What the Fed Can Do to Tighten the Money Supply

The U.S. Federal Reserve Wednesday said it would conduct further term deposit facility auctions to prepare for an eventual exit from its ultra-easy monetary policy.

The Fed's announcement, which it said had no implications for current monetary policy, comes when markets are focused on whether the Fed—the U.S. central bank—will have to ease more to support a weakening recovery.

Below are some of the tools the Fed has at its disposal for eventually tightening monetary policy.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

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.

Asset Sales

The Fed could sell a portion of its securities holdings into the open market.

Bernanke said on July 21 that members of the Fed's policy-setting committee agree that sales of agency-related securities should eventually be used to normalize the Fed's holdings.

Bernanke said sales would be communicated well in advance and be conducted gradually.

Discount Rate Increase

The Fed in February raised the discount rate—the rate it charges banks for emergency loans—to 0.75 percent from 0.5 percent, saying the move reflected healing financial markets and was not a step to tighten lending conditions.

Ahead of the Fed's last policy-setting meeting on Aug. 10, two regional Federal Reserve banks, Kansas Cityand Dallas, pushed again for a modest increase in the discount rate. The Fed board, which acts on discount rate requests, declined to back the proposal.