Paying Interest on Excess Reserves
The interest rate the Fed pays on excess reserves will be the one to watch once the Fed begins to raise borrowing costs.
By raising the rate it pays on bank reserves, the Fed creates a magnet for banks to keep those reserves with the Fed rather than lend them out.
"By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks," Fed Chairman Ben Bernanke told lawmakers on March 25.
A number of central banks around the world have effectively used similar tools.
Large-Scale Reverse Repurchase Agreements
The Fed could arrange large-scale reverse repurchase agreements (reverse repos), with financial market participants.
This would temporarily drain reserves from the banking system and reduce excess liquidity at other institutions.
This would be one way the Fed could tighten the linkage between interest on reserves and other short-term market interest rates, Bernanke said on July 21.
Reverse repos involve the sale by the Fed of securities from its portfolio with an agreement to buy them back at a slightly higher price at a later date.
Term Deposit Facility
The Fed began testing its new term deposit facility for banks in June, using auctions to offer term deposits for banks that are akin to the certificates of deposit banks offer retail customers.
On Sept. 8, the Fed said it expects to conduct term deposit facility auctions about every other month to ensure the tool is operationally ready when it is eventually needed.
Like the reverse repos, the auctions reduce the supply of funds banks have available to lend to each other. While the Fed already pays interest on reserves held overnight, a term deposit facility would lock up funds for longer.
Adjust Its Reinvestment Policy
The Fed could shift its approach to repayments of principal on the Treasury securities it holds to gradually normalize its balance sheet.
The Fed could reinvest the proceeds from maturing longer-term Treasury securities to shorter-term issues. This would reduce the average maturity of the Treasury holdings toward pre-crisis levels, while leaving the overall value of the holdings unchanged, Bernanke said in his July 21 testimony.
The Fed is currently reinvesting proceeds from maturing mortgage bonds into Treasuries to hold its balance sheet steady.