracted from the excess reserves that banks held at the Fed. Because excess reserves typically were only a few billion dollars, the funds rate was very sensitive to small changes in the quantity of reserves in the system.

The Fed’s response to Lehman and its aftermath included large-scale asset purchases that led to a thousand-fold increase in excess reserves. Consequently, since 2008, small open-market operations of a few billion dollars no longer alter the federal funds rate. Instead, the Fed introduced administered rates to change its policy stance. The most important of these—the interest rate that the Fed now pays on excess reserves (IOER)—sets a floor below which banks will not lend to other counterparties (since an overnight loan to the Fed is the safest rate available).

Until very recently, the Fed’s ability to control the federal funds rate seemed well in hand….

The Fed's successful tightening

No one should be surprised that the Fed is tightening monetary policy and expects to tighten significantly further over coming years. Unemployment is less than 5 percent, consistent with normal use of resources. Inflation is approaching the FOMC’s 2 percent objective. And policy rates remain below what simple guides would suggest as normal.

A key issue facing policymakers today is whether the Fed’s new operational framework is working effectively to tighten financial conditions without creating unnecessary volatility. While the FOMC’s actions are occurring in a familiar macroeconomic environment, the legacy of the crisis makes raising rates anything but routine. The key difference is the size of the Fed’s balance sheet. Unlike past episodes, when commercial bank reserves were relatively scarce, today they are abundant.

This difference—reflecting a balance sheet that is over four times its pre-crisis level—creates technical challenges for the Fed. The traditional approach of using modest open-market operations (through repurchase agreements of a few billion dollars) to control the federal funds rate—became ineffective as reserves grew abundant. This meant developing an entirely new operational framework. The good news is that—up to now—the challenges of policy setting with abundant reserves have been very clearly met. While this may seem mundane, it is no small achievement. Much like plumbing, had the Fed’s new system failed, everyone would have noticed. At the same time, there are still challenges to face, so we’re not completely out of the woods....

How the Fed tightened

Back in August, we explained the mechanics of how the Fed can tighten policy in today’s world of abundant bank reserves. Now that the first policy tightening under the new framework is behind us, we can review how the Fed did it, if there were any surprises, and what trials still lie ahead.

So far, the new process has been extraordinarily smooth – a tribute to planning by the Federal Open Market Committee (FOMC) and to years of testing by the Market Desk of the Federal Reserve Bank of New York (FRBNY). But it’s still very early in the game, so uncertainties and challenges surely remain.

How the Fed will tighten

Before the financial crisis, tightening monetary policy was straightforward. The Federal Open Market Committee (FOMC) would announce a rise in the target for the federal funds rate in the overnight interbank lending market, and the open market desk would implement it with a small reduction in the quantity of reserves in the banking system.

Matters are no longer so simple. The unconventional policies designed first to avert a financial and economic collapse, and then to spur growth and employment, have left the banking system with reserves that are so abundant that it would be impossible to tighten policy in the conventional manner.

So, as the FOMC moves to "normalize" monetary policy after years of extraordinary accommodation, how, precisely, will the Fed tighten monetary policy? ...

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Money, Banking, and Financial Markets