Daniel L. Thornton

English

Research Papers in Economics

August 2003
MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Alternative Policy
Weapons?
W
ith short-term interest rates at historic lows
and increased concern about deflation (not
disinflation, but deflation), many analysts have
expressed concern that the Fed will not be able to conduct
monetary policy if the federal funds rate—which the Fed
currently targets in the conduct of policy—falls to zero.
Others claim that the Fed has other weapons in its arsenal
that it could turn to in the event that the federal funds rate
drops to zero. One claim is that the Fed could conduct
monetary policy by buying government securities or other
assets instead of targeting the funds rate. There is a sense
in which this argument is correct and a sense in which it
is not. The point of this discussion is to make this distinc-
tion clear.
The Fed has used a variety of short-run operating
objectives over the years—free reserves, excess reserves,
nonborrowed reserves, and (since the mid-to-late 1980s)
the federal funds rate. While the operating objective has
changed, the primary tool for achieving the objective essen-
tially has been open market operations, i.e., buying and
selling government securities.
The federal funds market rate is the rate paid for bal-
ances held at the Fed by banks (and other institutions)
when those balances are traded. These balances are part
of the banking system’s reserves and are used to effect
payments and meet statutory reserve requirements. The
federal funds rate is determined by the supply of and
demand for these balances. The Fed influences the funds
rate by using open market operations to alter the supply
of reserve balances relative to demand. For example, if
the Fed wishes to reduce the funds rate, all other things
the same, it must increase the supply of reserves.1 Hence,
open market operations are not another weapon in the Fed’s
arsenal, but the only weapon in its arsenal.
There is a sense in which open market operations and
targeting the funds rate might be viewed as alternative
weapons, however. Consider the following example.
Assume that the Fed is targeting the funds rate and that
the market funds rate is currently at the target level. Now
assume that there is a decline in interest rates due, say, to
a drop in the demand for credit. This puts downward pres-
sure on the funds rate. If the Fed does not wish to change
its funds rate target, it must reduce the supply of reserves
by selling government securities. With the funds rate tar-
get unchanged, some would say that monetary policy has
not changed. From the perspective of open market opera-
tions, however, the Fed has tightened monetary policy.
Open market operations and the funds rate target need
not be viewed as alternative weapons even in this case,
however. Economists would generally argue that monetary
policy became tighter in the above example not only
because the Fed sold government securities, but because
it kept the funds rate above the level that it would have
moved to in the absence of these actions. According to
this view, monetary policy is tight (easy) when the Fed
attempts to keep the funds rate above (below) the level
that would exist in the absence of policy actions, which
might be called the equilibrium federal funds rate. From
this perspective, monetary policy can be viewed either in
terms of open market operations or the funds rate target
relative to the equilibrium level. In one case, the degree
to which monetary policy is tight or easy is measured by
the difference between the target and equilibrium funds
rates; in the other, it is measured by the magnitude of
open market operations. If the federal funds rate were to
reach zero, open market purchases of government securi-
ties would not cause the funds rate to fall further. Hence,
it would make no sense to characterize policy in terms of
the funds rate. Open market operations could continue to
serve as the policy tool, however, and the Fed could con-
tinue to ease policy by buying government securities.
—Daniel L. Thornton
1The Fed must change the supply of reserves even in cases where the funds rate
responds immediately to the announcement of a target change. (See Taylor,
John B. “Expectations, Open Market Operations, and Changes in the Federal
Funds Rate.” Federal Reserve Bank of St. Louis Review, July/August 2001,
83(4), pp. 33-47.)
Available on the web at research.stlouisfed.org
As of July 14, 2003, the St. Louis Adjusted Monetary Base and Reserve Series have been revised. For more information, visit
research.stlouisfed.org, click the “Monetary Aggregates” link in the “Economic Research” section of the left-hand column, and
scroll down to the “Federal Reserve Bank of St. Louis Monetary Base and Reserves” section.

Alternative policy weapons?

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Alternative policy weapons?

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