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The Fed’s Interest Rate Tools Thumbnail

The Fed’s Interest Rate Tools

The Federal Reserve (the Fed) is the central bank of the United States of America. Its primary objective is to ensure economic stability through monetary policy. Money supply, money demand, inflation, and unemployment all must be monitored, controlled, and adjusted by the Fed to instill economic balance within the US. 

Within the Fed’s arsenal of operations lay incredibly effective and interdependent tools that can be used to steer the economy in different directions. Wielded by the Federal Open Market Committee (FOMC), these tools carry varying implications aimed at addressing specific matters within the economy. The Fed’s job is managing the dual mandate, which entails achieving stable employment and low inflation. To accomplish this, the fed targets the Federal Funds Rate (FFR). The Federal Funds Rate is managed via Open Market Operations (OMOs), Interest on Reserve Balances (IORB), and Overnight Reverse Repurchase Agreement (ON RRP). The Interest on Reserve Balances and Overnight Reverse Repurchase Agreement establish the upper and lower bounds of the Federal Funds Rate floor. The Discount Rate (DR) establishes the Federal Funds Rate ceiling. The Discount Rate, Interest on Reserve Balances, and Overnight Reverse Repurchase Agreement are set directly by the Fed.   

The tools:

  • Open Market Operations (OMOs): Transactions of cash and treasuries between the Federal Reserve and large financial institutions. 
  • Federal Funds Rate (FFR): The interest rate at which depository institutions (banks) lend reserve balances to each other overnight. 
  • Discount Rate (DR): The interest rate the Fed uses on loans to depository institutions (banks). This rate acts as the “rate ceiling.”
  • Interest on Reserve Balances (IORB): The interest rate/yield extended to eligible depository institutions (banks) who hold reserves with the Fed. This rate acts as the ceiling of the “rate floor.” 
  • Overnight Reverse Repurchase Agreement (ON RRP): A transaction wherein the Fed sells securities to non-bank institutions with an agreement to buy them back in the near future at a set rate (the ON RRP rate).

The Fed communicates its stance on monetary policy by providing a target range for the Federal Funds Rate. To start, let’s examine the effects and implications of the Interest on Reserve Balances and Overnight Reverse Repurchase Agreement. Though mechanistically different, they both act as rate floors for reserves. The Interest on Reserve Balances is the interest rate the Fed pays banks on the reserves they hold at the Fed. This rate acts as a rate floor for banks as they are typically unwilling to lend their reserves at a lower rate than what they can earn risk-free from the Fed. 

The Overnight Reverse Repurchase Agreement provides a rate floor for non-bank institutions like money market funds, government-sponsored enterprises, and primary dealers (primary dealers are a select group of financial institutions that are authorized to trade government securities directly with the central bank). Logically, these institutions won’t lend their reserves at a rate lower than what the Overnight Reverse Repurchase Agreement provides. If institutions participate in the Overnight Reverse Repurchase Agreement market, they are buying treasuries with interest, whereas if banks deposit reserves at the Interest on Reserve Balances, they earn reserve interest. The Interest on Reserve Balances always provides higher yield than the Overnight Reverse Repurchase Agreement. In summary, these two tools guide the Federal Funds Rate by shaping incentive and setting guardrails, however, their implications vary from those of Open Market Operations. 

Working in a different but complementary way, exercising Open Market Operations also adjusts the Federal Funds Rate by draining or injecting cash into the banking system. If the Fed wants to drain cash from the banking system, it will issue new government securities or sell existing ones with attractive yields and prices to large financial institutions. When reserves decrease, the Federal Funds Rate is driven upwards as banks collectively agree to charge more for lending and pay more for liquidity. Conversely, if the fed wants to inject cash into the banking system, it will buy government securities from large financial institutions, freeing up reserves. With newfound cash in the banking system, banks collectively agree to charge less for lending and pay less for liquidity, driving the Federal Funds Rate downwards. 

Open Market Operations change the quantity of reserves, while Interest on Reserve Balances and Overnight Reverse Repurchase Agreement set the prices that anchor short-term interest rates. The two tools are interdependent because the level of reserves created or removed through Open Market Operations determines how sensitive the banking system is to the administered rates, and the administered rates determine how those reserves are priced in money markets. For example, when Open Market Operations provide ample reserves, institutions are not pressured to borrow, so the Federal Runds Rate naturally settles near the Interest on Reserve Balances and Overnight Reverse Repurchase Agreement. However, the Federal Funds Rate will not drop below the Interest on Reserve Balances and Overnight Reverse Repurchase Agreement (anchors) as institutions can always use these to earn returns. 

The federal Discount Rate fits into this framework as a rate ceiling, as it is the rate at which banks can borrow reserves directly from the Fed’s discount window. If market rates like the Federal Funds Rate rise too high, the Fed can lower the Discount Rate, so banks borrow there rather than spending more in the market. This acts as a price cap and prevents the Federal Funds Rate from spiraling too high. However, the Discount Rate is almost always set above the Federal Funds Rate to encourage banks to lend to each other rather than using the Fed. It is meant to act as a backup source of liquidity, not a routine funding channel. 

Combined, these tools are the foundation that enable monetary policy to function. They ensure the Fed can reliably influence interest rates, which means that spending, inflation, borrowing, and investment across the broader economy can be controlled. Without these tools, the Fed would be unable to steer conditions to the degree modern economies require. 


This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third-party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/  and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at info@avriowealth.com.