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short essays and reports on the economic issues of the day
2003 ■ Number 18

Alternative Policy Weapons?
Daniel L. Thornton
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 distinction 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 essentially has been open market operations, i.e., buying and
selling government securities.
The federal funds market rate is the rate paid for balances 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 pressure 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 target unchanged,
some would say that monetary policy has not changed.
From the perspective of open market operations, 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 securities 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 continue to ease policy by buying government
securities. ■

The 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.)

Views expressed do not necessarily reflect official positions of the Federal Reserve System.