14.3: Administered Rates and the Fed's Monetary Policy Tools

Historically, textbooks focused on monetary policy through the lens of the money supply and open market operations. However, the 2007-2009 financial crisis transformed how the Federal Reserve operates.  

Open Market Operations 

Open market operations (OMOs) are one of the traditional tools used by the Federal Reserve to implement monetary policy. These operations involve the buying and selling of U.S. government securities—primarily Treasury bills—in the open market. By conducting these transactions, the Fed influences the amount of reserve balances that banks hold, which in turn affects short-term interest rates, particularly the federal funds rate. See figure 2. 

Figure 2

The federal funds rate is the interest rate at which depository institutions lend reserve balances to each other overnight. These reserves are held at the Federal Reserve and are used to meet regulatory requirements and settle interbank transactions. Although these are very short-term loans, the federal funds rate serves as a benchmark for many other interest rates in the economy. 

The Target Rate vs. the Effective Rate 

The Federal Open Market Committee (FOMC), which is the policymaking body of the Federal Reserve, does not set this rate directly. Instead, it announces a target range for the federal funds rate (known as the federal funds target rate). This target reflects the Fed's desired stance on monetary policy, whether it wants to ease, tighten, or maintain current economic conditions. The actual rate at which banks lend reserves to one another, however, is called the effective federal funds rate (EFFR). This is calculated as a volume-weighted average of overnight lending rates and can fluctuate daily in response to supply and demand in the market for reserves. 

The Fed aims to keep the effective federal funds rate within the announced target range. To do this, it intervenes in the federal funds market through open market operations. 

How the Fed Uses Open Market Operations 

If the effective rate drifts above the upper bound of the target range, this indicates that reserves are in relatively short supply. In response, the Fed conducts open market purchases by buying government securities from banks. When the Fed buys these securities, it pays for them by crediting the reserve accounts of the banks at the Federal Reserve. This increases the supply of reserves in the system, putting downward pressure on the federal funds rate. 

Conversely, if the effective rate falls below the lower bound of the target range, this suggests that there are too many reserves in the system. In this case, the Fed sells government securities. When banks purchase these securities, their reserve balances are reduced, tightening the supply of reserves and putting upward pressure on the interest rate. 

These operations are managed by the Open Market Desk at the Federal Reserve Bank of New York. Through these routine adjustments, the Fed seeks to align the effective federal funds rate with its policy target. 

New Tool 

Today, the Fed operates under an ample reserves regime, which allows it to influence short-term interest rates directly through an administered rate like the IORB, rather than by adjusting the quantity of money in the banking system. 

This means that the IORB, an administered rate set directly by the Fed, has become the primary tool of monetary policy. When the Federal Open Market Committee (FOMC) wants to tighten policy, it raises the IORB; to ease policy, it lowers it. These changes flow through the financial system and influence other interest rates. 

Figure 2 illustrates the transmission of a policy rate decision through to the use of its “new” tool, the IORB. 

Figure 2

Table 2 provides a side-by-side comparison of how the FOMC conducted monetary policy using open market operations prior to 2010 and how it currently conducts monetary policy under the ample reserves regime. 

Table 2: The FOMC's Policy Rate Decisions

Desired change in policy stance	FOMC policy rate decision	Policy implementation
Tighten	FOMC raises the target range for the federal funds rate	Fed raises its administered rates including the IORB rate
Ease	FOMC lowers the target range for the federal funds rate	Fed lowers its administered rates including the IORB rate
No change	FOMC leaves the target range for the federal funds rate unchanged	Fed leaves its administered rates unchanged

With reliance on the ample reserve approach to monetary policy, the fed funds rate is no longer the key interest rate. The fed funds rate moves when the IORB moves (in the same direction). See figure 3. 

Figure 3

Source: Federal Reserve Board, Form FR 2420, Report of Selected Money Market Rates.

Note: Federal funds rate is a weighted median. Shaded area is the target range for the federal funds rate. IORB is interest on reserve balances.