As detailed in the 1978 amendment to the Federal Reserve Act, the Fed's goals when setting monetary policy are "to promote maximum sustainable output and employment and to promote stable prices." Monetary policy has historically been implemented through three main methods:
• Raising or lowering the fed funds rate -- This is the Fed's preferred method. The fed funds rate is the interest rate charged to banks for overnight borrowing from banks with excess reserves. Lowering this rate makes it less expensive for banks to borrow money and loan it out, while raising the rate has the opposite effect. Typically made at Federal Open Market Committee Meetings (FOMC meetings), changes in the fed funds rate are widely reported and are viewed as a public signal of the Federal Reserve's monetary policy. While the fed funds rate applies to a relatively small volume of borrowed reserves, it has broader implications. Other interest rates typically change in response to changes in the fed funds rate.
• Purchasing or selling U.S. Treasury securities in the open market -- If the Fed wants to increase reserves at member banks so more funds are available to lend to customers, it purchases government securities in the open market, paying for the securities with a Federal Reserve check. Since this check is not issued by a commercial bank, the entire banking system has more funds available when the check is deposited in a commercial bank. To reduce the supply of funds, the Federal Reserve sells government securities.
• Changing reserve requirements -- Each bank is required to keep a certain percentage of deposits on hand, which cannot be loaned out. Changing the requirements allows the Fed to change the amount of money available on a large scale.
How Is the Fed Responding to the Current Situation?
During the current recession, the Fed has responded to the large increases in the unemployment rate by aggressively cutting the fed funds rate, lowering it from 5.25% to essentially zero. Over the past two decades, the Fed has set the fed funds rate by lowering it 1.3% when core inflation decreases by 1% and lowering it by close to 2% when the unemployment rate increases by 1% (Source: FRBSF Economic Letter, May 22, 2009). During 2007 and 2008, the Fed's reduction of the fed funds rate by 5.25% was in line with this formula. However, the situation has worsened in 2009, meaning the Fed would need to reduce the fed funds rate to negative 5% by the end of 2009 to follow this formula. Obviously, they can't reduce the rate below zero percent, so they have had to resort to other methods to stimulate the economy.
Based on economic forecasts of the Fed's FOMC, the fed funds rate should be near zero for several years. Due to the severe depth of the recession, it will take several years of significant growth for the economy to eliminate all slack. Although it has not said exactly how long it expects the fed funds rate to be near zero, the Fed has said that it "anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."
The Federal Reserve has also implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets, which has significantly increased the assets on the Fed's balance sheet. As of May 2009, the Fed's balance sheet has doubled in size to just over $2 trillion, with commitments for further increases by year-end (Source: FRBSF Economic Letter, May 2009).
The first set of tools, which are closely tied to the Fed's traditional role as lender of last resort, involves providing short-term liquidity to banks, other depository institutions, and other financial institutions. Because of the global nature of banks, the Fed has also approved bilateral currency swap agreements with 12 foreign central banks to help them provide dollar liquidity to banks in their jurisdictions.
A second set of tools provides liquidity directly to borrowers and investors in key credit markets. The Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility, the Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility fall in this category.
As a third set of instruments, the Fed has expanded its traditional tool of open market operations to support the functioning of the credit markets through the purchase of longer-term securities for the Federal Reserve's portfolio.
When credit markets and the economy begin to recover from the current financial crisis, the Fed will need to wind down some of its various lending programs and eliminate others. The Fed's balance sheet can be reduced relatively quickly, since a substantial portion of the assets are short term in nature and can simply mature. The Federal Reserve also holds significant quantities of longer-term assets, such as agency debt and mortgage-backed securities. Although these longer-term securities could be sold, the Fed will likely not dispose of more than a small portion in the near future. As the size of its balance sheet and the quantity of excess reserves in the banking system decline, the Fed should return to using the fed funds rate as its primary tool to implement monetary policy.