Redistributive policy

How the Federal Reserve’s Monetary Policy Implementation Framework Has Evolved

In a series of four articles, we review the key elements of the Federal Reserve’s monetary policy implementation framework. The framework has changed significantly over the past two decades. Prior to the global financial crisis, the Fed used a system of scarce reserves and adjusted the supply of reserves to maintain rate control. However, since then the Fed has operated in a floor system, where active reserve supply management no longer plays a role in controlling rates, but instead the Fed’s administered rates influence the fed funds rate. . In this first article, we discuss the main features of the implementation framework in a stylized way.

Before 2008, scarcity of reserves

Prior to October 2008, the Federal Open Market Committee (FOMC) communicated the direction of monetary policy by announcing a target for the federal funds rate. The Fed would then use open market operations to make small adjustments to the supply of reserves so that the effective federal funds rate (EFFR) would print near the target set by the FOMC. This type of enforcement regime that relies on the scarcity of supplies is often referred to as a corridor system (as explained in this article). As part of this, depository institutions, or banks, were encouraged to hold as few reserves as possible since they were not earning interest on the balances in their Fed accounts. The reserve balances the banks held in their Fed accounts was a very small amount, as can be seen in the following chart. The banking system operated with an overall scarcity of reserves and relied on the redistribution of reserves in an active interbank market.

After 2008, reserve of abundance

With the onset of the global financial crisis (GFC), the Fed introduced liquidity facilities and conducted large-scale asset purchases (LSAPs) to improve conditions in financial markets and stimulate the economy. While these actions primarily influenced conditions through lending and specific asset purchases, they also added a substantial amount of reserves to the banking system. As the graph below shows, at the beginning of 2009, the reserves of the banking system exceeded 800 billion dollars, compared to around 10 billion dollars before the crisis. Over the next several years, the FOMC continued to make asset purchases to promote a stronger economic recovery, and reserves continued to rise through the end of 2014.

Reserve balances have expanded significantly

Source: Federal Reserve Economic Data (FRED).

With the significant expansion of reserves in the banking system, rate control was difficult to achieve through the previous corridor system because reserves were no longer scarce (more details can be found in this report). Small changes in the supply of reserves no longer had an impact on the federal funds rate. Since October 1, 2008, Congress has given the Fed a new tool that can help control the federal funds rate in such circumstances: the authority to pay banks interest on reserves. We will refer to this tool as Interest on Reserve Balances (IORB) throughout the blog series, in line with a recent rule change. As shown in the graph below which illustrates the banking system’s demand curve for reserves, at large amounts of reserves the demand curve becomes flat around the IORB rate as it sets a floor below which banks should not don’t want to lend. In this new regime, the FOMC announces a target range for the fed funds rate, and the Fed uses the IORB, along with other tools we will discuss in future articles, to maintain the EFFR (denoted by the circle red in the graph) in the range. This type of implementation scheme is often referred to as a floor system.

Banking system reserve demand curve

Notes: The discount window rate is the interest rate charged to deposit-taking institutions on loans they receive from the discount window mechanism. The Overnight Reverse Repurchase Agreement Rate (ON RRP) is the maximum interest rate that the Federal Reserve is willing to pay to the ON RRP facility. IORB is interest on reserve balances. The effective federal funds rate (EFFR) is represented by the red circle, where the demand for reserves and the supply of reserves intersect.

Flow control by the floor system has proven to be very effective. The following graph shows the IORB rate and the EFFR between 2009 and 2021. During this period, the EFFR remained close to the IORB rate, showing that with the IORB (with the help of other implemented), the Fed has been able to maintain its control of the fed funds rate even when reserves are not scarce. Moreover, as expected in the floor systems, fluctuations in the supply of reserves did not lead to large fluctuations in the federal funds rate. After reviewing the experience, the FOMC announcement that it would continue to implement monetary policy within the current framework.

The EFFR remained close to the IORB rate

Sources: Federal Reserve Economic Data (FRED); authors’ calculations.
Notes: EFFR is the effective federal funds rate. IORB is interest on reserve balances. The shaded area represents the Federal Open Market Committee’s target range for the federal funds rate. Month-end observations are deleted.

Benefits of the new framework

A full review of the costs and benefits of the new framework is beyond the scope of this article. In this section, we review the key benefits of implementing the policy using the current framework.

First and foremost, as noted earlier, the framework has so far been very effective at keeping rates in check and has shown strong resilience to changes in both supply and demand for reserves. In addition to the key role of the IORB, other policy tools, such as Overnight Repo Transactions (ON RRP), Repurchase Transactions and Technical Rate Adjustments IORB and ON RRP, have also played an important role. We discuss these tools in more detail in our next three articles.

Second, the current framework is robust in environments where the Fed needs to expand its balance sheet to deal with shocks or economic downturns, which has the effect of significantly increasing the reserves of the banking system. This was a key advantage of the framework in 2008 and proved valuable again in March 2020, when the financial system was rocked by strains related to the coronavirus pandemic. Further, this framework allows the Fed to use LSAPs to provide accommodation during periods of zero declines without worrying about the need to restore scarcity of reserves before interest rates can be raised.

Finally, another noteworthy benefit is related to financial stability. The framework allows the Fed to provide more of the most liquid asset – reserves – to the banking system, making banks more resilient. Reserves are an important asset that banks must hold in their high-quality liquid asset buffers, mandated by Basel III regulations, to deal with unforeseen cash outflows and as part of their resolution and recovery plans. risk management. Indeed, unlike other assets, reserves do not need to be turned into cash, as they are already cash and can be used immediately to meet payment obligations (see this Economy of Liberty Street post for details).

Summary and future outlook

In this article, we have described how the Fed’s monetary policy implementation framework evolved from one that required scarcity of reserves to control interest rates to one that relied primarily on administered rates . Our description of the current system has been stylized and centered on the demand curve for banks’ reserves and the power to pay interest on reserve balances. However, the financial system in the United States is complex, and banks represent only one segment of financial market activity. Thus, the Fed uses additional tools to help support rate control in a system where nonbank institutions also affect the transmission of monetary policy. In the following three articles, we describe these tools in the context of the Fed’s floor system and discuss how adjustments to these tools keep rates in check.

Gara Afonso is Assistant Vice President of the Research and Statistics Group at the Federal Reserve Bank of New York.

Gara Afonso is Assistant Vice President of the Research and Statistics Group at the Federal Reserve Bank of New York.

Lori Logan

Lori Logan is Executive Vice President of the Bank’s Markets Group and System Open Market Account Manager for the Federal Open Market Committee.


Anthony Martin
is Senior Vice-President of the Bank’s Research and Statistics Group.

William Riordan is Assistant Vice President of the Bank's Markets Group

William Riordan is Assistant Vice President of the Bank’s Markets Group.

Patricia Zobel is vice-president of the Bank's Markets group.

Patricia Zobel is Vice President of the Bank’s Markets Group and Deputy Director of the System Open Market Account for the Federal Open Market Committee.


Warning
The opinions expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.