Traditionally, academic attention has focused on the ultimate objectives and strategic aspects of central bank policy. Questions such as whether the Fed should adopt an explicit inflation target have dominated the conversation. However, far less attention has been paid to the operating procedures and tactics used to implement that policy stance. This is a shame, because the choice of operational procedures can have profound implications for money and capital markets.
A key tool in the arsenal of central bank policy tools is changing the rate at which a central bank charges financial institutions for borrowing its reserves or other assets. This rate, known as the discount rate or repurchase rate, can affect other interest rates in the economy, notably the rates that banks charge their customers. It is also a key determinant of the quantity of funds that are available in the market.
Another important tool is the central bank’s ability to manipulate its own balance sheet. Starting in late 2008, the Fed made large-scale asset purchases to put downward pressure on long-term interest rates and ease financial market conditions. This expansion of reserve balances significantly lowered money market rates, but it also increased the size of the Federal Reserve’s balance sheet. The question is how much this additional liquidity benefits the broader economy in terms of achieving the Fed’s monetary policy goals of maximum employment and price stability.
Finally, central bank communications play a crucial role in establishing credibility and expectations about future monetary policy actions. For example, when the Federal Reserve delayed tightening in response to Y2K fears, it did so on the basis that it would only raise rates once inflation expectations were well-anchored and money market conditions were firm.