The New Tools of the Fed
How monetary policy has changed since the financial crisis.
This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org
This article is from the
March/April 2022 issue.
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In any introductory macroeconomics course in college or high school, you learn that the Federal Reserve Board (the central bank of the United States, commonly referred to as “the Fed”) uses monetary policy to carry out its dual mandate of promoting high employment and ensuring price stability. And you then recite the catechism that the Fed uses three tools of monetary policy—the reserve requirement, the discount rate, and open market operations—to expand or contract the money supply and lower or raise interest rates.
Much of that, however, was never true in practice. First, historically the Fed has put price stability, which favors employers and investors, ahead of promoting maximum employment, which would increase workers’ bargaining power and push up their wages. Second, for over a decade, the Fed has no longer used those three tools to conduct monetary policy, at least not in the way you might have learned about in a macroeconomics course. Those tools were unable to stabilize a failing financial system during the Great Recession of 2007–2009, or to reinvigorate the sluggish economy in the decade that followed, or to cope with the failing economy during the Covid-19 pandemic during this decade.
During the Great Recession, the Fed turned to a new tool: the interest rate the Fed pays on the reserves (read: money) that commercial banks deposit at the Fed. And with its new tool and repurposed old tools, the Fed was freed up to turn the liquidity spigot to full blast to stabilize a financial sector that is increasingly plagued by crises. Even the Fed now recognizes the financial sector’s dominance of today’s economy—aka “financialization.” The Fed’s statement on monetary policy strategy, adopted in January 2012 and reaffirmed this January, reads that, “achieving maximum employment and price stability depends on a stable financial system,” thus making maintaining financial stability effectively a third mandate of the Fed.
Unless you subscribe to Federal Reserve publications, this is all probably news to you. So, let’s take a closer look at what happened to the Fed’s old tools, how the Fed puts its new tool to work, and how the Fed’s policies prop up today’s economy, which is marred by financial excesses and ever-worsening wealth inequality.
Out with the Old
A Federal Reserve Policy Glossary
- Bonds are promissory notes issued by both private entities, such as corporations, and governments, to raise money. The face or par value of a bond is the amount that will be paid to the holder of the bond at maturity, the date when the issuer must repay.
- Commercial banks, what most people think of when they hear the word “bank,” accept deposits and make loans; they safeguard assets deposited with them because they are backed up by the Federal Deposit Insurance Corporation (FDIC). There are also investment banks, which buy and sell stocks, bonds, and other assets. Investment banks are not subject to the tools of the Fed. Nevertheless, the fed helped to rescue some of the largest investment banks during the financial crisis of 2007–2008. There are some very large financial entities that do both commercial and investment banking, e.g., JPMorgan Chase and Bank of America.
- Reserve balances are the deposits that a commercial bank holds in its account at the Fed held in its regional Federal Reserve Bank.
- Reserve requirements were the deposits that the Fed required a commercial bank to hold at the Fed. “Were,” because this requirement was reduced, and then eliminated, after the 2008 financial crisis and the shift to what the Fed now calls an “ample reserve regime.”
- Interest on reserve balances (IORB) is the primary tool the Fed now uses to influence market interest rates, such as the deposit and loan rates that commercial banks offer their customers and in turn the spending and savings decisions of households and businesses. The resulting financial market rates influence price levels and employment demands in the economy, the two traditional mandates of the Fed.
- The Fed funds rate is the interest rate on overnight loans of reserve balances between banks. Since the IORB is a risk-free rate, banks will not accept any lower rate on a loan and the Fed funds rate will be above the IORB. The Fed sets and alters the IORB to target a range for the Fed funds rate.
- Open market operations are the buying and selling of securities, such as Treasury bonds (aka treasuries), to influence the supply of money in the economy and thus the level of interest rates. However, under the ample reserve regime, open market operations may be insufficient to influence rates. Thus, the increased reliance on the IORB.
- Quantitative easing or balance sheet policy is a policy tool the Fed now uses to supplement or even in place of traditional open market operations. Quantitative easing was the large-scale purchase of a broad range of assets to place downward pressure on long term interest rates with the goal of pushing the economy out of the deep recession caused by the financial crisis of 2007–2008.
—Bill Barclay
So, what did happen to the Fed’s old tools? The short answer is that one was abandoned, another was repurposed, and a third was given a new job.
The Fed no longer uses the reserve requirement. The reserve requirement determines the proportion of their deposits that commercial banks need to hold in reserve (either in their vaults or in the vaults of the Fed). An increase or decrease in the reserve requirement directly affected how much money commercial banks could lend to their customers. But from 1992 to 2020 the reserve requirement on large deposits never varied from 10%, other than to change the size of the large deposits subject to the 10% reserve requirement rate. Then on March 2, 2020, with the onset of the pandemic-induced shutdown of the economy, the Fed reduced the reserve requirement to zero. For now, the Fed has no plans to reimpose the reserve requirement.
The Fed still uses the discount rate, the interest rate that the Fed charges on its loans to commercial banks, but not in the same way as it did before. The Fed raises or lowers the discount rate in reaction to large swings in the economy. For instance, with the onset of the financial crisis of 2007–2008, the Fed repeatedly cut the discount rate to allow banks to borrow more easily. The discount rate then remained at 0.75% from 2010 to 2016, before the Fed gradually increased the rate to 2.25% as the economic expansion of the last decade continued. When the Covid-19 pandemic shut down the economy in 2020, the Fed cut the discount rate by two full percentage points to 0.25%. That’s still the current discount rate. But now the discount rate sets the upper bound of the short-term interest rate the Fed administers with its new tool, its interest rate on reserve balances. (More on how that works below.)
Open market operations, the Fed buying and selling securities, are still an important tool for the Fed. But open market operations perform a far different function than they had prior to the 2007–2008 financial crisis. Before that crisis, the Fed had used open market operations to adjust short-term interest rates, specifically the interest rate on overnight loans among banks called the “Fed funds rate.” By buying short-term bonds, the Fed put downward pressure on the Fed funds rate. The Fed selling bonds then put upward pressure on the Fed funds rate.
The financial crisis and the Great Recession dramatically changed how the Fed uses open market operations. Despite the Fed having pushed the Fed funds rate down to nearly zero (0.15%), long-term interest rates failed to drop, borrowing and spending failed to pick up, and the recession dragged on. Unable to further lower the Fed funds rate, the Fed turned to purchasing long-term bonds (such as 10-year Treasury bonds) on an unprecedented scale. Those large-scale bond purchases, the Viagra the Fed prescribed for its impotent monetary policy, came to be known as quantitative easing. The goal of the Fed’s action was to lower long-term interest rates, making business and mortgage borrowing cheaper, and thereby encourage investment and consumption. The Fed’s program of large-scale bond purchases continued even after the Great Recession ended. By 2013, the asset holdings of the Fed had increased to $3 trillion, a more than threefold increase from its asset holdings at the end of 2008. After the Fed’s large-scale bond purchases flooded the banking system with reserves, the much smaller bond purchases of traditional open market operations were no longer able to move short-term interest rates. Since then, open market operations have been devoted to large-scale bond purchases, or quantitative easing, intended to affect long-term interest rates and to shore up the financial markets.
In with the New
When the Covid-19 pandemic crippled the U.S. economy, the Fed went on another bond-buying binge. After initially cutting short-term interest rates to nearly zero in March 2020, the Fed upped its long-term bond purchases yet again. With those purchases the Fed’s asset holdings ballooned, reaching $8.76 trillion by December 29, 2021, more than double its March 2020 holdings.
The Fed bought Treasury bonds, which went to finance the federal budget deficit, and mortgage-backed securities (securities that packaged together different mortgages and were at the heart of the financial crisis a decade earlier) from commercial banks and bonds dealers. By buying mortgage-backed securities, the Fed took billions of dollars of toxic assets off of the balance sheets of banks, which made them less likely to fail—just as the Fed had done during the financial crisis. Their purchases pushed up bank reserves, the money banks had on hand or on deposit at the Fed, to unprecedented levels. For instance, when the Fed bought securities from commercial banks, its payments were deposited in the bank, increasing the bank’s reserves. If the Fed bought securities from non-bank bond dealers, the bond dealers deposited the Fed’s payments in their affiliated commercial bank, also adding to the bank’s reserves.
Today banks are awash in an ocean of cash. In Fed speak, bank reserves are no longer “limited” but “ample.” Compared to their level before the financial crisis, bank reserves surely are abundant. Total bank reserves at the end of 2007 were just $14.9 billion. At that time a 10% reserve requirement was in place to ensure that banks had an adequate level of those limited reserves on hand. By August 2019 bank reserves were $1.52 trillion, more than 100 times larger. And by the end of 2021, bank reserves had more than doubled again to $4.18 trillion. And with those ample reserves there is no longer a reserve requirement. When added together, those reserves (the largest liability on the Fed’s balance sheet) along with currency, Treasury deposits at the Fed, and other liabilities, match the total assets held by the Fed.
Ample Reserves and the Interest Rate on Reserve Balances
Commercial banks typically put their ample reserves to use in one of two ways. The banks could lend out their reserves from the Fed’s bond purchases to their usual customers at the prevailing interest rate, much as they had in the past. Or the banks could hold on to those reserves, although they are no longer compelled to do so since the reserve requirement is currently zero. But when the Fed began paying interest rates on reserve balances in December 2008 during the financial crisis, depositing reserves at the Fed became a more attractive option. For banks, this increased the opportunity cost of lending out their reserves—the potential loss from forgoing another opportunity, in this case the interest deposits at the Fed. In addition, the Fed’s policy lowered the interest rate banks could earn from making loans. Those changes tilted banks’ calculations toward holding more reserves. Finally, as bank reserves grew from limited to ample reserves, the interest rate on reserve balances became the Fed’s most important tool for conducting monetary policy.
Today, the Fed uses the interest rate on reserve balances this way. When the Fed lowers its interest rate on reserve balances, commercial banks deposit fewer reserves at the Fed and use more reserves to make loans to their customers, increasing the amount of money in circulation and lowering interest rates. The Fed raising the interest rate on reserves balances would have just the opposite effect: Banks would increase their deposits at the Fed and have less money to lend to customers, reducing the amount of money in circulation and pushing up interest rates.
The Fed’s discount rate and the interest rate on reserve balances together establish a range for the Fed funds rate. The interest rate on reserve balances acts as the floor for the Fed funds rate. Any bank lending out money, even overnight, would insist on earning an interest rate higher than it would get from leaving its reserve balances parked in the vaults of the Fed. The discount rate acts as the ceiling for the Fed funds rate. No bank would take out a loan from another bank with a higher interest rate than the discount rate, the interest rate it would pay to borrow from the Fed. Also, the Fed’s interest rate on reserve balances must always be lower than the discount rate. If not, banks would borrow money from the Fed and deposit it at the Fed, earning more interest than the Fed had charged them to borrow the money.
Before the pandemic, the Fed’s interest rate on reserve balances had reached 2.4%. At the onset of the pandemic crisis, the Fed cut interest rates on reserves to nearly zero (0.10%). During January of 2022, the Fed’s interest rate on reserve balances was 0.15% and the discount rate was 0.25%, setting the floor and the ceiling for their target short-term interest rate. The effective Fed funds rate, however, was just 0.10%, below the floor set by the Fed’s interest rate on reserve balances. That’s because several large non-bank financial institutions are eligible to lend money on the Fed funds market but are not eligible to earn interest on reserves deposited at the Fed. (Those include government sponsored enterprises such as Freddie Mac and Fannie Mae, which buy mortgages to provide liquidity for the mortgage market.) Unable to earn the interest on their reserves, they were willing to lend out their reserves at a rate lower than the floor.
One Fed insider, William C. (“Bill”) Dudley, former president of the New York Fed, now regards the Fed funds rate as a relic of the old system, which the Fed should abandon as an interest rate target. Instead, Dudley would have the Fed “set monetary policy using the interest rate on reserves,” a rate it controls directly.
Quantitative Easing, Wealth Inequality, and the Pandemic
The Fed’s quantitative easing bonds-buying spree during the pandemic recession and its aftermath drove up the prices of Treasury bonds and mortgage-backed securities. That made buying bonds a less profitable investment. Bond investors make money by making loans. They purchase bonds, which are promissory notes issued typically by entities—corporations or the Treasury—wanting to borrow large sums of money. But for the bond investors to turn a profit, the price they pay for the bond must be lower than the face value of the bond, the amount the issuer of the bond pays them when the bond reaches maturity. For example, if the price of a one-year $1,000 bond was $900, the bond buyer would make $100, or a rate of return of 11.1% at the end of the year. If the price of the bond increased from $900 to $950, the bond buyer would make just $50, and the rate of return on the bond would fall to 5.3%.
The rate of return on bonds is the definition of the interest rate. By purchasing bonds, especially large quantities of bonds, the Fed increases the demand for bonds, drives up their price, and lowers their rate of return—i.e., the interest rate. Also, from the onset of the pandemic in March 2020 through July 2021, the Fed bought about $2.3 trillion in Treasury securities, which went a long way toward financing the budget deficit the federal government ran up while fighting the pandemic and the economic downturn.
At the same time, the Fed’s massive bond buying made investing in the stock market attractive and shored up the financial sector. With lower rates of return on bonds, the chief alternative investment outlet to the stock market, and few other profitable investments available in a tanking economy, money poured into the stock market. On top of that, the Fed’s purchases of corporate bonds saved corporations billions in borrowing costs and protected them from bankruptcy, making their stock a better investment. Lower interest rates also made it easier to borrow money to buy stocks, further fueling the demand for stocks.
Stock prices soared. Six months after losing one-third of their value, stock prices were back to their pre-pandemic levels and by the end of 2021 they were yet another 40% higher (as measured by the Standard and Poor’s 500 Stock Price Index).
And inequality worsened. Rising stock prices benefited the wealthy. The richest 1% of households alone own two-fifths of stocks by value, while one-half of U.S. households own no stocks (see Ed Ford, “Concentration of Stock Ownership,” Dollars & Sense, January/February 2022).
In sum, the Fed’s large-scale quantitative easing program provided the liquidity needed to staunch the volatility of the financial markets, to finance much of the federal government’s pandemic spending, and to keep down the cost of borrowing for corporations, stock investors, and home buyers. Unsurprisingly, the recovery that followed bestowed its benefits overwhelmingly on the well-to-do.
Nonetheless, the solution to bringing about sustained economic growth that spreads its benefits widely is not to have the Fed tighten the monetary spigot because of the Fed-induced stock market boom. Monetary austerity would slow the economy and cost working people their jobs. What’s needed instead is to tax the wealth gains of those who have benefitted so handsomely during the stock market boom. And those tax revenues need to go to public spending that will do as much to make economic growth more equitable and sustainable as Fed policy has done to ensure the stability and profitability of the financial sector.
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