Federal Reserve Tools | Past and Present

I think it's pretty obvious that the Fed has changed over the past decade, and the tools they used to use have changed as well. Previously, these are the tools that you will read in textbooks that the Federal Reserve used to dictate monetary policy.

1. Federal Funds Rate - Set a target to which short-term funding and lending is based off of.

2. Discount Window - Set a rate at which banks can borrow from the Fed, usually higher than market rates.

3. Open Market Operations - Buying and selling securities in the open market.

The discount window is now irrelevant and the other two have morphed their nature, and now we see the emergence of a new, very powerful policy tool of forward guidance. The new tools that should be written in textbooks are as follows:

1. Fed Funds Rate - Still the same as previously, but there is a difference. The Fed has been talking about implementing a fixed-rate, reverse repo facility in early 2014. What will this do? In the past Fed Funds rate have hovered around the Fed Funds target rate, recently much lower. What this will do is allow the Fed to reverse repo their balance sheet (essentially unlimited) at fixed rates on the market, essentially giving repo rates and essentially all short-term rates a floor. The bands around the target rate will be much lower.

2. Open Market Operations - Same as previously although the extent and magnitude they are currently used at was probably not expected when they put a trading desk on the 7th floor of the NY Fed. This is now an extremely powerful tool that can make the Fed the biggest market participant and affect not only domestic markets, but as we've seen recently ALL other markets as well.

3. Forward Guidance - Another way of looking at this is "Open Mouth Operations". This is actually the most powerful tool the Fed has currently judging by market reaction, specifically volatility. If the Fed says "rates will stay low till x" or "rates will stay low till x happens" the market reaction is incredible. They can use this many different ways now with their tools saying "we will buy x till x" or "we will use the repo facility till x" or vice versa. This has been the primary change recently in Fed tools and should be used a lot going forward. Other central banks have taken note, with the BOE and ECB both using forms of forward guidance in their recent statements. This will likely be the primary tool of central banks, because hell, you don't have to buy a damn thing as long as you convince the market of something. Just look at the ECB's OMT program, it hasn't spent a single euro but the market reaction to the announcement has been fantastic.

This is a new era of central banks, hopefully the next 10 years of the market will be less dictated by monetary policy than the previous 5 but who knows. All we know is the arsenal of tools is much more robust.